Life (re)insurer ALM and Solvency II

In preparing for the upcoming 2020 Solvency II review an important area of focus for life insurers and reinsurers should be a reassessment of asset-liability management (ALM) strategies for long-term liabilities both from the perspective of legislative changes that are under consideration as well as shortcomings in practices that have already been highlighted by regulators. Firms should be assessing these issues for day-to-day solvency, the own risk and solvency assessment (ORSA) and overall risk management needs, bearing in mind the consequences for different types of business and the potential influence on business mix into the future.

In this blog post I highlight some of the key legislative changes currently under consideration regarding the treatment of long-term liabilities, including those that may affect each of the following areas which are important in the context of ALM:

  • The methodology and assumptions underlying the extrapolation of the risk-free rate curves for varying currencies including the last liquid point (LLP), the rate of convergence to the ultimate forward rate (UFR) and the level of the UFR itself
  • The volatility adjustment (VA)
  • The matching adjustment (MA)

I also summarise public feedback from the European Insurance and Occupational Pensions Authority (EIOPA) and national regulators regarding ALM best practices.

The long-term guarantee measures under Solvency II

As part of the final set of rules established prior to the commencement of the Solvency II regime in 2016, a set of measures was introduced regarding the treatment of ‘long-term guarantees’ or LTGs. These measures, commonly referred to as the ‘LTG measures,’ comprised the extrapolation of the risk-free rate, the VA, the MA and the transitional measures for the risk-free rate and technical provisions (TRFR and TTP).

Progress is well underway towards the review of the LTG measures, as originally envisaged to happen by the end of 2020 under the Omnibus II Directive. EIOPA has been charged with overseeing ongoing experience with regards to the LTG measures, publishing an annual report for each of 2016, 2017 and 2018. These annual reports are intended to be a key input informing the wide-ranging review of Solvency II. Indeed EIOPA is specifically required to submit an opinion on its assessment of the application of the LTG measures by the end of 2020.

Additional requests from the European Commission (EC) as part of the review process now make it clear that a point of focus regarding the LTG measures will be a reassessment of their appropriateness, particularly taking into account ALM practices of life (re)insurers.

Looking forward: The 2020 Solvency II review and the LTG measures

Kicking off the 2020 review process, the EC issued a request to EIOPA in April 2018 covering an assessment as to whether ‘assumptions for the valuation of technical provisions and the risk measure underlying the calculation of capital requirements is still appropriate’ so as to ‘to ensure that Solvency II reflects appropriately insurance and reinsurance undertakings asset-liability management’ all in the context of LTGs. This assessment remains ongoing and covers the following issues in particular:

  • Information on the actual and potential liquidity of liabilities for long-term products
  • The risk profile of the associated investments backing such liabilities from the perspective of the typical holding period of investments and on the ability of (re)insurers to decide the timing of buying and selling
  • Specific information on investments used in connection with business where the MA or VA are applied
  • Actual transfer values of (re)insurer liabilities in comparison to Solvency II provisions

This analysis is set to influence legislative changes that will aim to put a firmer foundation under the LTG measures, with an appropriate reflection of the interplay between companies’ assets and liabilities.

The EC issued a further request in February 2019 as part of the 2020 review process, the results of which will also be very relevant to many life (re)insurers from an ALM perspective. Areas to be investigated by EIOPA include the following:

  • The last liquid point (LLP) underlying the risk-free interest rate term structure. For the euro the LLP has been set at 20 years up to now but commentary from EIOPA and the European Systemic Risk Board (ESRB) suggests some likelihood that this will increase to 30 years as part of the 2020 review. Such a change would have a large negative impact on the financial position of many life (re)insurers. (See this Milliman research paper for more details.)
  • The VA, with the possibility of making the calculation mechanism more aligned to individual companies’ business and risk profiles and reflective of their own ALM strategies.
  • Under the banner of the EC’s Capital Markets Union (CMU) initiative, analysis of the treatment of long-term investments more broadly identifying the characteristics of insurance business and liabilities that enable (re)insurers to hold their investments for the long-term, with a view to adapting the equity and spread risk standard formula capital calculations to better reflect (re)insurers’ behaviour as long-term investors. (See this Milliman research paper, which analysed some changes introduced in relation to the CMU as part of the 2018 Solvency II review.)

Probably the most important impact for many companies is the potential change to the LLP alluded to above. In its 2018 LTG report, EIOPA estimated a reduction in average solvency ratios (on a Pillar 1 basis) of 24% in absolute terms if the euro LLP is extended from 20 to 30 years. Of course, some companies may already reflect sensitivities to the LTG measures within their Pillar 2 capital assessments.

