EIOPA’s extensive recent consultation1 on the 2020 review of Solvency II gives a first indication of the changes to Solvency II that EIOPA will recommend to the European Commission.
This blog highlights ten over-arching topics from the consultation that we consider indicate where significant change is and is not likely, and which in turn could have an important bearing on the UK’s post-Brexit prudential capital regime. Each topic is detailed in the appendix to this blog.
The key points are:
- The risk margin: EIOPA proposes no changes despite interest rate sensitivity. This is likely to increase pressure within the UK for a UK-specific solution.
- The last liquid point (“LLP”) for the euro: EIOPA’s data analysis supports a 50 year LLP for the euro, but in our view adoption of EIOPA’s proposed alternative method to extrapolation, based on a gradual blending of market and extrapolated data, is a more likely outcome given the solvency pressures that a 50 year LLP would likely create in a number of jurisdictions, including Germany.
- Volatility adjustment: The range of options analysed points to a substantial redesign, which could significantly change the quantum of the adjustment, potentially reducing substantially the ultimate VA adjustment when spreads are wide. While still supportive of the dynamic volatility adjustment (DVA), EIOPA proposes new regulatory measures that could in practice make the DVA more burdensome to apply.
- Matching adjustment: The proposed recognition of diversification benefits would align standard formula treatment with internal models and strengthen solvency ratios for some firms.
- Sensitivity testing of the LTG measures: EIOPA proposes powers to restrict capital distributions where insurers would breach SCR under prescribed LTG stresses.
- SCR standard formula: A proposed new methodology for interest rate risk would apply more severe shocks, closer to those applied by internal model firms.
- Minimum Capital Requirement: EIOPA proposes more prescriptive requirements on MCR breach and withdrawal of authorisation that would reduce scope for supervisory discretion.
- Reporting and disclosure: Proposed updates to reporting would require systems change, and EIOPA’s proposed harmonised audit requirement would increase costs for some insurers.
- Group supervision: EIOPA proposes to clarify expectations for many aspects of the group rules, including non-transferability of transitional measure benefits. These proposals could reduce group solvency ratios for some groups
- Macro-prudential policy and recovery and resolution: EIOPA’s proposals are far-reaching, but the European Commission has not taken forward similar proposals in the past and we see no compelling reason to expect a change in their stance.
Overall, EIOPA’s proposals would represent a quite far reaching set of changes to Solvency II, if, for example, the European Commission were to take forward proposals on the extrapolation of risk free interest rates or the VA. However, the final changes that will be made in the 2020 review will be determined by the European Commission and will become evident only as the review process unfolds. In the end, the review may well amount more to an adjustment (albeit potentially a radical one in the case of the VA) and in some cases fine tuning of the existing Solvency II framework rather than a radical redesign.
Nevertheless, many of the changes, which arguably reflect already diminishing UK influence in ESA policy formulation, will have a bearing on the potential pressures for divergence between the UK and EU regulatory frameworks for insurance post-Brexit; this is a topic we cover in detail in our report Solvency II: Continuity, Change, and Divergence in a post-Brexit world. While it is highly uncertain whether, or how, the UK regulatory framework may change post-Brexit, on many points of potential reform (for example, the risk margin), the Prudential Regulation Authority (PRA) has stated that it will look in the first instance at whether specific UK concerns about Solvency II are addressed through the 2020 review. The Consultation suggests that in a number of areas, most importantly the risk margin, this condition appears unlikely to be met.
EIOPA’s advice will be a very important factor for the European Commission to take into account as it formulates its Solvency II recommendations. The consultation therefore provides a vital, if relatively short, window for insurers to seek to influence the outcome.
APPENDIX: 10 Key Topics in the Consultation
The Risk Margin
Despite concluding that the risk margin calculation is interest-rate sensitive for certain insurers and products, EIOPA does not propose any changes to the current calculation or fixed cost of capital rate.
EIOPA’s analysis shows, not unexpectedly, that the risk margin is more sensitive to interest rates for UK long term insurers applying the MA. However, EIOPA found the calculation also to be sensitive in some Eurozone jurisdictions, such as the Netherlands. EIOPA also found that the risk margin becomes more interest rate sensitive if a later LLP is applied for the euro risk free curves – an observation that is likely to be relevant for any decision to change the LLP for the euro in the course of the 2020 review (as discussed further below).
Overall, a decision not to change the risk margin calculation is likely to prove disappointing to the UK in particular, and is highly likely to increase pressure for the PRA to take forward a UK-specific solution at the appropriate time.
