Solvency II under review: EIOPA’s Final Opinion on the 2020 Review

Figure 6. Euro Risk

-free Rate with current and Proposed Shocks as of 15/02/2021

Source: EIOPA, DWS International GmbH. As of: 15 February 2021 
 

Spread risk

Background 
For bonds and loans, the spread risk SCR is determined as a function of the credit quality step (CQS) and modified duration with charges increasing both with CQS (i.e. deteriorating quality levels) and with duration.  EIOPA evaluated the option to introduce a framework for lower capital charges for specific long-term investments in bonds and loans with similar conditions as for long-term equity investments.

Conclusions and Analysis 
Ultimately, EIOPA does not propose any changes to the spread risk sub-module.

EIOPA concludes that there is no need to further incentivize (long-term) fixed income investments as:

• Solvency II may already over-incentivize fixed income investments due to relatively mild spread risk charges. In general, EIOPA finds that the current calibration of the spread risk charges is relatively mild compared to the calibrations originally proposed by CEIOPS in 2010 and by EIOPA in 2011. This is prevalent in bonds and loans with a duration between 1 and 10 years where the current spread risk charges are approx. 30% lower than the original calibrations. With increasing duration, the differences between the current and proposed calibrations decreases. In EIOPA’s analysis, these lower capital charges might not reflect the actual spread risk and could make fixed income investments more attractive than other investments.
• Sovereign bonds issued by EEA member states are already subject to a zero capital charge.
• The proposed reduction in risk charges was similar to matching adjustments already available (though at 50% of the matching adjustment reduction due to the lesser liability matching requirements)
• A new long-term treatment would also be inconsistent with the 1-year Value-at-Risk (VaR) framework.

Property risk

Currently, Solvency II sets a uniform risk charge of 25% for all real estate investments irrespective of the type of property or its location. Due to limited market data available, the 25% capital requirement was calibrated solely based on data for the UK real estate market, which is deemed to be the most volatile property market in Europe. Hence, this was viewed as overly conservative and not representative for other real estate investments outside the UK.

Overall, EIOPA shares this view but does not see a sufficient improvement in availability of granular historical data, which would allow for a re-calibration of the existing shock for different real estate markets. Additionally, the impact of COIVD-19 would be expected to increase volatility, but EIOPA finds it difficult to quantify the potential impact on prices for residential and commercial real estate.

Volatility Adjustment (VA)

Background 
Under the VA, insurance companies can add a spread to the risk-free discount curve in order to stabilize their Solvency II balance sheet in times of higher spread volatility. For each currency, the VA spread is derived from a representative portfolio of assets, which is updated by EIOPA on an annual basis largely using the average asset allocation of European insurance companies. The spread is calculated on a monthly basis and is adjusted by a fundamental spread, a spread measure that should reflect the long-term average default and downgrade risk of the underlying fixed income instruments in the representative portfolio (and not short-term liquidity effects or similar). Ultimately, 65% of the residual (i.e. risk-adjusted) spread is added to the risk-free discount curve. In times of a significant spread widening in a specific country, a higher VA spread based on a country-specific reference portfolio is applied. Overall, EIOPA has identified key shortcomings in the current design of the VA:

• Company specific circumstances could be better reflected in the VA design
• “Cliff-edge” effects during periods where spreads fluctuate around the trigger point of the country-specific VA. In the past, this had been a problem for undertakings in Southern Europe, for example during the 2011-2013 sovereign debt crisis.

Conclusions and Analysis 
Firstly, EIOPA advises to split the VA into a permanent VA and a macro-economic VA, which under the current framework correspond to the currency-specific VA and country-specific VA, respectively.

The permanent VA should become more company-specific by taking into account the illiquidity of liabilities and asset-liability matching features of the individual insurer. This is done by the means of two firm-specific application ratios. The first application ratio measures the degree of illiquidity of liabilities of a company, clustered into three categories of high, medium and low illiquidity (see Figure 7). Companies with a larger share of less liquid liabilities are allowed to make greater use of the VA.

