Solvency II and the low interest rate environment

Olav Jones8 October 2013

Insurance Europe

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Insurance Europe represents 95% of European insurance market and more than 5 000 European (re)insurers, which:

• generate premium income of more than €1 100bn

• employ almost one million people

• invest almost €8 400bn in the economy

Founded in 1953: 34 members from EU and related areas

Why has SII been delayed?

Insurance industry has supported a risk-based system

The Quantitative Impact Study in 2010 (QIS 5), combined with significant market turbulence, showed that Solvency II required adjustments to measure all risks correctly

Delay until 2016 needed to get agreement on the changes and fix Solvency II so it will work as intended

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Adjustments to Solvency II required to take into account long-term nature of industry

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Economic consequences of long-

term liabilitiesProblems identified by

QIS 5 in 2010Solutions identified

Insurance companies can reduce or eliminate their exposure to actual losses due to temporary falls in asset prices.

Solvency II was assuming companies are always exposed to all market price movements.

This exaggerated the true risk and created enormous and unmanageable artificial volatility in the balance sheet.

Adjust the measures to recognise the economic impact and benefits of the long-term model.

Even if a change (eg shift to low interest rates) may be permanent, insurance companies usually have many years to address the issue.

Solvency II was assuming that any shortfall must be immediately filled.

This would create unnecessary financial distress.

Include transition measures and extend recovery periods.

Why this matters?

Insurers’ long-term approach is vital

For policyholdersAccess to a wide range of long-term productsAccess to additional yield from investing long-termSharing/pooling of investment returns among policyholders over time

For the wider economyLargest institutional investor, with a long-term perspectiveStable funding for economic growthStability and counter-cyclical role during crisis

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Balance sheet volatility has a very large impact on the actual capital companies will in practice need to hold

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Valu

e o

f ass

ets

Assets Liabilities

Best

est

imate

lia

bili

ties

Risk margin

SCR

Surplus

Available capital

Capital (Own funds)

Buffer needed to cope with balance sheet volatility

Total capital companies will need to allocate to meet Solvency II requirements as well as coping with volatility created by the Solvency II measure

Example 1: How much volatility would Solvency II have created without adjustments?

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Package of solutions under discussion is not ideal but can avoid Solvency II causing unnecessary damage

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Adjustment What it is meant to achieve

Matching Adjustment Recognise that in certain cases insurers can eliminate exposure to asset price volatility (but is exposed to risk of actual default)

Volatility Adjustment Recognise that even where conditions for Matching Adjustment are not met, companies are not fully exposed to asset volatility

Extrapolation Recognise that risk free curve needs to be extended because liabilities can be longer than available market data

Transitional measures Recognise that long-term nature of business means that insurance companies both need and have time to adapt from previous regime, products and market situations to new one

Extension of recovery period

Give more time to deal with exceptional situations, such as falls in financial markets

What does this mean for low interest rates?

Current low interest rate environment is difficult for some companies

The volatility adjustment will better reflect the economic position of the company and avoid exaggerating the low interest rate issues faced by companies with a mismatch

The transition measures will provide time for companies to adapt, however companies should not delay in addressing the issue

Solvency II will encourage new products to be designed in a way that can cope with the full range of interest rate conditions

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Example 2: Why transition measures are so important to deal with the current low interest rates

Solvency problems:can be due to current market conditions => might only be temporary the long-term nature of the business means that there may be many years to allow for solving

There is a difference between:Immediate shortfalls (eg €200m due to a windstorm) Future shortfalls (eg €200m due to current low interest rates)

Likely impact of Solvency II

Impact will depend on how Solvency II is finalised Appropriate package of adjustments to Omnibus II to cope with long-term issuesAppropriate implementation where there are still a large number of improvements needed (implementing measures)

If we get a reasonable set of solutions then Solvency II will likely lead to:

Better risk management and very high standards of protection for policyholdersBetter matching of assets and liabilitiesProduct pricing better reflecting the real risksChanges in product design (especially on guarantees)

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