The Solvency II 2020 review is looming, keeping the European insurance industry on tenterhooks. The European Commission asked the European Insurance and Occupational Pensions Authority (EIOPA) to provide proposals for an update of Solvency II by June 2020. And on Oct. 19, 2019, EIOPA published an almost 900-page consultation paper (CP) with manifold suggestions for almost all Solvency II aspects.

S&P Global Ratings understands EIOPA's aim is that the impact of the 2020 review, beyond the interest rate stress, should be balanced for insurers in Europe, arguing that Solvency II has worked well since its introduction. We believe this is reasonable because potential large drops in solvency ratios could lead to uncertainties among companies, investors, and other stakeholders (for instance, with regulatory predictability and capital management). On the latter, we believe that insurers will have to update their capital management plans, given that the Solvency II update might affect regulatory ratios. Cumulating the EIOPA's estimates for the three most important measures, the interest rate stress, the last liquid point (LLP) and the volatility adjustment (VA), we estimate the impact on the Solvency II ratio could be anywhere from 30 to 70 percentage points on average per country (before diversification and potential loss-absorbing capacities), and for some life insurers by over 100 percentage points.

The impact will vary between regions, sectors, and individual risk exposure of insurers. In general, we anticipate that life insurers with long-term guaranteed liabilities will be affected most, which is particularly the case for Germany, The Netherlands, and the Nordic countries. The ultra-low interest rate environment could exacerbate the impact of EIOPA's proposals, particularly as rates have decline even further in 2019 (see chart 1). Still, we acknowledge that some proposals (such as catastrophe risk and property risk charge) might also be beneficial. Also, potentially reducing the risk margin from the current 6%--a recurring request of insurers--would be positive for an insurer's solvency ratio, although EIOPA has not hinted at any changes on this front.

Chart 1

EIOPA's Proposals Are Sound, But A Final Agreement Is Likely Years Off

We welcome the review, especially evaluating whether the current assumptions in the Solvency II calculation are appropriate. EIOPA reiterated that its goal is to ensure policyholder protection. Furthermore, we understand that the authority makes suggestions to adapt for the changed macroeconomic environment since Solvency II's introduction in January 2016. This is underpinned for example by the proposal to reflect negative interest rates in the interest rate stress module and to better calibrate the VA in function of underlying exposure. We also welcome that EIOPA aiming to strengthen macroprudential considerations within Solvency II.

There is a long way to go in the process. EIOPA will make its recommendations to the EC, which, along with national parliaments, will have the final say. We believe it might take until 2023 before the update becomes applicable, and that insurers will follow developments closely to be as prepared as possible. Furthermore, we anticipate there will be a transition period, particularly if the impact is meaningful.

We Expect Only Limited Effects On Ratings

Overall, we believe the impact on our ratings due to the Solvency II review will be limited. Our financial strength ratings on insurers will likely be unaffected because we base our view on capitalization mainly on our risk based capital model unless we determine there is a significant risk of breaching the minimum regulatory capital requirements. In addition, insurers have healthy solvency positions on average. According to EIOPA's financial stability report from December 2019, the Solvency II ratio for all types of insurers (life, nonlife, and composites) stood on average above 200% at second-quarter 2019.

However, our ratings on hybrid instruments might be affected. If an issuer's solvency ratio comes under stress due to this update, we could lower the hybrid ratings to reflect the increased risk of coupon nonpayment. The potential cumulative impact on the Solvency II ratio might be 100 percentage points in some cases, indicating less buffer left to the mandatory deferral trigger level.

Setting The LLP Is Critical For Evaluating The Best Estimate Of The Technical Liabilities

A key element for the Solvency II calculation is the interest rate curve used to discount an insurer's liabilities, the so-called risk-free curve, to calculate the best estimate of liabilities (BEL). This means that, in general, a lower curve leads to higher BEL, and lower own funds and solvency ratios.

The current discussions to move the LLP for the risk-free curve (for the euro) to 30 or 50 years from the current 20 might lead to a significant lower overall risk-free curve. The risk-free curve consists of a so-called liquid part, and an illiquid part. For the liquid part, EIOPA derives the curve from observed values from the swap market, up to the LLP. Beyond the LLP, in the illiquid part, the curve will be extrapolated to the ultimate forward rate (UFR), which stands at 3.75% since January 2020. In other words, the relative high level of the UFR compared to the swap rates leads to a significant increase in the curve's illiquid part, so choosing the LLP can have significant ramifications.

In its CP, EIOPA discusses keeping the LLP at 20 years, or amending the LLP for the euro, for example, to 30 or 50 years, which means to start the extrapolation towards the UFR later. Based on the current yield environment, this would lead to a significant lower risk-free curve (see chart 2).

