Written by Francis Furey, Principal Consultant and Divyank Garg, Senior Consultant
BACKGROUND
The European commission (EC) published a comprehensive review of the Solvency II (SII) Directive (The Directive) on 22 September 2021. This was based on the extensive work conducted by the EIOPA to provide its opinion on SII by the end of the year 2020 (see reference for Finalyse article as requested by the EC earlier in year 2019.
The EC has provided the proposed text of the Directive to the European Parliament and to the Council for their consideration and approval. It is expected that the approval will be made in 2023 and once this is done, the Member states must transpose it into National law within 18 months. Updates to the Delegated Acts and Implementing Technical Standards are foreseen to be applicable in the coming months.
The timeline below gives details of each milestone.
Outlined below are the changes proposed by the EC. We address in detail several key topics - long-term guarantee measures of estimating risk margin, volatility adjustment, solvency capital requirement under the interest rate risk sub-module and extrapolation of the risk-free yield curve.
RISK MARGIN
The risk margin under the SII standard formula approach represents the cost of transfer of insurance obligations to a potential purchaser. It is calculated using a cost of capital approach. The EC has proposed an exponential time-dependent factor λ (lambda) to be applied to the risk margin formula, in respect of the SCR amount for year t. Below are the two-formula showing the calculation of risk margin under the current and proposed approach.
The intended application of lambda, with a value between 0 and 1, is to allow for a reduction in the impact of risks that are more distant in time. EIOPA concluded that a calibration of lambda equal to 0.975 provides a significant reduction in volatility and effectively addresses the issues identified by EIOPA. However, the EC is yet to finalise the value for this parameter. Using a simplified example of a life insurance business with a duration of 10 years and SCR of €100m at time 0, the implementation of the proposed new formula above would result in a risk margin reduction of c.€15m (approximately 20% of reduction where the cost of capital rate equals 6%).
VOLATILITY ADJUSTMENT
The volatility adjustment (VA) is an adjustment applied to the risk-free interest rate in the best estimate liability (BEL) calculation to reduce the impact of short-term bond spread volatility on the solvency position. It is calculated for all insurance and reinsurance eligible obligations of a currency and can be adjusted for country considerations under stressed conditions.
The formula under the current approach is:
The VA is calculated by applying a GAR of 65% on the risk corrected spread (RCS) which is based on a representative portfolio specific to a currency. Additionally, an adjustment including country-specific RCS is added under stressed conditions only if that RCS is greater than 100 bps.
As part of the SII 2020 review, there were potential deficiencies identified in the design of the VA. These include: the dampening effect of the VA being significantly higher or lower than the loss on assets, the cliff-edge effect when a country specific VA is triggered, and the failure to adequately allow for the illiquidity characteristics of the liability. The EC has proposed changes in the Directive to address some of these deficiencies and avoid any contravention of the existing VA objectives i.e., prevention of pro-cyclical behavior and mitigating the impact of bond spreads on own funds.
The proposal includes the removal of a condition that triggers country specific VA and introduces a smoothed increase in the VA via an addition to the permanent component in crisis situations.
The proposed formula for the calculation of the VA is as follows:
To address the issue of the movement in liability values overshooting movement in asset prices due to the application of VA, the EC has proposed a credit spread sensitivity ratio (CSSR) to be included in the calculation of VA (formula provided in the appendix). The estimation of this would be entity specific.
The CSSR can be defined as the sensitivity of assets of an insurance entity to changes in credit spreads, divided by the sensitivity of technical provisions (TP) to changes in the interest rate. This would help to reduce the basis risk with respect to EU representative portfolios, leading to a more accurate matching of spreads after VA adjustment. In addition, GAR has also been changed from 65% to 85% to capture unexpected credit and other risks.
The impact of the above amendments will depend on a company’s specific risk profile. Those entities that are in most need of the VA due to their circumstances will stand to benefit the most, while those companies that already have a well-matched asset-liability portfolio would see minimal gains. The average VA is expected to increase from 7 to 14 basis points at the EEA level.