Extrapolation of risk-free interest rates and determination of the LLP
EIOPA’s primary focus in the consultation is how the LLP is derived for the euro. The euro LLP, from which risk free rates are extrapolated to the Ultimate forward rate (UFR), is currently set at 20 years, a cut-off point reached in the original Directive negotiations on the basis that Europe lacked sufficiently deep and liquid markets at longer maturities. However, EIOPA’s recent analysis concludes that suitable deep, liquid and transparent swap market data exists to support an LLP of up to 50 years.3
EIOPA analyses the effect on solvency cover (see the chart further below) and volatility of setting the LLP at 30 years and 50 years, as well as an “alternative method” that would steadily blend market data following a “First Smoothing Point” (FSP), to be set at 20 years for the euro.
As expected, extending the LLP reduces solvency and increases volatility for insurers applying the euro risk free curve. In some cases the impact would be substantial: in Germany, for example, a 50 year LLP would reduce the market-wide SCR ratio by 182 percentage points. The alternative method would have the same effects, but to a much lesser extent (the German SCR ratio would reduce, for example, by 49 percentage points).
Given this difference in solvency cover reduction, we expect any significant change to the LLP would receive significant pushback during negotiations. However, EIOPA’s conclusions on the availability of euro market swap data at long durations may make maintaining the status quo difficult to justify.
In our view, therefore, the alternative method may prove a likely compromise position. As it would apply to all currencies, this outcome would, in fact, produce a no-doubt welcome uplift in risk free rates for insurers applying the GBP, USD, CHF or AUD curves.
EIOPA consults on a wide range of range of redesign options for the VA, which together highlight the potential for a substantial redesign of the VA. In the main, these options are designed to avoid the VA “overshooting” or “undershooting” the actual spread fluctuations experienced by an individual insurer. If taken forward, these proposals could substantially change the quantum of the VA adjustment, with the effect varying by individual insurer.
A more tailored approach should, at face value, bring the VA closer in effect to the MA, though we consider it unlikely that the review will ultimately go so far as to abolish the MA, as mooted in the European Commission’s call for advice.
EIOPA proposes several methods that would tailor the VA adjustment more closely to insurers’ actual asset and liability profiles. EIOPA also proposes several more targeted technical “fixes”, which would also have a significant overall effect on the quantum of the VA in different economic conditions. For example, a proposed updated calculation of the risk-correction used to calculate the VA4 could substantially reduce the ultimate VA adjustment when spreads are wide (see the chart below).
EIOPA also proposes to update the methodology for macro-economic risks. This could include an explicit “macro-economic VA” to apply in crisis situations, if the “permanent VA” is not sufficiently tailored to the individual insurer to capture, in particular, country risks.
EIOPA also reviews the application of the dynamic volatility adjustment (DVA), which has been a controversial aspect of the design of Solvency II owing to its accommodation of firm assumptions as to how the authorities are likely to respond in severe stress conditions. While supportive of the DVA in principle for internal model firms, EIOPA explores various disincentives that the DVA could pose in practice to risk and investment management.
EIOPA considers these to amplify disincentives that already exist in the constant VA. Accordingly, EIOPA’s preference is to solve these disincentives “at source” in the VA methodology. However, in the event the review does not take forward suitable proposals on the VA to address these concerns, EIOPA proposes that further regulatory measures (which EIOPA has not yet specified) should be introduced to address these disincentives. Such proposals could affect the use and design of the approaches to calculating the DVA, and could make it practically more burdensome for insurers to apply the DVA.
EIOPA recommends that the DVA should not be introduced into the standard formula.
EIOPA proposes to remove the restriction in the standard formula on recognising diversification benefits between matching adjustment (MA) portfolios and the remainder of an insurer’s business. This would align the treatment with internal model firms, and could reduce SCR requirements for standard formula users. In practice, EIOPA’s impact assessment shows a greater potential benefit in Spain than in the UK.
Sensitivity testing of the LTG measures
EIOPA proposes additional sensitivity testing requirements for the LTG measures which would, most importantly, make capital distributions subject to supervisory oversight where an insurer would breach its SCR under certain stresses. The relevant proposed sensitivities are an LLP aligned to the longest duration for which deep, liquid and transparent market swaps data is available (50 years for the euro), a reduction in the UFR of 100 basis points, and non-application of the MA, VA and transitionals.
These proposed requirements could make these benchmarks – which insurers would be required to disclose publically - extremely important for capital planning, even if they did not set the formal solvency standard.
Solvency Capital Requirement standard formula
EIOPA considers interest rate risk is currently severely under-estimated in the standard formula SCR, in part because it does not stress negative rates. EIOPA therefore “strongly recommends” a revised “relative shift” methodology that would apply stress parameters which vary in function of maturity and would take into account negative interest rates.
This proposed approach would be likely to align standard formula firms more closely with internal model firms, many of which already apply more severe interest rate stresses in their capital calculations. The proposed changed approach should, in theory, increase interest rate risk SCR levels for standard formula firms; for example, the graph below shows the proposed GBP down stresses across a range of durations. However, the actual effect of the proposals could well be mitigated in practice by firms’ existing hedging strategies. EIOPA recognises that its proposals would represent a material change and has expressed openness to a gradual implementation.