Chart 2

But why consider moving the LLP? Besides deriving the risk-free curve from observable market data as long-dated as possible, we understand that EIOPA is seeking to ensure that the BEL is neither under- nor over-estimated. Based on the current low-yield environment, the risk to underestimate the BEL is more relevant. According to the CP, a later LLP could have material impact on the SII ratios, and varies between countries (see table 1).

Table 1

Some German and Dutch insurers will be particularly affected, with a decline in a Solvency II ratio as per 2018 to 347% from 457%, and to 144% from 212%, respectively, should the LLP be 30 years. Although the starting point of the Solvency II ratio in Germany and the Netherlands is rather high, the decline is significant. The reason for the sharp decline is mainly that the German and Dutch life insurance sectors have significant exposure to interest rate risk due to the guarantees and the liabilities' long-term nature in their back-books. Nevertheless, by assessing the potential impact only by focusing on the change on average over all insurance sectors might be misleading, because life insurers will in general be more affected than nonlife entities. In this context, due to the decline in interest rates since year-end 2018, the impact on the solvency ratio due to a potential change to a later LLP based on the current risk-free rate is even higher.

We believe the key question is to what extent markets are liquid. From our perspective, the euro-denominated bond market beyond 20 years is less liquid but insurers will still invest in securities beyond 20 years. Basing the LLP entirely on the swap market might lead to additional risks (such as increased volatility) because swaps are mainly traded over-the-counter (OTC). Furthermore, from our view, the level of UFR has a much bigger impact on the derivation of the discounting curve than moving the LLP later in the curve.

EIOPA has suggested another alternative in which it bases the LLP's derivation and the curve's calculation on a new method. Basically, beyond the LLP, market data factor in the extrapolation. We understand a key parameter for the calculation is a convergence factor that implies how quickly the curve approaches the UFR. We believe accepting the convergence factor's deduction would be important for accepting this alternative. This method would also affect other currencies, not only the euro. For the euro, the resulting risk-free rate would be between the curves for an LLP of 20 and 30 years.

Furthermore, EIOPA suggests options to introduce safeguards, such as insurance companies performing sensitivities calculations for a LLP of, for example, 30 and 50 years, and disclose them in their Solvency and Financial Condition Reports. We believe this would make the robustness or volatility of an insurer's BEL and overall solvency positions regarding the risk-free rate more transparent.

Also, we think that the LLP question is equally important from a risk management viewpoint. Insurers aim to match their assets and liabilities and hedge their exposure to interest rate risk, so having an economic understanding of the liabilities that reflects the assets' economic value is critical. We believe that the proposals could help with this.

Interest Rate Stress In The Standard Formula: Adapting For Negative Rates Is Reasonable, But Will Increase Solvency Requirements

To assess the solvency capital requirement for interest rate stress, a stressed (lowered) interest rate curve is used to calculate the BEL instead of the risk-free rate. Since the introduction of Solvency II, a factor approach determines the stressed curve for the standard formula, such that the magnitude of the stress depends on the level of the risk-free curve (the lower the curve, the lower the stress). In particular, negative rates are not stressed at all (see chart 3). This is one of the key differences between the standard formula and internal regulator-approved models that insurers develop to assess their solvency requirements.

However, in the prevailing low interest rate environment, we have observed that rates may decline deep into negative territory. For example, throughout 2019 the rates have declined such that the risk-free rate as per November is lower than the stressed interest curve as per year-end 2018 (see chart 3). Given that within the Solvency II framework the stress is supposed to reflect a 1-in-200-year interest rate shock, we believe the current interest rate stress is not appropriate.

Chart 3

We therefore welcome EIOPA's suggestion to amend the interest rate stress and widen the stress, particular for negative rates, although the impact on an insurer's solvency ratio could be material. The proposed stress would not only multiply factors to the risk-free rate, but the curve also shifts down by an additive component, through the "shifted approach."

In its "second set advice to the EC on specific items in the Solvency II Delegated Acts" from February 2018, EIOPA suggested using the shifted approach. In this paper, it estimated that impact for life insurers would be a decline of 14 percentage points on solvency ratios. However, this is an average of all life insurers independent of their portfolio composition and region. We believe that the hit for life insurers with long-term, guaranteed liabilities would be significantly higher. Moreover, given that interest rates have declined since then, the impact is likely now even more pronounced. Furthermore, transitional rules that potentially were taken into account in the impact study from 2018 are receding.

Based on EIOPA's suggested calibration, the potential changes could be significant. For example, the stressed curve as per year-end 2018 under the new scenario would remain negative for 16 years, and below 0.5% for 27 years. Taking the risk-free rate for November 2019 as a starting point, the stressed curve could remain negative even for 27 years, and below 0.5% for 36 years. Consequently, the stressed curve under the new method would be significant (about 100 basis points) below the current stressed curve (see chart 4).

