Solvency II review to strengthen the insurance sector

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Sophie Debehogne, Senior Client Solution Manager, Solution and Client Advisory Group (Multi Asset Quantitative and Solutions Group) at BNP Paribas Asset Management, and Mehdi Hacini, Quantitative Analyst, Quantitative Research Group, say that while the EC proposal does not revolutionize Solvency II, eight of the changes it contains have important implications for insurance companies. In a new article, they explain why.



The objective of the Solvency II review is not to call into question the solvency of the insurance sector, which is reasonably solid and has withstood the Covid-19 crisis well.

Rather, the proposed changes aim to better align Solvency II with:

  • Market realities, e.g. low yield environment and associated risks
  • Long-term investment horizon profile of insurers and their important role as contributors to the economy
  • The special nature and credit sensitivity of individual insurance companies
  • Reduce industry sensitivity to market fluctuations
  • Better cope with certain risks, such as those related to climate change.

Overall, the EC expects the proposed measures to free up €90 billion in short-term capital. That said, while measures such as those relating to the discount curve and interest rate shocks are expected to increase insurers’ capital requirements, the real the amount of capital released will probably be reduced to 30 billion euros in the long term.

The eight amendments likely to have the most impact

1. Modification of the haircut curve

There will be a new risk-free rate (RFR) curve to discount insurer liabilities. The proposed extrapolation method takes into account longer-term market interest rate information beyond 20 years for a more natural distribution of interest rate sensitivities on the liability curve.

It will better align the “regulatory” sensitivities on the curve with the true “market” curve than the current method does.

There will be a transition period until the end of 2031 from the existing curve to the new one. While the planned transition mechanism will initially have no impact on the level of the curve, it will affect the interest rate sensitivity of the liabilities from day one.

Overall, the consequence of this change in the RFR curve is that insurers hedging some of their liabilities to contain their SCR will have to adjust their hedging strategy.

2. Amendment relating to rate shocks

The second major change relates to interest rate shocks. Under the existing Solvency II regulations, these shocks are based on a matrix that provides a relative percentage change to be applied to the interest rate for each maturity between year 1 and year 90. The matrix is ​​different depending on interest rates rise or fall suddenly. . The percentages also decrease with maturities.

As this approach creates an asymmetry between the curves relating to bullish and bearish shocks, EIOPA and the EC seek to better align this SCR module with current market conditions.

The impact of these changes will mainly concern:

  • Life insurers with long-term liabilities and a strong duration mismatch between their assets and liabilities. In particular, life insurers with cash and short-term exposures will have a high capital charge.
  • More generally, insurers with a duration mismatch.

3. New approach to calculating the volatility correction

Volatility adjustment (VA) aims to mitigate the short-term volatility of insurers’ solvency, taking into account their long-term perspective. It reduces the impact of short-term variations in credit spreads on the valuation of insurance liabilities, thus helping to make capital resources less volatile.

According to the proposals, the way the PV is calculated will change, so that the size of the PV will depend more on the situation and the credit sensitivity of the each insurer rather than using a default VA for all insurers (Part 1).

4. Changes to Long-Term Equity Investment Eligibility (LTEI)

The EC has revised the eligibility criteria for the Long-Term Equity Investment (LTEI) module, which was designed to better take into account the long-term nature of insurers’ business and help the industry finance the economy.

The complexity of the criteria inhibited the use of this module. To make LTEI more attractive to insurers, the proposed eligibility conditions will be simplified and will help to ensure that the capital pool either covers long-term liabilities or that there will be no forced sale simply to deal with liabilities.

5. Adjustment of the correlation matrix

EIOPA proposes to modify the correlation matrix only in the event of down interest rate shocks. The change concerns exclusively the correlation between the spread and the interest rate risks, which has been reduced from 50% to 25%. This will largely reduce the total market solvency capital requirement for insurers with significant interest rate and spread SCR.

6. Widening the bandwidth of the symmetric capital adjustment

The symmetric equity adjustment is used to reduce the procyclicality of an insurer’s equity investment. The goal is to make stocks cheaper in SCR after a market decline and more expensive after a market rise.

This symmetrical adjustment was initially set at a minimum of -10% and a maximum of +10%, based on the current level of a benchmark portfolio relative to its average over the last three years. By revising Solvency II, this bandwidth will probably be widened from -17% to +17%.

The main objective is to reduce procyclicality and prevent the insurance industry from having to sell equity positions at the worst time, for example after a market decline.

7. Reduction of the risk margin

The risk margin regulated by Solvency II is intended to cover non-hedgeable risks in the event of transfer of the activity of an insurer to a third party. The proposed revision aims to reduce the size and volatility of the risk margin as the current formula is considered too conservative.

8. Introduction of climate change scenario analysis

The EC will introduce an obligation for insurers to carry out analyzes of the impact of climate change on their activities and their financial results. The aim is to ensure that the insurance industry better takes into account and manages climate risks and the associated systemic risks.

Warning

All opinions expressed herein are those of the author as of the date of publication, are based on available information and are subject to change without notice. Individual portfolio management teams may have different views and make different investment decisions for different clients. The opinions expressed in this podcast do not constitute investment advice.

The value of investments and the income from them can go down as well as up and investors may not get back their initial investment. Past performance does not guarantee future returns.

Investing in emerging markets, or in specialized or restricted sectors is likely to be subject to above average volatility due to a high degree of concentration, greater uncertainty as less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of developed international markets. For this reason, portfolio transaction, liquidation and custody services on behalf of funds investing in emerging markets may involve greater risk.

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