Solvency II - What does the evolution of EIOPA's thinking tell us?

On 2 March, the European Insurance and Occupational Pensions 
Authority (EIOPA) published its call for evidence as part of its holistic impact assessment of Solvency 2. This is the latest step as EIOPA develops its thinking in advance of publishing its final advice to the European Commission.

Compared with its draft advice of 800+ pages, the technical document is much shorter and shows that EIOPA is beginning to home in on more targeted recommendations.

In its consultation, EIOPA had suggested various different methodologies to address that it sees as the underestimation of risks linked to the current calculation of the risk-free rate, including extending the Last Liquid Point (LLP) to 30 or 50 years. While Solvency II aims to use market-consistent interest rates derived from swap rates as the basis for discounting future liabilities, this can only be done where there are deep, liquid and transparent markets in such instruments. The point at which market-consistent rates can no longer be measured accurately is known as the Last Liquid Point, currently set at 20 years for the euro, beyond which the risk-free interest rate must be extrapolated until it converges with the Ultimate Forward Rate (UFR). The historically low interest rates translate into a lower discount rate, meaning firms have to hold more capital, whereas rates beyond the LLP that are extrapolated from the UFR, currently set at 3.90%, are higher and therefore require firms to hold less capital. EIOPA had suggested various options to address this issue, including extending the Last Liquid Point to either 30 or 50 years, which would have therefore extended the use of the lower market consistent rates, and therefore requiring firms to hold more capital. However, in the holistic impact assessment, EIOPA is now focusing on testing the alternative extrapolation method rather than changing the LLP. The new method would maintain the LLP at 20 years (but renamed the First Smoothing Point) but would take into account market rates beyond that point.  

While such a change would still reduce firms’ Solvency Capital Requirement (SCR) ratios, it is by far the least worse option that EIOPA had sketched out in its consultation.

However, EIOPA warned that this new methodology could increase the volatility of own funds where firms are not well matched, and will also have knock-on impacts to the interest rate risk calibration, which EIOPA continues to call for changes to in order to take into account low and negative interest rates.

While changes to the interest rate term structure and interest rate risk module may be negative for firms, other proposals by EIOPA are likely to be more positive.

For the volatility adjustment, EIOPA is focusing on moving towards a permanent Volatility adjustment (VA) complemented with a macroeconomic VA.

In its data request, EIOPA has signalled a move towards increasing the sensitivity of the VA to illiquid liabilities to better enable this to be taken into account in firms’ investment decisions. EIOPA proposes that liabilities should be classified into three buckets - high illiquidity, medium illiquid and low illiquidity.

EIOPA is equally testing an alternative set of criteria for the long-term equity (LTE) risk module to make these provisions less restrictive for firms to apply. This includes removing the need to ring-fence the assets against a specific business line and removing the requirement to be able to host the assets for 12 years in the case of an economic shock, which has been replaced with a provision that the LTE risk charge can be applied where the firm has long-term illiquid liabilities (as defined under the alternative VA bucketing approach described above) or that a liquidity buffer is put in place.

A key question is whether the above measures, taken in combination, are likely to significantly alter the quantum of capital held by insurance firms. In its final advice, EIOPA will need to triangulate between the demands of regulators for a more risk-sensitive regime, the demands of policymakers to recalibrate the regime to incentivise long-term and green investments and the demands of industry to not materially increase solvency requirements for firms.

While the initial request for information was due by the end of March, as a result of the market disruption due to the coronavirus pandemic, EIOPA has announced that it will delay the deadline until 1 June and this will likely impact the overall timeline for the Solvency II review. 

Glossary

The European Insurance and Occupational Pensions Authority (EIOPA) is a European Union financial regulatory institution

The last liquid point (LLP) is is the point after which the risk-free interest rate term structure is based on an estimate of the ultimate forward rate (UFR)

The extrapolation methodology assumes that forward rates will converge on an ultimate rate. This rate is known as the Ultimate Forward Rate (UFR), at a given speed (alpha)

The solvency capital requirement (SCR) is the amount of funds that insurance and reinsurance companies are required to hold under the European Union's Solvency II directive in order to have a 99.5% confidence they could survive the most extreme expected losses over the course of a year