What’s new in the Solvency II review
We summarise the key points from the European Commission’s recently published review package and the implications for insurance investors.
The European Insurance and Occupational Pensions Authority (EIOPA) kickstarted the review of Solvency II in 2019 and led multiple impact assessment studies over the course of 2020. The publication at the end of 2020 summarised the key recommendations to review the legislation, referencing the impact studies from year-end 2019 and mid 2020.
On 22 September 2021, the European Commission (EC) published a “review package” that did not accept many of the EIOPA recommendations – focusing mostly on the role that insurers could play in the economic recovery. The next step is for the European Parliament and the member states in the Council to negotiate the final legislative texts on the basis of the EC’s proposals.
The EC estimates that up to EUR 90 billion of capital could be released in the short term at the EU level. That number could be EUR 30 billion in the long term as the more capital intensive changes will be phased in over the next 5 to 10 years, assuming the economic conditions of end 2019, or over EUR 16 billion assuming the economic conditions of mid 2020. These figures represent the increase in capital resources in excess of capital requirement. For perspective, the total European insurance capital requirement was around EUR 750 billion as of year-end 2020.
The review package has two parts:
- Proposal to Solvency II
- Various impact studies, where a lot of details lie and are particularly relevant to investment portfolios
Some of the changes listed below come from the proposed directive while others are options likely to be included in a later publication. Overall the result of impact assessment leads to a decrease in the solvency ratio of around 3%, based on data collected in mid 2020, compared to EIOPA’s recommendations, which would have led to a decrease of 22%.
We summarise below the key changes for each section and also specify if this is part of the proposed directive or the impact assessment.
Extrapolation method (Directive)
No quantitative information on the extrapolation method to be used was included in this review – it will likely follow what was suggested by EIOPA in their review. It is worth noting that the extrapolation will take into account available information in the financial markets even past the last smoothing point. Extrapolation parameters will be phased in linearly until 2032. The first smoothing point is defined as:
- Markets for financial instruments of that maturity that are deep, liquid and transparent
- Percentage of outstanding bonds of that or a longer maturity among all outstanding bonds denominated in that currency is sufficiently high
The first smoothing point is not transitioned over time and applicable immediately. The directive did not specify the years for each currency.
Interest rate shock (Impact assessment)
The EC opinion is to implement the changes suggested by EIOPA in terms of risk-free curve shock, such as shocking negative rates. The ultimate forward rate (UFR) will also be shocked and extrapolation method will be applied between the last smoothing point and the UFR. There will be a five-year phase-in period, resulting in a limited impact on Solvency Capital Requirement (SCR) ratios now and a 22% drop in SCR ratios when fully phased in, according to EIOPA’s impact assessment.
Based on the sample of companies considered in the impact assessment, the changes in interest rates together will ultimately result in lost capital resources of EUR 73 billion (reference date mid 2020) or EUR 48 billion (reference date end 2019). This is an improvement of around EUR 8 billion over the original proposal from EIOPA. Please note that these will be phased in over the next five years (IR Shock) and 10 years (extrapolation method).
Volatility adjustment (Directive)
The updated volatility adjustment does not implement all the recommendations from EIOPA but does address some of the issues identified in EIOPA’s review.
The general application ratio increases to 85% but an additional application ratio capturing the credit spread sensitivity of assets vs liabilities is applied (CSSR – credit spread sensitivity ratio). The latter is entity specific and will help reduce overshooting or undershooting effects, while also incentivizing companies to better match asset and liability duration in order to maximise the application of the volatility adjustment (CSSR is between 0 and 1). The application ratio capturing the illiquidity of liabilities has been removed. Removing the illiquidity application ratio would help free up between EUR 5 billion and EUR 11 billion of capital.