Figure 7. Application Ratio based on the Illiquidity of Liabilities

Source: EIOPA. As of: December 2020 

The second application ratio is based on the asset-liability spread-sensitivity matching of a company to reduce potential “overshooting” effects of the VA. Companies with well-matched sensitivities are allowed to benefit more of the VA. Since the introduction of the two firm-specific application ratios reduces some of the uncertainties and risks inherent in the VA, EIOPA suggests to increase the general application ratio for the VA from 65% to 85%. As outlined in Figure 8, only companies with a very high share of highly illiquid liabilities and well-matched assets and liabilities can benefit from a higher overall application ratio compared to the current general application ratio of 65%. Based on data provided by EIOPA, the average overall application ratio across Europe would be around 59%. The average illiquidity application ratio and the average asset-liability application ratio is 76% and 91% respectively. Especially, the illiquidity ratios differ significantly across countries. For example, very high values can be observed for Germany, France and Italy while low values are observed for the Netherlands in particular.

Figure 8. Overall VA Application Ratio – Current and Proposed Methodology

Source: DWS International GmbH. As of: February 2021

The macro-economic VA is a revised version of the country-specific VA. Under the current design of the VA, the country-specific VA is activated if the spread on the country-specific reference portfolio exceeds the spread on the currency-specific reference portfolio by 200% (relative trigger) and the country-specific spread is at least 85 bps over the risk-free rate (absolute trigger). In that case, the currency-specific VA is increased by 65% of the amount of the relative trigger spread (i.e. in excess of 200%).

Under the new macro VA, the relative trigger is reduced to 130% of the scaled risk-adjusted currency spread (the scale is based on the proportion of fixed income assets in the representative portfolio). The absolute trigger is reduced to 60 bps after which a linear activation of the country-specific VA starts. The full activation occurs at spreads over 90 bps. Overall, these proposed changes would make the macro-economic VA more likely to be activated due to lower triggers as well as more stable as the absolute trigger leads to a gradual activation rather than a binary outcome.

Finally, EIOPA proposes two other changes. First is a change in the current design of the risk correction.  They propose decoupling the risk correction from the fundamental spread since analysis indicates a “sticky” risk correction with less reflection of recent changes in credit risks. Hence, they propose the risk correction be calculated as a fixed percentage of current spread levels but with an allowance for a higher VA impact when spreads exceed their long-term average. Overall, the new design of the VA would partially limit the benefit of the VA in times of widening spreads.

Second, EIOPA proposes that standard model users should not be allowed the usage of the dynamic VA.  However, internal model users may still use the dynamic VA. This might disproportionately impact insurers whose asset allocation differs significantly from the reference portfolio.

Matching Adjustment (MA) 

In contrast to the VA, the MA has received relatively little attention under the Solvency II review. The MA is currently only used by insurance companies in the UK and Spain.

An MA portfolio is a separated portfolio of assets and liabilities in which cash flows are matched and assets assigned to that portfolio are exclusively devoted to cover the best estimate of the liabilities included in the portfolio. Like LTE portfolios, MA portfolios are subject to a “ring-fencing light” but not to a legal ring-fencing. Nevertheless, under current treatment, MA portfolios and legally ring-fenced funds are treated in the same way by not taking into account diversify- 
cation benefits when aggregating the SCR across those and other portfolios.

EIOPA noted that this ring-fencing is not symmetric; while it is true that the assets in the MA portfolio cannot be used to cover losses outside the MA portfolio, other outside assets can be used to cover losses from the MA portfolio. Additionally, the assets in the MA portfolio only have to cover expected losses (best estimate) but not unexpected losses, which are covered by assets that back the risk margin and the SCR. Hence, EIOPA opines that a higher SCR resulting from limited diversification benefits cannot be justified and may discourage insurers from using the MA. In fact, there are examples where the loss of diversification in the SCR exceeds the increase in own funds resulting from the use of the MA in the calculation of the liabilities. Therefore, EIOPA advises to remove the limitations to the diversification between the assets in the MA portfolio and other assets in the SCR calculation. This is also in line with the methodology of most internal model users.

