EIOPA’S Opinion on the Review of Solvency II – Topic: Volatility adjustment

Written by

Chirag Sehgal, Finalyse Consultant

Francis Furey, Finalyse Managing Consultant

Finalyse has produced a more extensive white paper which focuses on the following aspects of EIOPA’s proposals:

1. Technical provisions (“TPs”)
2. Solvency Capital Ratio (SCR)
3. Minimum Capital Requirements (MCR)
4. Own funds
5. Long-term guarantees measures (LTG)
6. Measures of equity risk

Over the next couple of weeks Finalyse plans to issue several smaller blog posts on the material changes proposed by EIOPA. The first topic we have picked concerns the volatility adjustment.

If you wish to receive a copy of this paper, please contact francis.furey@finalyse.com

There are several design concerns namely:

Over or undershooting effect of the VA

The dampening effect of the VA may exceed the effect of a loss in the market value of fixed-income assets. EIOPA has proposed that VA should be based on the undertakings’ portfolio rather than any reference portfolio and an application ratio should be applied to the adjustment which measures the duration and volume mismatch between fixed income investments and insurance liabilities of the undertaking.

Consideration of illiquidity characteristics of liabilities

EIOPA recommends the use of an illiquidity factor based on a “bucketing approach”, i.e., another application ratio should be introduced based on a categorisation of liabilities which captures the stability and predictability of cash-flows.

Underlying assumptions of VA are unclear.

The VA can be considered as a compensation for exaggerations in bond spreads or represent an additional illiquidity premium on assets that replicates the liabilities. EIOPA recommends that the VA should be split into a permanent VA reflecting the long-term illiquid nature of insurance cash flows and its implications on undertakings’ investments decisions; and a macro-economic VA that would only exist when spreads are wide during a financial crisis that affects the bond market.

Cliff effect of the country-specific increase, activation mechanism does not work as expected.

There can be a cliff-edge effect from the country VA during periods where spreads of a single Member State fluctuate around the trigger point of the country specific VA with activation and deactivation of the country specific VA leading to volatility in Own funds. EIOPA proposes that the macro-economic VA should be based on an improvement of the current country-specific increase of the VA to mitigate cliff-edge effects and improve the activation mechanism.

Misestimation of risk correction of VA

Several potential problems with this risk-correction have been identified:

• May insensitivise credit spread changes.
• Does not reflect actual default losses.
• Does not reflect credit risk premium for unexpected losses.
• Unnecessarily reflects cost-of-downgrade.

Currently, the VA is calculated as a fixed percentage of a spread. EIOPA recommends that this should be based on a percentage of the spread which should be differentiated with respect to issuers, namely between sovereign exposure of EEA countries (‘government bonds’, 30%) and other bonds (‘corporate bonds’, 50%).

Overall, EIOPA recommends that all these components of the proposal should not be considered in isolation but jointly form an enhanced and more targeted design of the VA.