INTEREST RATE RISK
Several issues were identified that led to under-estimation of the interest rate risk under the SII standard formula approach. These included, inter alia, actual interest rate movements being stronger than those assumed by stresses in the regulation already in place, negative interest rates not being stressed and deviation in the measurement of interest rate risk by internal model users. The concluding remarks of the impact assessment, in the SII 2020 review, state that the capital requirements are not sufficient for this material risk.
Thus, the EIOPA recommended a method that introduces new parameters to assess interest rate risk within the standard formula, along with a new formula for calculating the stressed rates. The previous formula had solely a relative shock component. The new formula includes an additive shock in addition to a relative shock, with a new set of parameters which has been calibrated to the last liquid point (LLP) of 20 years and the additive shock component. The EC has not yet provided details of the formula as these are covered by Level 2 texts. The formulas for the stressed interest rates for the calculation of interest rate risk are provided in the appendix.
Additionally, the recommended formula ensures that the minimum shock of 1% is removed in the rising interest rate scenario and that negative interest rates are stressed in the falling rate scenario. The below graphs show a comparison of the base, current stressed and proposed stressed curves in the up and down interest rate scenario (as at Year End (YE) 2022).
The graphs illustrate a clear shift in the stressed interest rate curve when moving to the proposed method. If the Up shock is biting, the pre-diversified interest rate shock could double at earlier durations. If the Down shock is biting, this will lead to a doubling of the undiversified shock at nearly all durations. These changes are expected to increase capital requirements, particularly for entities with long-term liabilities and an asset portfolio with a significantly shorter duration than that of their liabilities. For example, a book of business with BEL at time 0 of around negative €500m, the pre-diversified SCR for interest rate risk would nearly double from €23m to €45m in the Up scenario and €21m to €39m in the down scenario.
A gradual implementation process is recommended to be grandfathered for the new definition of the downward interest rate shock that should not last longer than 5 years of time.
EXTRAPOLATION OF THE RISK-FREE YIELD CURVE
The EC has proposed to change Smith-Wilson method of extrapolating rates from the LLP, to converge to an Ultimate Forward Rate (UFR). For Euro-denominated zones, the LLP is determined to be 20 years and the convergence to the UFR happens over 40 years after the LLP.
The SII 2020 review of the extrapolation method or the risk-free yield curve indicated that the current setting of LLP implicitly impacts the interest rates beyond 20 years, which has ultimately led to under-estimation of the TPs. In addition, the deviation of the extrapolated rates from the actual market rates is a contributing factor to volatility of TPs and risk management incentives. The proposed changes to LLP are in conjunction with the convergence speed to the UFR.
There is no stipulated convergence period to the UFR with the recommended convergence factor set at 10%. The following graph shows the impact of using different convergence factors and a comparison of the current and proposed methods of extrapolating yield curve as at YE 2022.
As evident from the graph above, the proposed methodology would lead to lower interest rates and an increase in TPs for long term liabilities (durations greater than 20 years). This is aimed to enhance policyholder protection and promote good risk management, as TPs will now be closer to achieving market consistency. It is worth noting that the impact will only be seen beyond the LLP (this is 20 years for euro-denominated zones) and so the biggest impact will mainly, for example, be for annuity providers.
The Directive mentions phasing in of the method until year end 2031, gradually. The parameters shall be decreased linearly at the beginning of each calendar year until final parameters of extrapolation are applied as of 01 Jan 2032.
FURTHER AMENDMENTS
Other Pillar 1 amendments proposed by the EC are set out below. Some of these are not yet specified in the proposal by the EC and are covered in the implementing regulations:
- Easing of the restrictions around risk diversification between portfolios with matching adjustment and the remaining parts of the business.
- Widening of lower and upper bounds in the estimation of the symmetric adjustment that is applicable to equity risk capital requirements. The bounds are proposed to widen from ±10% to ±17%.
- Reducing the correlation factor between interest rate and credit spread from 0.5 to 0.25.
- Amendments in respect of the treatment of long-term equity investment, addressing the risks of equity held over a longer horizon.
