The IAIS has recently kicked off1 the final year of field testing of its Insurance Capital Standard (ICS), which it is scheduled to adopt at its Annual Conference in November 2019. This blog is part of a two-part series examining the calculation of market-consistent technical reserves in the ICS, which is one of the most important points of valuation methodology for a market-consistent regime.2 In doing so, it draws comparisons with the experience of Solvency II. As it develops the ICS, the IAIS is tackling many of the same policy issues that have already been faced by Solvency II, and how it approaches these issues could prove to be important in the context of the 2020 Solvency II review.
The first blog in this series, available here, discusses the calculation of the risk margin adjustment in the ICS, and compares it, from the perspectives of both interest rate sensitivity and overall quantum, with the Solvency II risk margin. It concludes that the IAIS methodologies should be less interest rate sensitive than the Solvency II risk margin. Nevertheless, it also highlights that at their upper ends, the ranges of calibration being tested by the IAIS approach the current level of the Solvency II risk margin.
This blog examines the calculation of the respective regimes’ long-term discount rates and concludes that:
- while the ICS follows a broadly similar approach to Solvency II, the resulting euro and sterling discount curves could nonetheless differ, potentially introducing significant valuation differences between the regimes;
- the need to move away from reliance on LIBOR and EURIBOR in the future could introduce new differences in methodology for risk free rates; and
- 2019 field testing may provide an illustration of how a “single adjustment mechanism”, replacing the VA and MA, could work in Solvency II, as recently envisaged by the European Commission.
Implications for firms
In each of the areas covered by these connected blogs, the 2019 field test is the last opportunity for the IAIS to test its narrowing policy choices before finalising the ICS that it will put to adoption at its Annual Conference. 2019 is thus the last year in which the ICS can be influenced through participating in field testing.
The ICS is testing a number of policy approaches that could well have implications for the 2020 review of Solvency II currently underway. Insurers with an interest the future shape of Solvency II and the ICS would thus be well-advised to participate in field testing if eligible, as well as engaging in any associated consultations.
Field testing is scheduled to run until the end of July.
Valuation of insurance liabilities
Both the ICS and Solvency II value technical provisions as the sum of a best estimate and risk margin – in Solvency II terms the premium over the mean valuation that an arm’s length purchaser would require to take on the portfolio of liabilities. The calculation of appropriate long-term discount rates to be used in this valuation is thus a critical input for long-term business.3
Risk free interest rate term structures
On long term discount rates, the IAIS’s risk-free rate methodology for field testing is conceptually similar to Solvency II. It produces discount curves that are, broadly, similar to their Solvency II equivalents. However, comparing the curves applied for 2018 and 2019 field testing nonetheless suggests some variability between the regimes that could lead to material differences in valuation.
The charts below compare the risk free curves for the euro and sterling used for ICS 2019 and 2018 field testing with those published by EIOPA for Solvency II for the same reference dates, in each case showing both base and volatility-adjusted curves.4
The following can particularly be noted about the respective curves:
- The Solvency II Ultimate Forward Rate (UFR) and ICS Long Term Forward Rate (LTFR) are critical assumptions, as would be expected, particularly for the euro curve with its earlier Last Liquid Point/Longest Observed Term (LLP/LOT). The fact that the IAIS stresses the LTFR by 15 basis points in its general bucket “central scenario” notably aligns the adjusted curves by bringing the LTFR closer to the UFR.
- Both curves apply a LLP/LOT of 50 years for sterling and 20 years for the euro. The significant effect on the curves of this difference is obvious, given that both converge to the same UFR/LTFR.
- The shape and quantum of the respective adjustments for volatility is clearly variable to some extent, but significantly so in the case of sterling. It is important to stress that the ICS charts below take only the “general bucket” element of an overall three-part adjustment to the curve. The adjustment is, therefore, conceptually similar to the Solvency II volatility adjustment, though likely based on a portfolio of assets that is not entirely comparable to the VA representative portfolio. The actual level of variability for any individual insurer would depend on the assets of that insurer and how they are treated under the IAIS’s three bucket approach.5
- The IAIS’s three bucket approach may prove to be similar in concept to the “single adjustment mechanism” envisaged in the European Commission’s formal request for advice to EIOPA for the 2020 Solvency II review. The results of 2019 field testing may be instructive for any future consultation on the long-term guarantee measures for the Solvency II review.
- As well as any further changes made to the ICS methodology over the rest of this year, both methodologies will need to be updated to the extent they rely on instruments linked to LIBOR or other transitioning benchmark rates.6
In summary, respective discounting approaches between the ICS and Solvency II could well drive differences in valuation or volatility. Any divergence in key assumptions and methodologies, in particular long-term rate, convergence, and curve adjustments, could ultimately lead to highly significant differences in valuation between the ICS and Solvency II for some insurers.
- IAIS Public 2019 IAIS Field Testing Yield Curves
- IAIS Public 2018 Field Testing Template and Yield Curves
- EIOPA Risk Free Interest Rate Term Structures
1 The IAIS published the 2019 quantitative field testing package for the ICS on 25 June 2019.
2 The calculation of regulatory capital requirements is also, of course, of critical importance.
3 This blog does not consider further the calculation of the best estimate by insurers. The best estimate is calculated for both Solvency II and the ICS as the probability-weighted average of the present value of future cash flows, calculating using the relevant prescribed risk-free interest rate term structure.
4 The charts show the base risk-free curves (represented by solid lines), and adjusted curves (represented by dotted lines) incorporating the regimes’ respective adjustments intended to mitigate excessive volatility in capital resources. For the purposes of this analysis, the adjustments taken are the “general bucket” adjustment for ICS and the volatility adjustment for Solvency II.
5 The above, also, does not consider any change in the IAIS’s approach to calculating the general bucket adjustment between 2018 and 2019 field testing, which may stabilise in the final ICS approach.
6 Solvency II risk-free curves are currently calculated based on market swap rates linked to LIBOR for sterling and EURIBOR for the euro. In previous field testing exercises, the IAIS has calculated the ICS curves by reference to the same benchmarks.