For the euro, the introduction of a country-risk-corrected spread is progressive, therefore avoiding the cliff-edge effect that was observed in Italy and Portugal recently. This is restricted to the euro. The volatility adjustment shall be increased by a macro volatility adjustment calculated as follows:
𝑉𝐴𝐸𝑢𝑟𝑜,𝑚𝑎𝑐𝑟𝑜 = 85% ∙ 𝐶𝑆𝑆𝑅𝐸𝑢𝑟𝑜 ∙ max(𝑅𝐶𝑆𝑐𝑜 − 1.3 ∙ 𝑅𝐶𝑆𝐸𝑢𝑟𝑜; 0) ∙ 𝜔𝑐𝑜
- VAEuro,macro is the macro volatility adjustment for a country co
- CSSREuro is the credit spread sensitivity ratio of an insurance or reinsurance undertaking for the euro
- RCSco is the risk-corrected spread for the country co
- RCSEuro is the risk-corrected spread for the euro
- wco is the country adjustment factor for country co.
The amendment to the volatility adjustment helped to further increase available capital. EIOPA’s recommendation already provided a boost of around EUR 13 billion in extra capital vs EUR 45 billion under the EC review (data based on a sample of companies only, reference date mid 2020).
Risk margin (Impact study 1)
The risk margin will be reviewed, with the goal of making it less volatile and smaller. In particular, the cost of capital will be revised down from 6% to 5%. Based on the changes proposed, the capital release will be around EUR 30 billion across Europe (reference date mid 2020) vs EIOPA’s original proposal, which would have released around EUR 18 billion). These figures are for a sample of companies participating in the impact study.
Symmetric adjustment (Directive)
The symmetric adjustment corridor has been relaxed to +/- 17 percentage points. This means that in times of stress, equity capital charges will fall to 22%. This measure will help reduce the impact of market stress and avoid fire sales.
Long-term equity (Impact assessment 1)
Multiple options are under consideration:
- Option 1: Status quo
- Option 2: Relax the long-term equity (LTE) requirement (no further details were provided)
- Option 3: Reduce capital requirements on all equity investments
- Option 4: Introduce qualitative climate change scenarios
- Option 5: Introduce quantitative rules for sustainability risks, for example, potentially lower capital charges on “green equity”
The preference is to introduce Option 2 and Option 4. While there are limited details on Option 2 available in the impact study, the EC estimates that it would at least lead to twice as many insurance firms willing to use the LTE asset class and almost six times the amount of equities eligible to a preferential treatment (from EUR 4.2 billion to EUR 26 billion), therefore releasing around EUR 10 billion of capital.
Overall the publication from the EC clearly states the willingness to incentivise investments into equities, and SMEs in particular. Equity investments have been declining significantly over the course of this century.
The directive introduces the need to apply climate change stress scenarios to the balance sheet, which would be part of the Own Risk Solvency Assessment (ORSA). In addition, environmentally or socially harmful investments could incur capital charges. A review will be published no later than 2023 and will also include a recalibration of the natural catastrophe risk module.
Currently only about 5% of all investments are “taxonomy-eligible”. As part of the European Green Deal, favourable treatment may potentially be given to “green” assets to incentivise insurers to invest in them
A new paragraph was inserted in the directive. Insurers will have to develop liquidity risk indicators. Furthermore, national supervisory authorities (NSAs) will have additional powers to intervene in the event insurers experience liquidity vulnerabilities and, as a last resort, freeze redemption options on life policies (either market wide or at the company level).
In order to ensure consistent application of this article, EIOPA shall develop draft regulatory technical standards to further specify the content and the frequency that the liquidity risk management plan will be updated. A study on this topic from EIOPA is expected towards the end of 2021.
Avoiding systemic risk in the insurance sector (Impact study 1)
The impact study mentions a proposed a list of targeted amendments to prevent financial stability risk. This includes the illiquidity risk assessment discussed earlier, which will be implemented by NSAs. Prudential rules would also be amended so that banking-type loan origination activities by insurers are not subject to a more preferential treatment than in the banking sector, thus preventing regulatory arbitrage and “shadow banking”. This would be achieved through amendments to counterparty default risk so that it would be aligned with banking sector regulations (Basel III). We expect this change to affect the allocation to mortgages in the Netherlands and Belgium, where this issue is prevalent.
Overall, the update from the European commission is very welcome. The progressive phase-in of the more restrictive measures, such as the extrapolation method and interest rate shock, allows capital to be released in the short term and help insurers support the economic recovery post-pandemic, while also deploying capital towards green assets and supporting the European Green Deal.