Besides changes to the diversification benefits, EIOPA has also reviewed the MA eligibility of restructured assets (i.e. assets that may have been restructured specifically to meet the MA cash flow requirements) and of assets with an uncertain timing of cash flows, such as callable bonds.

With respect to restructured assets (e.g. securitisation structures), EIOPA proposes to introduce a look-through approach to assess the eligibility of those assets. More specifically, restructured assets must meet the following conditions in order to be eligible for inclusion in a MA portfolio

• The underlying assets have to provide a sufficiently fixed level of income. For example, securitisations backed by residential mortgages might not be MA eligible in case the underlying mortgages are exposed to prepayment risks (unless such pre-payments are cured as below).
• The cash flows of the restructured asset must be supported by loss absorbency features such that those cash flows are sufficiently fixed in term. For example, an asset can be securitised into a range of tranches where the junior tranche absorbs specific losses so that the MA-eligible senior tranche is only exposed to default and downgrade risks.
• Where underlying assets include financial guarantees written on the performance of non-MA eligible assets, these guarantees cannot provide an additional MA benefit, i.e. the additional spread resulting from the guarantee cannot be added to the MA spread.
• The insurance company must be able to properly identify, measure, monitor, manage, control and report the underlying risks.

Besides this, EIOPA also evaluated the option to allow MA eligibility for assets with uncertain timing of cash flows given that the MA benefit will be calculated based on the yield-to-worst. However, EIOPA decided to not follow this approach as it remains detrimental to the principle of cash flow matching.

Conclusions

Overall, EIOPA describes the proposed changes to the market risk module as an evolution rather than a revolution.

We would agree to this statement. In many aspects the review lacks revolutionary elements.

Nevertheless, some changes will still have a significant impact on the Solvency II balance sheet of European insurers. In our view, the most material changes relate to interest rates. Even though the proposed methodology for extrapolating the risk-free interest rate curve is only a small step towards greater realism of lower interest rates, it will still have a severe impact on the solvency position of insurance companies with long-dated liabilities. Additionally, the proposed increase of the downwards interest rate shock will result in a significant increase in SCR for companies that run larger duration gaps. Consequently, affected insurers will likely further increase their efforts in narrowing their duration gap by either increasing their asset duration and/or shortening their liability duration for new business and, where possible, for in-force business. For increasing the asset duration, companies may rely on both traditional asset classes such as government bonds or high-rated corporate bonds as well as on alternative assets such as infrastructure debt, government-guaranteed loans or residential mortgages.

A sound asset-liability management will also be encouraged by the proposed design of the VA, which will make this measure more effective for companies with well-matched assets and liabilities. However, the suggested changes to the risk correction may dampen the effect to a certain degree and will make the VA probably more volatile.

Besides this, potential changes to the long-term equity investments treatment may allow a broader and easier use of this concept across Europe instead of only the few countries, which have favourable liability structures. This may encourage further passive equity investments and in particular private equity investments where the capital benefit is the highest and the holding period is anyway rather long-term by nature given the illiquidity.

Nevertheless, in the end it is worth noting that EIOPA’s opinion is not binding. As we have already seen in the past, the European Commission (EC) may decide – e.g., for political reasons – not to follow EIOPA’s guidance in certain areas. In particular we have seen this with regard to changes to the interest rate shock previously.

The current proposal would bind up further more capital in the fixed income instruments, which is contrarian to the positioning of the EC with regard to the Capital Markets Union (CMU) where they would want to foster stronger allocations to Equity markets from the Insurance Industry.

Therefore, it remains to be seen if the considered changes will be adopted as proposed by EIOPA.

We have looked at the effects on asset-liability management from the changes and show the impact on own funds and strategic asset allocation. Please reach out for more information to your DWS Sales representative or to the authors of this paper.

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