We predicted in our 2020 Regulatory Outlook that the Solvency II review would result in important changes for insurers to factor into their strategies and planning. Less than two months into the year, the review is already seeing twists and turns. This blog discusses two prospective important changes that now look likely to come out of the review – to the risk margin methodology, and to the euro long-term discount curve – and highlights connections with EIOPA’s concurrent project on IBOR transitions.
Keeping Solvency II “fit for purpose”
EIOPA’s Chair, Gabriel Bernardino, recently stated that “Solvency II was designed in very different market conditions” to the prevailing ultra-low interest rate environment. He suggested that EIOPA would recommend updates to both the risk margin methodology and the LLP1 for the euro, as part of “[ensuring] that the regime continues to be fit for purpose by being capable to reflect the evolution of the market conditions”.
The operation of these components of Solvency II in the low interest rate environment makes them arguably two of the most important topics in the Solvency II review.2 However, as recently as October EIOPA’s stated position was non-committal on the euro LLP, and that the risk margin methodology should not be adjusted.
So, what has changed?
In short, our view is that we are starting to see the political direction of the Solvency II review unfold: as we stated in our 2020 Regulatory Outlook, “the risk margin and the LLP for the euro are only likely to be reformed, in our view, should the European Commission provide the necessary political direction.”
Potential changes to the risk margin and euro discount curves
Prospective changes on these two topics are best viewed in the round. There was plenty of discussion at DG FISMA’s3 January 2020 conference on the Solvency II review about how the objective should not be to increase the overall capitalisation of the European insurance industry. It is the implications for insurers’ capital that make changes to either the risk margin or the euro LLP potentially so controversial – EIOPA’s initial impact assessment indicated, for example, that a change to a 50 year euro LLP would reduce the market-wide SCR ratio in Germany by 182 percentage points.4
However, a package of changes could well balance a lower and less volatile risk margin against a lower and more volatile discount term structure, broadly balancing the effect on overall sector capital levels. Importantly, both components could end up being more market consistent - potentially by following similar approaches to the IAIS’s Insurance Capital Standard5 – hence arguably improving the design and risk-sensitivity of the Solvency II regime overall.
In practice, the drive to make these changes is likely to have come in part from the evidence gathered by EIOPA on the depth, liquidity and transparency of euro swap markets. We discussed this topic in another recent blog, arguing that EIOPA’s findings make maintaining the status quo of a 20 year LLP difficult to justify. The inevitable increases in capital that a more market-consistent euro curve would bring for some insurers could very well be balanced by a less interest rate sensitive risk margin. EIOPA is also likely to have received quite significant pushback on its consultation proposal not to change the risk margin, which will have created further pressure for continued review and potentially reform.
Connection to IBOR transitions
All of the above, however, begs the question of how the overall package of changes may be affected by the transition to new benchmark rates (IBOR transitions). The current Solvency II risk free interest rate term structures are commonly based on Interbank Offered Rates (IBORs). These ultimately need to be replaced by new discount term structures based on overnight index average rates (OIS), such as the Euro Short Term Rate (€STR) and the Sterling Over Night Index Average (SONIA).
EIOPA’s newly-released IBOR transitions discussion paper (DP) is primarily concerned with the transition from the old to the new curves, but also notes EIOPA’s assessment that none of the OIS curves can, at this time, be considered deep, liquid and transparent (DLT). EIOPA expects “that this can change rapidly within the next six to nine months”, but the transition methodology will be of great importance as the relevant DLT assessments evolve rapidly.
The link to the Solvency II review discussions on the LLP for the euro, and the extent to which it is based on observation of DLT market data, is obvious. On first principles, any methodology changes agreed for the Solvency II review should be capable of application regardless of changes to the financial instruments underlying the market portion of the curves. However, an impact assessment carried out based solely on IBOR swap market data is clearly going to be of limited value to support a decision about the future, and there is likely an increased risk of unintended consequences with respect to insurers’ overall capital levels.
Next steps and implications for insurers in 2020
EIOPA has stated that it plans to carry out an impact assessment in the spring on what should be a narrowed down set of Solvency II review policy recommendations, and the European Commission also suggested that it intends to launch its own 12 week consultation on the review. Concurrently, EIOPA’s IBOR transitions DP is open until the end of April 2020, following which EIOPA will issue a consultation paper. It is, therefore, likely to be the autumn at the earliest before any more settled policy is apparent. We are unlikely to know the final legislative proposals for the Solvency II review until some way into 2021, and implementation, potentially with transitional provisions, is unlikely before 2022.
However, EIOPA’s spring impact assessment should, all being well, provide a clearer picture of its proposals for the risk margin, and should build on its previous analysis on potential changes to the euro LLP and extrapolation methodology. It may, also, start to provide impact analysis on the implications of the IBOR transitions for the eventual Solvency II discount curves themselves – setting aside the transition. Notwithstanding the limited amount of available DLT market data, insurers will need to evaluate how the revised curves will affect their products, capital, risk management strategies and business models. While larger insurers can very likely carry out all the necessary analysis in-house, some published data from EIOPA – heavily caveated as necessary – will likely be extremely useful for many insurers as they plan for the transition.
It now appears more likely than ever that the Solvency II review will produce a package of changes that may affect insurers’ capital and strategies to varying degrees. We expect insurers to remain engaged with the review in 2020, and indeed we recommend that they do so in order to make the most of the various remaining opportunities to provide comment and help steer the review outcomes.
1 Last Liquid Point
2 The risk margin increases liabilities (and hence capital) in a low interest rate environment, while the LLP for the euro decreases liabilities by contributing to a steeper-than-market discount curve for long dated liabilities.
3 Directorate General for financial stability, financial services and capital markets union
5 For further discussion of the Insurance Capital Standard, please see our recent blog at https://blogs.deloitte.co.uk/financialservices/2020/01/international-insurance-regulation-is-the-post-crisis-reform-programme-now-complete.html.