Chart 4

As with the risk-free curve, the stressed curve will also depend on the LLP (see chart 5).

Chart 5

We understand EIOPA's proposal that the interest rate stress would apply to the whole interest curve, including the UFR, that is, the whole interest curve will be stressed. The insurance industry has voiced concerns that the stress should be only applied up to the LLP, excluding the illiquid part. We believe the rationale is that a real interest shock affects to a larger extend the liquid part of the curve with observable interest rates; also, the UFR is a fundamental concept that should apply universally also in a stress scenario. We expect this question will be further discussed, before a final decision by EIOPA and ultimately the EC will be taken. A potential conclusion to only stress the liquid part could materially soften the overall negative impact of the proposed new stress calculation, which is questionable in a lower-for-longer scenario.

The Proposed Changes To Volatility Adjustments Are Overall Moderately Negative, Although There Could Be Benefits

The volatility adjustment (VA)--along with the matching adjustment (MA)--is the key factor in mitigating the negative impact of market spread volatility of insurers' long-term technical reserves. Contrary to the transitional measure on technical provisions, it is also a permanent feature of Solvency II. The VA has provided significant regulatory solvency benefit for those insurers that use it. In 2018, EIOPA calculated the average benefit at 17 percentage points (see table 2).

Table 2

Table 2 nevertheless also highlights that insurers in some countries benefit much more than others, including insurers in countries that were not thought to be in need of VA when it was designed in 2013. There are some limitations in the way the VA functions that EIOPA wishes to change:

• The euro-wide VA is derived from a theoretical reference portfolio that, when applied by an individual insurer with a different asset, duration, and liability profile, can overstate that insurers exposure to spread risk (the VA overshoots).
• The high threshold for triggering the country-specific VA has limited the benefit to insurers in times of market volatility such as in Italy and Portugal in recent years (the VA undershoots).
• There is a very big difference between the VA benefit in the standard formula and the so-called dynamic VA (DVA) in internal models.

EIOPA has outlined up to eight different options to change the VA calculation, but mainly focuses on two different approaches, each combining three of the eight options. Approach 1 combines a permanent VA and a macro VA. The permanent VA would be slightly lower than current VA, with EIOPA estimating a negative impact for most countries of one-to-two percentage-point on solvency ratios, mainly reflecting the corrections proposed to the VA calculation based on asset liability duration mismatches and based on the surrender risk of the liabilities.

The proposed VA in approach 2 would also be less beneficial than in the current Solvency II regulation for the same reasons but would have the advantage of introducing an undertaking-specific asset weighing of each insurer's asset portfolio. In this case, we believe calibrating the VA would likely more accurately reflect the asset mix of each insurer and lessen the risk of regulatory arbitrage. In addition, this solution would avoid the need for two different types of VA as in approach 1 with the threshold effects between one mechanism and the other (see table 3).

Table 3

Under both proposals, we believe that VA would be much more volatile than in the current Solvency II regulation. Under approach 1, the correction factor corresponding to the fundamental credit spread would change to 30% of current spreads on government bonds and 50% of current spreads on corporate bonds and no longer be based on very long-term credit spread averages. Approach 2 would also use a correction factor based on a percentage of the current spread (30% for bonds with a credit quality step [CQS] of zero, including government bonds, 40% for CQS 1 bonds, 50% for CQS 2 bonds, 60% for CQS 3 bonds), which in our view could increase the VA's procyclicality.

Similar to many other market participants, we believe that EIOPA's proposal to use current spreads on fixed-income instruments has potential limitations as an indicator of long-term credit risk, because credit spreads can be influenced by many other short-term factors, including demand and supply as well as GDP and inflation expectations.

Beyond these slightly negative impacts of both approaches, the VA could still benefit insurers if the current general application ratio (GAR) of 65% increases. EIOPA clearly states a GAR of 100% would not be appropriate, but an increase beyond 65% could be motivated by including previously unquantified haircut mechanisms in case the VA overshoots.

Lastly, EIOPA's CP clearly indicates that applying the DVA to insurers under the standard formula would not be appropriate because it would raise the key issue of the absence of a spread risk charge for government bonds in the standard formula. That is why EIOPA believes that extending the DVA to all insurers would not create a more level playing field even if, based on year-end 2017 data, there was a very large difference between VA and DVA for internal models (1% versus 25% benefit in Solvency II).

