Solvency II update
EC submits request to EIOPA for technical advice on the review of Solvency II
08 Apr 2019
It will be a busy year ahead for the European Insurance and Occupational Pensions Authority (“EIOPA”). On 11 February 2019, the European Commission (the “EC”) submitted a formal request to EIOPA for technical advice on 19 items ahead of the EC’s 2020 review of Solvency II. The EC has asked EIOPA to respond to its request by 30 June 2020.
Some of the highlights
The end of the Matching Adjustment?
Perhaps of most interest will be the EC’s request that EIOPA reviews the Matching Adjustment (“MA”) and Volatility Adjustment (“VA”) “whilst not precluding the possibility of a single adjustment mechanism”.
With the United Kingdom’s potential departure from the EU approaching, this could be a means of simplifying the regulation once the UK leaves. Once the UK departs, only 15 undertakings across the EU (all of which are in Spain) will apply the MA. Compare this to the VA: 673 entities across the European Economic Area (excluding the UK) apply the VA1.
If EIOPA were to take a single adjustment mechanism forward, how the mechanism would work is unclear at the moment. However, the EC does ask EIOPA to consider a “[volatility] adjustment that takes into account the illiquidity features and/or duration of insurers’ liabilities”2 – perhaps hinting at an “upgraded VA”?
However, combining the MA and VA is by no means a foregone conclusion. The EC also asked EIOPA to consider further changes to the Matching Adjustment:
- Allow partial / full diversification across MA portfolios;
- A review of criteria for eligible assets.
The Volatility Adjustment
The VA has come under fire from some member states because under normal circumstances it is formulated based upon a currency portfolio, rather than a country-specific portfolio. Therefore, except under extreme circumstances, the VA for Italy will be the same as the VA for France, for example. The EC has therefore asked EIOPA to review the methodology for the activation of the “country component” of the VA.
In addition to reviewing the country component of the VA, the EC has asked EIOPA to consider two approaches to the VA:
- An adjustment that considers the illiquidity features and/or duration of insurers’ liabilities; and
- The application of an adjustment that considers the weights of own assets holdings of each insurer.
The Risk Margin
In February 2018, EIOPA published its Second set of advice to the European Commission on specific items in the Solvency II Delegated Regulation. In its advice, EIOPA stated that at that time it was only concerned with the cost of capital rate; kicking the risk margin can down the road. EIOPA stated that “the review of other aspects of the risk margin should be done as part of the review of Solvency II that the Commission is required to undertake after five years of implementation”.
Now the 2020 review has arrived, and the EC has asked EIOPA to consider the following aspects of the risk margin:
- The design of the risk margin, considering work undertaken by EIOPA on transfer values following a recent request from the EC, in which “… EIOPA is asked to compare the transfer values with the valuation of the transferred liabilities and assets, if any, under the Solvency II framework.”;
- Assumptions regarding the asset mix of the reference undertaking (in particular, interactions between market risk and the use of the MA / VA in the risk margin calculation);
- The use of a fixed cost of capital; and
- The assumptions used to derive the cost of capital rate, including the absence of leverage and the derivation of the equity risk premium.
Risk-free interest rate term structure
The EC has asked EIOPA to provide evidence on criteria to determine the last liquid point (“LLP”) for all countries of the European Union. Where this analysis suggests the current LLP is inappropriate, the EC requires EIOPA to conduct an impact assessment of potential modifications to the LLP.
Although EIOPA has only been asked to comment on the LLP, EIOPA could, on its own initiative, decide to consider the Ultimate Forward Rate (“UFR”) and convergence period as well. We note that EIOPA considered the impact of both of these on firms’ solvency positions as part of its Long Term Guarantee Report 2018.
As we discussed in a previous newsflash ("Preparing for the discontinuation of LIBOR") it is expected that the London Inter-bank Offered Rate (“LIBOR”) and equivalent reference rates in other currencies will be discontinued in the near future. This begs the question of what will happen to the Solvency II risk-free rate curves, which are currently based on these rates. So far there is no indication of how and when any changes may be implemented, but clearly the impacts of any change will have potentially wide-ranging impacts for firms.
Interest rate risk
In its second set of advice to the EC on items in the Solvency II Delegated Regulation (published in February 2018), EIOPA included an “own initiative” to address issues it had identified with the assessment of interest rate risk within the standard formula. EIOPA believes that the current approach “underestimates the real interest rate risk in a low yield environment” and fails to stress negative rates, despite reality proving that these are an economic reality. Importantly, EIOPA also believed that the existing approach didn’t comply with Article 101(3) of the Solvency II Directive.
To address its concerns, EIOPA proposed to model interest rate risk in the standard formula using a “relative shift approach” – an approach widely used by Internal Model users. EIOPA did acknowledge that the changes could impact correlations but considered this out of scope of its review at the time. These changes were rejected by the EC at the time. However, the latest call for technical advice explicitly includes interest rate risk. And it unambiguously asks EIOPA’s review to take “into account the low interest rate environment”.
Should EIOPA recommend significant changes to the areas highlighted, this could potentially have a material impact on insurers’ businesses. At this stage, it is too early to hazard a guess about what EIOPA may propose. However, we shall follow developments in this area, including any consultations that EIOPA may publish over the course of the review.
Hymans Robertson has a wealth of Solvency II experience. If you would like to discuss Solvency II with one of our specialists, please get in touch.