It is worth nothing that EIOPA also proposed updates to the interest rate risk calculation in the 2018 Solvency II review. Following that review, the European Commission stated that it “acknowledges the necessity to address certain shortcomings in the current calibration” but expressed a preference to consider the topic through the 2020 review. Changes to the calculation therefore appear likely through the 2020 review.
Minimum Capital Requirement
EIOPA proposes to clarify and strengthen the regulatory requirements around non-compliance with MCR. The proposed changes would require earlier submission of a scheme to restore compliance or avoid a breach, and would reduce supervisory discretion and flexibility around how and when authorisation is withdrawn where an MCR breach is not remedied. In practice, this could mean that any extension to the three month MCR recovery period could only take place in specific circumstances, upon agreement by EIOPA, or even not at all, depending on which recommendations, if any, are implemented.
Reporting and disclosure
As well as detailed changes to certain aspects of regulatory reporting (e.g. to information reported on specific templates), EIOPA proposes to introduce an audit requirement for firms’ SFCRs. Audit requirements already exist in 16 EU member states, and in these cases EIOPA’s proposed minimum scope – the Solvency II balance sheet – is unlikely to add materially to the audits already carried out. However, an audit requirement would be likely to increase costs for insurers in other jurisdictions, as well as those currently exempt from national audit requirements on proportionality grounds (for example, small UK insurers), given EIOPA does not envisage exempting smaller or less complex firms. EIOPA recognises the likelihood that the cost of audit would be relatively higher for smaller insurers than it is for larger insurers.
EIOPA proposes several other changes in terms of Pillar 3 reporting, including amendments and additions to specific QRT templates, changes to reporting deadlines (including to accommodate the proposed audit requirement), and changes to the structure and contents of the SFCR and RSR. While EIOPA’s proposals in some cases seek to simplify or increase proportionality in reporting, the proposals on balance are unlikely to address many industry concerns about the volume and proportionality of reported data. While the implications of the proposed changes would differ for each individual insurer, many would be likely to require changes to reporting systems and processes, and hence could represent a material cost for many insurers.
EIOPA’s draft advice proposes additional prescription for many aspects of the group supervision rules. In many cases, the proposals could make clearer the application of Solvency II to particular group structures, for example around the definition of insurance groups, and the detail of group solvency calculation. They would also provide clearer powers to be applied by the group supervisor.
EIOPA’s proposal that the benefit of the transitional measures on technical provisions and risk free interest rates at solo level should be treated as non-transferable for the purposes of group solvency could reduce group solvency ratios for some groups.
Macro-prudential policy and recovery and resolution
EIOPA consults on proposals that are far wider than requested in the European Commission’s call for advice, explaining that “In EIOPA’s view, the financial crisis revealed that either no appropriate tools existed or microprudential measures were used for addressing identified system-wide risks, which were not successful or sufficient in the financial sector.”
EIOPA’s proposals include capital surcharges imposed by supervisors to address systemic risks, as well as a minimum harmonised recovery and resolution framework and a macro-prudential policy toolkit to be applied by national resolution authorities.
If implemented, these proposals would transform the macroprudential tools available to EU insurance supervisors. However, EIOPA has previously laid down its ideas on these topics in other discussion papers and opinions. Given the limited scope which the European Commission asked EIOPA to consider in its call for advice, a substantial change in political will – of which there is little sign currently - is likely to be necessary in order for the proposals to be taken forward.
1 The consultation runs to 878 pages, to which a qualitative impact assessment is attached, covering many aspects of the Solvency II Directive. Topics covered by the consultation include: long-term guarantee measures and measures on equity risk; technical provisions; own funds; the Solvency Capital Requirement (SCR) standard formula; the Minimum Capital Requirement (MCR); reporting and disclosure; proportionality; group supervision; freedom to provide services and freedom of establishment; macro-prudential policy; recovery and resolution; insurance guarantee schemes; transitionals; and fit and proper requirements. The consultation deadline is 15/01/2020.
2 The graphs presented in this blog, except where otherwise stated, represent the data presented by EIOPA in its consultation document. In some cases, data has been approximated from EIOPA’s published charts. Source: EIOPA - European Insurance and Occupational Pensions Authority, https://eiopa.europa.eu/.
3 The depth, liquidity and transparency of swap markets is not the only criterion that determines the LLP at present, hence the current 20 year LLP.
4 The VA is calculated as 65% of the risk-corrected spread of a reference portfolio, being the current spread minus a risk correction, which is intended to capture risks to which the insurer remains exposed as an investor. EIOPA notes that “[u]nder the current design of the VA, the risk-correction hardly changes with credit spread changes.”
5 Analysis by Deloitte, based on EIOPA’s consultation proposals.