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EIOPA’S Opinion on the Review of Solvency II – Topic: Volatility adjustment

Written by

Chirag Sehgal, Finalyse Consultant

Francis Furey, Finalyse Managing Consultant

 

Introduction

On February 2019, the European Commission (EC) requested EIOPA to provide, by the end of 2020, technical advice on the full review of Solvency II rules (EIOPA 2020 review).

The implementation of the proposed changes is expected to happen around the end of 2025.

 

 

Finalyse has produced a more extensive white paper which focuses on the following aspects of EIOPA’s proposals:

  1. Technical provisions (“TPs”)
  2. Solvency Capital Ratio (SCR)
  3. Minimum Capital Requirements (MCR)
  4. Own funds
  5. Long-term guarantees measures (LTG)
  6. Measures of equity risk

Over the next couple of weeks Finalyse plans to issue several smaller blog posts on the material changes proposed by EIOPA. The first topic we have picked concerns the volatility adjustment.

 

If you wish to receive a copy of this paper, please contact [email protected]

 

Volatility Adjustment (VA)

There are several design concerns namely:

Over or undershooting effect of the VA

The dampening effect of the VA may exceed the effect of a loss in the market value of fixed-income assets. EIOPA has proposed that VA should be based on the undertakings’ portfolio rather than any reference portfolio and an application ratio should be applied to the adjustment which measures the duration and volume mismatch between fixed income investments and insurance liabilities of the undertaking.

Consideration of illiquidity characteristics of liabilities

EIOPA recommends the use of an illiquidity factor based on a “bucketing approach”, i.e., another application ratio should be introduced based on a categorisation of liabilities which captures the stability and predictability of cash-flows.

Underlying assumptions of VA are unclear.

The VA can be considered as a compensation for exaggerations in bond spreads or represent an additional illiquidity premium on assets that replicates the liabilities. EIOPA recommends that the VA should be split into a permanent VA reflecting the long-term illiquid nature of insurance cash flows and its implications on undertakings’ investments decisions; and a macro-economic VA that would only exist when spreads are wide during a financial crisis that affects the bond market.

Cliff effect of the country-specific increase, activation mechanism does not work as expected.

There can be a cliff-edge effect from the country VA during periods where spreads of a single Member State fluctuate around the trigger point of the country specific VA with activation and deactivation of the country specific VA leading to volatility in Own funds. EIOPA proposes that the macro-economic VA should be based on an improvement of the current country-specific increase of the VA to mitigate cliff-edge effects and improve the activation mechanism.

Misestimation of risk correction of VA

Several potential problems with this risk-correction have been identified:

  • May insensitivise credit spread changes.
  • Does not reflect actual default losses.
  • Does not reflect credit risk premium for unexpected losses.
  • Unnecessarily reflects cost-of-downgrade.

 

Currently, the VA is calculated as a fixed percentage of a spread. EIOPA recommends that this should be based on a percentage of the spread which should be differentiated with respect to issuers, namely between sovereign exposure of EEA countries (‘government bonds’, 30%) and other bonds (‘corporate bonds’, 50%).

Overall, EIOPA recommends that all these components of the proposal should not be considered in isolation but jointly form an enhanced and more targeted design of the VA.

 

 

General Application Ratio (GAR)

The level of GAR should not be set too high that it leads to under-reserving of TPs or too low that it fails to serve its main purpose to prevent the pro-cyclical behaviour on financial markets and mitigate the effect of exaggerations of bond spreads. EIOPA has therefore considered whether the current GAR factor should be changed, and if yes by which amount.

EIOPA states that some risks and uncertainties will remain even in the improved design, so the general application ratio still needs to be significantly below 100%. Therefore, it advises to increase the GAR from 65% to 85%.

All the above changes will also ensure that all risks contained in the spread are captured, whilst ensuring that VA is still effective as a countercyclical measure.

 

The average VA increases from 7 basis points to 14 basis points at EEA level.

 

 

How can Finalyse help you?

Finalyse has extensive experience in risk management for insurance companies and can help you make sense of the EIOPA proposals:

  • Gap Analysis: Perform a gap analysis detailing your situation against regulatory requirements and proposals published.
  • Roadmap: Developing a roadmap for the integration of proposed changes into your business.
  • Workshops: Conducting workshops with the objective to upskill the relevant stakeholders within your business on the EIOPA proposals.
  • Strategic support: Understanding the SII proposals for your business including on the long-term business strategy.
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