- Change in thresholds with the aim to exclude small companies from the scope of the Directive.
- Introduction of the classification “low risk profile” for an undertaking with the aim to benefit from the principle of proportionality.
- Following are the proportionality measures introduced for low risk profile undertakings:
- Allowing prudent deterministic valuation for contracts with asymmetric options and guarantees, if immaterial.
- Simplified calculation of immaterial SCR modules and sub-modules.
- Reduced frequency of ORSA reporting from annually to once every two years and exemption from including Climate Risk scenario.
- Review of written policies to be done only once every three years, among other exemptions.
- Flexibility to assign persons responsible for risk management, actuarial and compliance functions to perform any other key function.
- Granting exemptions to certain low risk profile, with certain limits, undertaking from quarterly reporting.
The Pillar 2 changes proposed by the draft Directive include:
- The supervisor has the power to suspend or restrict dividend payments in times of exceptional market wide shocks.
- Insurers will be required to include macroprudential considerations and systemic risk in the ORSA.
- Insurers will be required to consider risks related to economic downturns and credit cycles into their investment strategy.
- All entities will be required to draft liquidity risk management plans for identifying and addressing potential liquidity stresses and supervisor power to temporarily freeze redemption rights of policyholders of the undertakings affected by significant liquidity risk in certain exceptional circumstances.
- Insurers will need to identify material exposure to climate change risks.
- Prudential treatment of exposures to assets or activities associated with environmental and/or social objectives.
Amendments to Pillar 3 topics relate to reporting and disclosure requirements. Proposed changes include modifications to the structure of the Solvency Financial Condition Report (SFCR) and an external audit requirement for the balance sheet disclosed as part of the same, as well as a requirement for most insurance companies to submit pre-emptive recovery plans. Under the proposed approach, the deadline for submission of the solo SFCR will be extended from 14 weeks after YE to 18 weeks. The group SFCR deadline would also be extended by 4 weeks – from 20 to 24 weeks after YE.
CONCLUSION
The EC has proposed changes in the Directive, after careful analysis of the impact assessment provided by the EIOPA. The changes, related to Pillar 1, 2 and 3, were selected for proposal by the EC from several options that were recommended as part of the SII 2020 review.
The impact of the change in the estimation of risk margin for insurers will likely be material for most insurers. Changes proposed for the calculation of VA seems quite significant which needs to be implemented by insurers that are allowed to apply a VA. And the impact of the change in the methodology for extrapolation of the risk-free yield curve is likely to concern insurers with books of longer duration i.e., with considerable liabilities after 20 years for Euro.
The EIOPA carried out impact assessment, for most of the amendments proposed, where certain amendments, such as for risk margin is expected to let the own funds increase, while others such as for interest rate stresses, are expected to increase the SCR.
HOW CAN FINALYSE HELP YOU?
The proposed Directive intends to make the SII framework more aligned to the economic outlook and addresses the inadequacies identified. Finalyse has extensive experience in Actuarial and Risk management for insurance companies and can help you make sense of the proposals under the draft Directive including:
- Gap Analysis: Perform a gap analysis detailing your situation against regulatory requirements and proposals published.
- Roadmap: Developing a roadmap for the integration of proposed changes into your business.
- Workshops: Conducting workshops with the objective of upskilling the relevant stakeholders within your business on the EC recommendations.
- Strategic support: Understanding the SII proposals for your business including on the long-term business strategy.
APPENDIX
Proposed credit spread sensitivity ratio (CSSR) formula:
Formula for the calculation of credit spread sensitivity ratio (CSSR) used for calculating volatility adjustment under the proposed approach.
Proposed Interest rate stresses formula:
Formula for estimating interest rate curves for up and down scenario for calculating SCR interest rate under the proposed approach:
Where for different maturities m (in years):
r(m) = risk-free rate at maturity m
rup(m) = rate at maturity m in rising interest rate scenario
rdown(m) = rate at maturity m in declining interest rate scenario
s vector value is linearly interpolated between 20 and 90 years.
b vector value is zero beyond 60 years and is linearly interpolated between 20 and 60 years.