We understand that the stumbling block of absence of spread risk on government bonds in the Solvency II standard formula stems from the general political view that eurozone government debt should be considered as the basis for setting the risk-free rates. We believe this approach is unlikely to change as the absence of an explicit risk charge on government bonds is also the basis for the global Basel banking regulation and we believe it is unlikely the European insurance regulators would diverge from banking regulators on this topic. In both our insurance capital and bank capital models, we apply a credit risk charge for government bonds based on the rating we assign to the respective country.

Catastrophe Risk: Potential Changes Are Likely Positive, But Which Insurers Might Benefit Is Unclear

EIOPA's suggestion to adjust catastrophe risk charges for companies applying policy conditions that deviate significantly from country's average is likely to improve the solvency ratios for companies selecting this approach.

We believe this will better reflect companies' risk exposures and allow those with tighter contractual limits, higher deductibles, exclusions, or specific policy conditions to benefit from an offset on their catastrophe risk charges. This approach will converge with S&P Global Ratings' risk-based capital model that allows for company-specific risk charge to reflect differences in underwriting practices for catastrophe risk. However, it is difficult to say whether this proposed change would apply to many P&C insurers given there was no clear definition of what significant deviation means in practice.

Macroprudential Considerations Will Strengthen, Aiming To Level The Playing Field

EIOPA is working on considerations around embedding macroprudential elements into Solvency II. This follows identification of potential macroprudential tools within Solvency II, like the symmetric adjustment for equity risk, VA, matching adjustment, transitionals, and prohibition or restriction of some financial activities. Focus areas have been defined as ORSA, drafting of systemic risk management plan, liquidity risk management and liquidity reporting, and the prudent person principle (PPP). We believe that EIOPA's considerations of entity-based and activity-based sources of systemic risk display some similarity with the International Association of Insurance Supervisor's (IAIS) thinking behind the entities based approach and activities based approach. EIOPA complements those with considerations about behavior based sources of systemic risks, such as indirect systemic risks from collective reactions to exogenous shocks.

EIOPA's toolbox ranges from strengthening existing Solvency II elements, like expanding the use of ORSA and PPP, to granting national supervisory authorities (NSAs) the power to require capital surcharges for systemic risk and requirement of preemptive recovery and resolution planning from undertakings covering very significant share of national markets. EIOPA also is highlighting some challenges, like the unclear future of G-SII identification process by FSB, and a lack of an EU level playing field of definitions of domestic systemically important insurers and specific definitions around activities, which might require a surcharge.

We welcome EIOPA's holistic view on macroprudential considerations being strengthened within Solvency II, as well as addressing potential missing items. Its holistic view, referencing to IAIS' holistic framework for the assessment and mitigation of systemic risk in the insurance sector, embraces macroprudential considerations applicable to many insurers also falling into the scope of IAIG. We believe that maintaining a level playing field in the EU is a crucial consideration. We view positively the measures EIOPA refers to which limit systemic risk or strengthen risk capital held against systemic risk. However, we believe those measures would create a competitive disadvantage in case a level playing field on EU level is not ensured. EIOPA actively stresses the point that EU-wide definitions of systemic importance are required before macroprudential tools are strengthened.

What This All Means For The Sector

We concur with the aim of the European insurance regulators to strive to best reflect the heightened risks that the low for long interest rate environment bears on European insurers. We also believe that policyholders' interests are best provided for if regulation provides the appropriate incentives for insurers to continue to provide long-term insurance solutions to European consumers, especially given aging demographics and limits on public spending. In this context, we would expect that the final agreement on the update of the Solvency II framework to not be disruptive for European insurers and any negative impact on solvency ratios to be smoothed over a transition period.

We do not expect the update of the Solvency II framework to have a negative impact on our financial strength ratings on European insurers, because we base our view on capitalization mainly on our risk based capital model. The EIOPA's proposals on the LLP have caused a lot of reactions but it is rather the calculation method of the UFR that creates important cascading effects on the choice of the LLP and on the calibration of interest rate shocks. Also, the proposed changes would create solvency ratios that are more sensitive to changes in interest rates and credit spreads, potentially making the Solvency II ratio more procyclical.

Potentially lower and increasingly procyclical Solvency II ratios could nevertheless lead us to lower the ratings on insurance hybrids on an insurer in case of stress. In these cases, if the buffer of the regulatory Solvency II ratio above the trigger for mandatory deferral would materially reduce, we could lower the ratings of the hybrid instrument to reflect increased nonpayment risk.

Related Research

• Eurozone Economic Outlook: Consumers Won't Give Up In 2020, Nov. 28, 2019
• EMEA Insurers Buckle Down As Low Interest Rates Make An Unwelcome Return, Nov. 6, 2019
• IFRS 17 Highlights How Low Interest Rates Hurt Insurers, Sept. 18, 2019