What impact will the Solvency II review have on European insurers?
Insurers in the EU have an excellent opportunity to review their asset-liability management practices and climate scenario analysis, in preparation for making the most of the upcoming reforms.
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The 2020 review of Solvency II, which started in February 2019, is now taking shape. The European Commission, Council and Parliament will initiate negotiations for EU member states to adopt these changes by June 2025.
The review is expected to bring important changes to the insurance industry in Europe, including changes to the technical provisions, Solvency Capital Requirement (SCR) and firms’ Own Risk and Solvency Assessment (ORSA). We believe these changes will incentivise better asset liability management, as well as allow firms to release capital and technical provisions which could boost the growth and transition of the European economy.
- Click here to read the full article: Solvency II review: what do the new changes mean for European insurers?
So, what are the key changes coming to Solvency II and what they will mean for insurers?
We look at six main changes:
- Risk margin
The risk margin is a provision under Solvency II that insurance companies must hold. This represents the theoretical amount the insurer would need to compensate another firm with for taking on its best estimate liabilities.
The European Commission's 2021 Impact Assessment Report recommends reducing the risk margin through the introduction of a tapering parameter called 'lambda’ and reducing the cost-of-capital rate from 6% to 5%. The European Parliament's proposed amendments in July 2023 suggest bringing down the cost-of-capital rate further to 4.5%.
If both changes are adopted, insurers could benefit from a substantial release of technical provisions, estimated to be a 30% to 40% release of risk margin for a long-term insurer.
This reform is expected to reduce the volatility of the insurer’s solvency positions and release significant capital to finance European economies and long-term green investment. The Commission estimates the proposed changes would cut the size of the risk margin by more than €50 billion across the sector.
2. Long-term equities
The Long-Term Equity Investments provision in the Solvency II review is another measure meant to incentivise investments in the real economy. However, the current criteria are perceived to be too restrictive.
To make the provision more accessible, the European Commission and European Parliament propose relaxing requirements around the ring-fencing and holding period of assets and introducing a differentiation between life and non-life firms. The reduction in capital requirements for equity risk could reach approximately €10.5 billion, which can be released and invested in the long-term financing of the European economy and infrastructure.
Insurers can easily adopt the long-term equity measure to back long-dated cash flows with equities, benefiting from higher expected returns without attracting disproportionately penal capital charges.
Investments can qualify at portfolio level, not just individual equities, making investments in collective investment undertakings or alternative investment funds more attractive (e.g. ELTIFs).
3. Equity Risk – Symmetric Adjustment
The symmetric adjustment is a change to the equity risk charge on some equity investments to prevent procyclicality. The European Commission and European Parliament agree to widen the so-called symmetric adjustment corridor from +/-10% to +/-17%, strengthening the potential countercyclical effect of the symmetric adjustment in extraordinary market conditions.
Over long periods of time, the symmetric adjustment should average to zero, and the impact of this change over a long-term horizon should therefore be low. However, the corridor widening can make a difference to SCR and solvency levels during extraordinary periods of market rally or distress.
4. Risk-free rates
Under Solvency II, "risk-free curves" are used to calculate best estimate liabilities (unless a volatility adjustment or matching adjustment is applied). To calibrate the risk-free curves, under the current terminology, the European Insurance and Occupational Pensions Authority (EIOPA) uses market swap rates up to a certain point, and then extrapolates to an "ultimate forward rate".
EIOPA's 2020 review, conducted in a low-yield environment, found that there was a gap between Solvency II risk-free rates and market rates. To close this gap, the European Commission proposed a new yield curve methodology all currencies, which is expected to be gradually implemented over time.
The proposed changes are more likely to affect insurance companies with long-term liabilities (such as life insurers). However, with significant rate rises since the changes were first proposed, the impact of these changes is now expected to be much smaller.
5. Volatility adjustment
Under Solvency II’s long-term guarantees package, firms are also allowed to use a "volatility adjustment" to increase the discount rate they use to value liabilities under certain conditions. The European Commission and European Parliament have proposed a series of changes, including:
- Any new uses of the volatility adjustment will require regulatory approval.
- The percentage of "risk-corrected spread" that can be included in the adjustment will be increased from 65% to 85%, meaning that firms with good asset-liability management practices should expect to be able to further increase their discount rates (and reduce liabilities).
- A new “credit spread sensitivity ratio” will be introduced to incentivise closer asset-liability duration matching.
- A new "undertaking-specific adjustment" may be incorporated to partially reflect differences in spread on firms’ own portfolios and the reference portfolio.
- For euro countries, there will be changes to country volatility adjustments.
These reforms are likely to increase the volatility adjustment for insurers with good asset-liability management practices and who optimise their fixed income portfolios for risk-adjusted spread.
We would encourage firms to review their liability-backing portfolios to maximise their volatility adjustment under the new rules, and to consider applying the volatility adjustment if they are not already doing so.
6. Climate risk, ESG factors and biodiversity risks
Firms must now conduct long-term scenario analysis as part of their ORSA, considering at least two scenarios: one where the global temperature increase remains below two degrees Celsius, and another where it is significantly higher than that.
The European Parliament also requires insurers to develop specific plans to address the risks that come from environmental, social, and governance factors. Insurance companies will need to think about how they can reduce their impact on the environment and society and create measurable goals to track their progress.
They also need to make sure that their investment strategy is resilient to climate risks, including investing in companies that are working to address social or environmental issues.
- Click here to read the full article: Solvency II review: what do the new changes mean for European insurers?
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