By Benoît Leman, Managing Partner, Vincent Braun,Senior Consultant, and Joana Elisa Maldonado, Regulatory Compliance Assistant
The current macroeconomic environment features high volatility driven by economic and political events in addition to the continued low growth and low interest rates. Many supervisors therefore worry about the resilience of financial institutions and insurance companies in particular. In this context, the European Insurance and Occupational Pensions Authority (EIOPA) conducted an insurance stress test to assess the resilience of the life insurance industry to adverse market developments.
EIOPA’s report and recommendations on this first stress test since the official start of Solvency II in 2016 gave rise to a debate among supervisors and stakeholders. While both agree on the validity of the test, there are diverging interpretations of the results: supervisors perceive the result as rather negative, referring to the evidence of vulnerability. Industry stakeholders, however, reject EIOPA’s correcting measures, arguing that insurers proved to be sufficiently capitalised and that the simulated stress scenarios are highly improbable. How did EIOPA proceed and what do results of the stress test show? Which correcting measures are proposed and are these recommendations reasonable? We give here the answers to your questions on the stress test, the announced measures and the current discussion.
No – EIOPA analysed a sample of 236 life and mixed insurers from 30 countries at solo level, which are particularly vulnerable due to their predominant long term life business. This included major European undertakings as well as medium and small-sized companies, reflecting national market structures. In terms of relevant business, the sample reached a market coverage of 77% and represented 60% of the EU/EEA insurers’ total assets, dominated by British, German, French and Italian companies.
The selected companies reported 75% of their total technical provisions to be life business (excluding unitlinked, which accounted for 23%) and less than 2% to be non-life business.
Example: at Belgian level, 23 mixed or life solo insurance companies were included, representing 96.23% of the national market in terms of life insurance technical provisions.
EIOPA set the focus on financial risks, which it considers as the biggest threat to the stability of the European insurance market. The simulation was therefore based on two scenarios, 'low-for-long' and 'double-hit':
EIOPA applied instantaneous shocks to the regulatory balance sheet, the composition of assets and cash flow projections. Stresses were applied to the portfolios effectively held on the reference date of 1 January 2016. Valuation of the balance sheet was based on Solvency II and undertakings were obliged to use those Solvency II measures and features for which they had obtained an explicit approval by their supervisors, such as long term guarantees (LTG). The analysis followed a two-step validation process with examination at both European and country level.
No – the stress methodology differed from the Solvency Capital Requirement (SCR) standard formula. Several factors were shocked at the same time (no correlation matrix), assets were revalued after stress and shocks differently defined.
In the baseline, all participating undertakings had an excess of assets over liabilities. The average assets over liability (AoL) ratio amounted to 110%, i.e. sample companies held 10% more assets than the net present value of their liabilities. The overall SCR amounted to 196% and the Minimum Capital Requirement (MCR) to 533%. With 90% tier 1 unrestricted capital, the quality of own funds was high. Bonds constituted, with 47%, the lion’s share of the assets, half government and half corporate, the majority in the AAA to A buckets, with a certain home bias. Over 90% of the total liabilities were technical provisions.
In both stress scenarios, the excess stays positive. Nevertheless, insurers lose about a quarter of the total excess they had in the baseline.
In the LY scenario, liabilities increase by €380bn and assets by about €280bn. The total excess of baseline assets over liabilities hence decreases by €100bn (18%). Overall, 38 companies would lose more than a third of their excess of assets over liabilities, 16 more than half and 3 all of it.
In the DH scenario, total baseline assets decline by €610bn (9.7%) and liabilities by €450bn (7.8%). This means a negative impact on the balance sheet of €160bn (28.9%). 104 insurers lose more than a third of their excess assets over liabilities in this situation, 42 even more than half, and 5 all of it.
Example: the 23 Belgian insurers in the sample were particularly vulnerable to the DH scenario, with an average decrease of 38,6% in their excess assets. In the LY scenario the decrease averaged 15,5%.
Most insurance companies can. For only 1% (LY) and 2% (DH) of sample companies, the AoL ratio fell below 1 under stress. The two stress scenarios reduce the average AoL ratio by approximately 2% points, with – in contrast to the excess measure – a slightly bigger impact under the LY simulation.
However, the AoL measure cannot determine if an undertaking is able to operate in the market, since it does not take into account the coverage of regulatory capital.
Companies experiencing the largest drop in AoL had relatively high pre-stress AoL and in both scenarios still relatively high post-stress AoL. Larger undertakings in terms of baseline assets were more likely to have a low post-stress AoL. EIOPA further points out that LTG and transitional measures have an alleviating effect. They are the key to keeping the AoL ratios above 1 in the DH scenario by relieving the liability side, while they play less of a role in the LY situation.
Due to limited data, there is no conclusion on the impact of derivative hedging. EIOPA notes that the use of derivatives decreased the interest rate sensitivity of some undertakings, but emphasizes that the use of derivatives can expose undertakings to other risks, such as counterparty risk.
