S&P Global Credit Portal: Europe's insurers welcome EIOPA's assessment on long-term guarantees, but Solvency II uncertainty remains

31 July 2013

EIOPA's recent assessment of the potential effect of Solvency II regulation on LTGs on life insurance products is a welcome step towards the finalisation of the new solvency regime. But S&P believes numerous hurdles remain, leaving even a planned 2016 implementation of Solvency II far from certain.

Solvency II's design is founded on market-consistent principles. As the past five years have illustrated, market-based indicators (such as credit spreads) can periodically over- or under-state underlying economic risk. This need not be problematic for insurers with a close matching of assets and liabilities. However, in much of Europe there is a dearth of investments with sufficient duration to match very long-term life insurance liabilities. Furthermore, many of these liabilities include insurance policies with high levels of guarantee, giving rise to significant reinvestment risk. With interest rates currently at low levels, this is an economic risk that insurers are having to address. In addition, S&P considesr that some of Solvency II's design features--the use of credit-spread volatility as a basis for credit-risk capital requirements, for example--may actually amplify market volatility.

Life insurers' main concern is that the design does not sufficiently recognise the industry's demonstrated willingness and ability to hold bonds to maturity. The proposed "classical" matching adjustment goes some way toward this for products that have strict asset liability management, no lapse risk, and therefore minimal risk of forced asset realisation. The insurance industry sought to extend this principle more broadly with an extended matching adjustment, which has been rejected by EIOPA. While Ś&P acknowledges the merits for such an adjustment, S&P recognises that it would have added a layer of complexity to an already complex design.

In its overall package of proposals, EIOPA has sought to offset heightened volatility with new transitional measures and extended recovery periods. However, the mitigating effect of the package will be made fully transparent in detailed public domain regulatory returns. This may be problematic, in S&P’sview, unless the coverage of the Solvency Capital Requirement (SCR) at 100 per cent is communicated consistently by national supervisors as a target rather than a minimum, and is understood as such by investors, intermediaries, and policyholders. The problems for insurers may manifest themselves in higher risk aversion generally, and pro-cyclical behaviour in the midst of volatility.

As part of the assessment, EIOPA considered five measures, the appropriateness and effectiveness of which were tested under 13 scenarios. Some 427 European insurers, representing 59 per cent of the life industry and 25 per cent of the non-life industry, provided data.

Below is a high-level overview of the package of measures proposed by EIOPA:

• Volatility balancer (VB)
  • This replaces the Counter Cyclical Premium (CCP) previously proposed. The VB will lead to an adjustment to the discount rate when credit spreads expand beyond the increase in default risk. The key advantage of the VB is that it will be formulaic and automatic, allowing insurers to incorporate it into their capital management process. This would address a major criticism that the wider industry had of the CCP, since its use was to be triggered at EIOPA's discretion. Also, the VB design allows for national adjustments, in addition to currency adjustments, to take account of country-specific financial crises. However, only 20 per cent of the relevant spread is added to the discount rate because this produced similar outcomes to the CCP. If the VB makes it into the finalised version of Solvency II, insurers will want to see this proportion increased as a result of political negotiations.

• Matching adjustments
  • The "classical" matching adjustment (CMA) operates through an increase of the discount rate of a portfolio of liabilities, which satisfy certain requirements. In particular, it requires liabilities to be closely matched to a ring-fenced portfolio of assets. EIOPA's recommendation is to apply CMA only to highly predictable insurance liabilities. In order to avoid providing an incentive for companies to seek exposure to illiquid or higher credit risk assets, the Authority recommends certain limits (including a 33 per cent limit on 'BBB' rated corporate bonds and none lower than 'BBB'), which insurers feel are too constraining. EIOPA tested, but did not support, the introduction of the Extended Matching Adjustment (EMA). The EMA had fewer restrictions than the CMA and would have been applicable to a wider group of insurance liabilities that are exposed to lapse and material mortality risks.
  • EIOPA recognises that a major stumbling block for the CMA is the potential for insurers to "fall off a cliff" following a credit downturn, when their lower credit quality portfolios may no longer qualify them to use the CMA. The disqualification of the CMA might then lead to a significant reduction in solvency ratios that would compound volatility. We believe insurers would likely seek to avoid that risk by positioning matching asset portfolios very conservatively.

• Extrapolation
  • Because of the shortage of investments for matching liabilities beyond a certain duration, EIOPA proposes the use of extrapolation. The Authority recommends the use of a long (say, 40 years) extrapolation period between the last liquid point--20 years for the euro--and an "ultimate forward rate" set at 4.2 per cent. It considers that long extrapolation periods are more aligned with market-consistent principles and provide less volatile SCR coverage ratios compared with 10-year extrapolation periods. However, we believe this is likely to lead to higher liabilities in the current environment because discount rates for longer durations will be lower. One of the industry's main criticisms of this approach is that it ignores any market information beyond the last liquid point.

• Increased recovery period
  • For insurers with long-term liabilities (that is, more than 12 years), EIOPA recommends an extension of the recovery period to seven years following any decline in an insurer's SCR coverage to less than 100 per cent during a financial crisis. (The standard recovery period can be up to 30 months.) The aim of this measure is to help insurers to deal with the difficulties of managing long-term business by affording them more time to take the necessary remedial actions. EIOPA recognises there is a risk that this may see insurers purposefully delaying the implementation of these actions. Therefore, the close supervision of insurers (by their respective national supervisors) during this extended period will be critical, in S&P’s view.

• Transitional measures
  • EIOPA proposes to use a discount rate that moves from a Solvency I basis to a Solvency II basis over a period of seven years. The reason for this is to give insurers more time to adapt to operating on a market-consistent basis. S&P’smain concern here is similar to that over the increase in the recovery period; it may lead to insurers delaying taking the necessary risk management actions. Also, EIOPA acknowledges that the transitional measures present major application challenges, in particular due to the need to calculate two full Solvency II balance sheets. However, EIOPA's proposal also offers a simplified approach.

As a whole, S&P views positively that the proposed package is not a departure from general economic principles. However, S&P recognises that these measures may throw up significant challenges for some insurers' existing business models. These insurers may need to make considerable changes to their product design, pricing, investment, and capital management once Solvency II regulations are finalised. S&P deems it appropriate that some of the recommended measures will provide insurers with more time to take necessary actions to deal with the complexities of managing long-term business. However, S&P will view negatively those insurers who use the extra time to delay taking actions that are economically justified.

S&P expects politicians to be pragmatic when finalising the design of Solvency II. Against an economic growth agenda, we expect them to further mitigate threats to the pricing and availability of traditional life insurance products and consequent threats to insurers' ability to continue long-term investing. This may come about naturally through further delays in implementation, broader transitional rules, longer transition and recovery periods, or through other means. Solvency II is far from a done deal.

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