Looking back: Risk management and ALM under regulators’ focus

The 2017 and 2018 LTG reports included thematic reviews of risk management and disclosure aspects with regards to ALM in the context of the LTG measures. In particular, the thematic reviews considered specific articles of the Solvency II Directive relating to ALM, highlighting certain general shortcomings observed in companies’ practices as summarised below.

Risk management, RSR and the ORSA

In the 2018 LTG report, EIOPA included an analysis of risk management aspects in view of the specific requirements on the LTG measures set out in Article 44 and 45 of the Solvency II Directive. Such requirements include:

  • A risk management system that covers ALM risk
  • The liquidity plan for undertakings applying the MA or the VA
  • The assessment of sensitivity of technical provisions regarding the assumptions underlying the extrapolation of the risk-free rate curves, the MA and the VA
  • The assessment of compliance with capital requirements with and without the measures and potential measures to restore compliance
  • Analysis of LTG measures in the ORSA

In turn, Article 35 of the Solvency II Directive requires the Regular Supervisory Report (RSR) to contain certain information in relation to the above items and the 2018 LTG report highlighted that national supervisory authorities (NSAs) have identified room for improvement in relation to the level of detail in such reporting. In addition, case studies were performed by NSAs to explore further how companies build the results of the assessments on ALM into their overall ALM and risk management systems. Practices observed were noted to vary across countries and measures. Key comments made by EIOPA included the following:

  • A number of insufficiencies were mentioned with regards to supervisory reporting, including:
    • EIOPA said it was not sufficiently clear what is addressed with ‘underlying assumptions’ as undertakings did sensitivities on the interest rate or spread level but not on the key parameters of the interest rate term structure or on the building blocks of the VA, for example.
    • Information in the RSR is rather general at present. More detailed and quantitative information would be useful.
    • Where information is provided in the RSR, judgement on the relevance of assumptions or the sensitivities calculated is often missing.
    • Typically details are not reported on how ALM is performed.
  • Undertakings do not typically reflect explicitly on the use of the LTG measures in their written policies on investment management.
  • The following table outlines the share of undertakings in an accompanying EIOPA sample analysis of RSRs that provided information on the sensitivity analysis which is required under Article 44:

Clearly a large number of firms are not currently providing the required disclosures with regards to extrapolation and VA sensitivity analysis. Even in cases where the sensitivity analysis was mentioned, it was reported that not all undertakings gave detail on the assumptions underlying the measures that were considered in the sensitivity analysis.

  • The following table shows the share of undertakings giving further detail in the RSR on how the LTG measures affect the assessments of compliance with capital requirements in their ORSAs (which is a strict requirement under Article 45).

Despite the current legislative rules being quite light on detail it is clear that EIOPA expects NSAs to encourage companies to generally up their game in relation to ALM and how it is addressed in RSRs and ORSAs.

SFCR public disclosures

Article 51 of the Solvency II Directive requires public disclosures regarding general ALM risk, the use of the MA, the use of the VA and the overall impact of the LTG measures.

In the 2017 LTG report, EIOPA found that NSAs were broadly satisfied with the completeness of the information disclosed by undertakings in their public Solvency and Financial Condition Reports (SFCRs) as well as its consistency with the information reported privately in the RSR. However, specific considerations where NSAs were not satisfied with the quality of the way the measures are described in the narrative part of the SFCRs included the following:

  • The level of detail of the information provided varies by undertakings. Whereas some undertakings focus solely on quantitative information others provided further qualitative information including background information on the LTG measures.
  • The summary of the SFCR was not always considered to be complete and sufficient in addressing the use and impact of the measures.

EIOPA also asked selected stakeholders, including analysts, rating agencies, journalists and consumer protection organisations about their perception of the public disclosure. Those stakeholders suggested further mandatory disclosures in the SFCRs such as the following:

  • Information on the portfolio of assets on the basis of which the MA is determined as well as explanations on the derivation of the MA and the final size of the MA that is applied in the valuation of technical provisions. In the UK some firms already voluntarily disclose information regarding the MA but practice varies.
  • Solvency ratios with and without the measures—the Quantitative Reporting Templates (QRTs) only provide the own funds and Solvency Capital Requirements (SCRs) separately with and without the measures.
  • A general analysis of change to track changes in the valuation and solvency position from one year to the next year—this suggestion was not solely related to the use of LTG measures.
  • Where undertakings calculate sensitivities, the comparability between undertakings is limited. Standardising the scenarios to ensure comparability was suggested.

EIOPA further notes that the International Monetary Fund (IMF) has also lent its voice calling for more qualitative discussion of the use of LTG measures in SFCRs.

EIOPA has recently consulted on its proposals for the 2020 review regarding supervisory reporting and public disclosure. EIOPA’s proposals did not cover elements specific to the LTG measures but it might be expected that at least some of the above items will feature elsewhere in the wider 2020 review.

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