A qualitative questionnaire on second order effects could not confirm fears of large scale sales of assets, which are individually rational in response to stress but collectively worsen the situation. In an enduring DH scenario, the majority of respondents indicated to follow strategies of dividend retention, focus on unit-linked products, reduced profit-sharing and reviewing the interest rate policy. To maintain profitability over the medium term, insurers plan to cut administrative costs and commissions, adjust the product mix and lower guaranteed interest rates.
No – a stress test is not necessary to find that companies with a large share of unit-linked business are less impacted and undertakings with high guaranteed rates more vulnerable in an LY scenario. The only surprise was EIOPA’s interpretation and reaction to the result.
Although EIOPA acknowledges that the sample undertakings are adequately capitalised from a regulatory point of view, it concludes that the test confirmed the vulnerability of the insurance sector to the low interest rate environment and pronounced reassessment of risk premia.
EIOPA: “A noteworthy number of undertakings may be expected to face challenges meeting their SCR, particularly in the case of the DH scenario.”
The report claims that the risk bearing capacity of any individual company is a combination of capitalisation and balance sheet sensitivity to stress. This refers in particular to small undertakings, which are better capitalised in SCR and AoL, but suffer the biggest impact under stress.
Insurers had expressed their criticism over the stress test set up and the unlikely scenarios early on. Yet, EIOPA considers these scenarios as extreme but plausible. The report justifies the extreme simulations with the fragile economic situation in the period of the test realisation. It refers to the low European growth, large public debt, fragmented markets, struggling recovery and excess liquidity, which lead to low sovereign and investment grade corporate bond yields, search for yield behaviour and an increase in valuation risks.
No – the sample focused on insurers with large exposure to the more vulnerable long term life business. This is why stakeholders argue that if the whole industry had been included, resilience would have been even stronger.
Yes. EIOPA emphasises that the goal of the stress test is to identify potential systemic risks and vulnerabilities from the micro-prudential level. It gives the stress test a branding as vulnerability analysis and underlines
that no recalculation of the SCR or MCR poststress is required. Nevertheless, EIOPA infers that the results deserve supervisory response. In a recommendation paper, it asks national competent authorities (NCAs) to act on risk management and business model sustainability, modelling of lapses and best estimates, impact of group solvency and group support.
Summary of the Main Stress Test Results
|Low-For-Long Scenario||Double-Hit Scenario|
|Excess of Assets over Liabilities||↓ €100bn (18%)||↓ €160bn (28.9%)|
|Asset over Liability Ratio||↓ 2%|
Additional analysis: in the short term, NCAs will assess risk appetite and portfolio allocations, and the viability of business models. Moreover, they will collect information at group level and analyse the potential impact for groups. In the medium term, supervisors will review and assess the behaviour of management and policy holders as well as the risks and values of guarantee clauses.
The National Bank of Belgium announced that it will implement EIOPA’s recommendations. It will focus on assessing those insurance companies, which appeared vulnerable in the LY scenario.
In the short term, supervisors demand from insurance companies to integrate the LY and DH scenarios in their Own Risk and Solvency Assessment. Depending on the result of their additional analysis, NCAs might request a reduction of maximum guarantees and profit participations and cancellation or deferral of dividend distribution. Further, NCAs will report to EIOPA about the outcome of the group assessment and potential measures taken by 31 October 2017. Other actions from EIOPA concerning insurance groups might follow then.
Not according to stakeholders, who say EIOPA is overreacting: Insurance Europe, the European association of insurers, issued a press release stating they are “puzzled by the long list of supervisory actions recommended”. They argue that insurance companies are highly capitalised under the baseline scenario and prove resilient under the very severe scenarios. The association also points out that a reduction in surplus assets under stress is natural in any insurance business, because the holding of surplus assets protects clients from risks. Stakeholders therefore do not see the reduction of excess assets under stress as a vulnerability. Finally, it is interesting to recall that supervisors already have the power to intervene under Solvency II when necessary. Another problem is that the proposed measures could lead to a shift towards unit-linked business. This protects insurers from the impact of interest rates, but not the policy holders. When policy holders then bear the negative consequences, a unit-linked business model might not be viable in the long term either.
Solvency II has introduced high capital standards, strict risk management and governance requirements. But the challenge for insurers continues: first, a difficult macroeconomic environment and now additional supervisory measures. Recent papers about expanding EIOPA’s supervisory powers in a European Insurance Union, similar to the Banking Union, further fuel insurers’ worries about regulations.
EIOPA: “The financial year 2016, with the application of Solvency II, is a milestone in regulation for the European insurance and reinsurance undertakings.”
Economists predict that insurance firms will react to the challenging circumstances by buying new types of assets, which are better-yielding but more illiquid, and choose to outsource more to external asset managers to save costs. EIOPA also mentions that asset management firms, ETFs and FinTechs will transform the market in the coming years.
Lately, the inflation rate has picked up but remains low and the ECB continues its expansionary policy. There is hence nothing else for it but to hope for better times – and in the meantime ensure adequate Solvency II compliance as well as resilient risk management and business strategies.
The report and recommendations of 15 December 2016 are available on EIOPA’s website.
Finalyse’s insurance experts are happy to answer all further questions you have!
Contact us at +32 (0)2 537 43 73 or firstname.lastname@example.org.