European Commission adopts review of Solvency II

On 22 September, the European Commission adopted a review of Solvency II following the consultation launched by EIOPA in 2020, whose final guidance was published in December 2020. As the Commission notes, the 2020 review of the directive met several objectives:

• remove the obstacles to long-term financing of the economy and redirect investment by the insurance sector;

• reduce the complexity of the prudential framework and enhance its proportionality;

• mitigate the short-term volatility of the Solvency II prudential  indicators and better adapt the directive to the risk profiles of  insurers;

• increase the integration of the European insurance market and the convergence of supervisory practices.

Overall, the Commission’s opinion is in line with EIOPA’s final recommendations. However, some of them have been amended to further reduce the capital charge, thereby enhancing the ability of European insurers to contribute to the economic recovery in the EU after the Covid-19 crisis. The Commission hopes to release up to an estimated €90 billion of capital which could be invested in the EU in the short term. The Commission’s proposed amendments cover a wide range of issues to meet all these objectives.

Long-term equity investments

This is a “long-term” class of equities subject to a reduced 22% shock rate used to calculate regulatory capital requirement, or for market risk (in place of the 39% or 49% applied to “traditional” equities).  As a reminder, this class was introduced in the amendment of the Delegated Regulation 2015/35 published on 18 June 2019, in line with the European Commission’s objectives for a Capital Markets Union.

However, the eligibility requirements for this asset class were exacting: equities within a portfolio of ring-fenced assets, an average holding period of more than five years, or issuers listed or with their registered office in an EEA member country.

But these conditions restricted recourse to this asset class. On the basis of EIOPA’s opinion, the Commission, therefore, proposes to relax the eligibility rules, in particular by lifting the “ring-fencing” condition which has been widely criticised by the market.

It also proposes to provide more clarification about other criteria that have given rise to difficulties of interpretation in the market.

The Commission hopes that this measure will reduce the capital requirements for equity risk by €10.5 billion, on the assumption that easing these criteria would increase the “long term” equity segment by 15%.

Risk-free rate curve and rate risk

Amendments have been made to the method of extrapolating the risk-free rate curve. The Commission’s opinion is fully in line with EIOPA’s final guidance. Under the proposed alternative approach, risk-free rates remain calibrated to market data up to the last liquid point, currently set at 20 years by EIOPA.   Subsequently, they are extrapolated to converge towards the ultimate forward rate (UFR ) using a new methodology. The amendment addresses the limitations of the current approach by taking more account of market data, correcting – albeit partially – the overestimation of rates beyond the last liquid point. The new approach will have a negative impact on capital, which will be more pronounced for portfolios with long-term guarantees.

In addition, insurance organisations will have to carry out a sensitivity analysis of the convergence parameter and publish it, in particular in their solvency and financial condition reports.

The Commission also proposes to amend the formula for calculating stressed interest rates (for the interest rate risk capital requirement), in particular by allowing the downward stressing of negative interest rates. This measure will make it possible to take better account of the current economic environment, characterised by low or even negative rates in some cases. There are also plans to shock the UFR level in deviating rate curve scenarios.

The cumulative impact of these two measures would lead to an increase in regulatory capital of between 20 and 25 billion euros and a decrease in equity of between 35 and 70 billion euro. The Commission proposes to phase implementation over the period between the effective date of the amendment¹ and 2032 in order to smooth the impact.

Volatility adjustment (VA)

The volatility adjustment, applied to the basic structure of risk-free rates, is intended to prevent pro-cyclical market behaviour. Currently, the VA is notified by EIOPA and is therefore not entity-specific. The proposed amendment introduces two own application ratios that would adjust the reference VA level downwards. The first is intended to mitigate “overshooting” effects,  correcting the excessive reduction in technical provisions that can result from the application of the VA. The second aims to compensate portfolios of “illiquid” liabilities. To offset the impacts of these application ratios, EIOPA proposes to raise the reference illiquidity spread to 85%  instead of the current 65%. The Commission proposal is broadly in line with EIOPA’s recommendations, except for the application of the “illiquidity” ratio, which it judges to be inappropriate:  the Commission considers that the proposal would penalise, inter alia, products with portability options, such as PACTE products.

Players will also have to disclose the “overshooting” coefficient in their financial reporting and seek approval from the local regulator for the use of the volatility adjustment if they did not do so before the amendment came into force.

Risk margin

EIOPA proposed a change to the risk margin calculation by applying an allowance factor to projected regulatory capital, with a floor.

The Commission recommends a modified version of this proposal by reducing the risk margin further:  removing the floor parameter and lowering the cost-of-capital rate used from 6% to 5%.

These envisaged changes would reduce the size of the risk margin by more than €50 billion across the sector in the EU, with a greater benefit for insurers with long guarantees.

Proportionality principle

The principle of proportionality is strengthened by the review: on the one hand, the thresholds below which the Solvency II Directive does not apply have been raised, so that this exemption applies to more undertakings.  Secondly, the review introduces a new concept of “low-risk profile undertakings” which may apply all the simplifications in the amended Directive.

Quality of supervision and reporting

The Commission proposes several measures for improving the quality of the supervision and oversight of the systemic risks, including a requirement to have the Solvency II economic Balance sheet and the Solvency and Financial Condition Reports audited by an approved external auditor. This requirement will not apply to “low-risk profile” undertakings.

Transparency in financial reporting is also highlighted by the review of the Directive, for example through the modification of the structure of the SFCR disclosures, which should now have two main parts: one for policyholders and another for analysts.

Miscellaneous 

Among the second-order amendments proposed, two measures merit attention. The symmetric adjustment corridor is extended from  +/- 10% to +/- 17% in order to cushion the equity shock more effectively in an extreme economic environment. The Commission also proposes to introduce requirements on long-term climate change scenario analysis, in line with the objectives of the Green Pact for Europe.

¹ The effective date of the amendment could be 2026, given the importance of the issues addressed and the consultations that will be necessary between the Commission and the Member States before the legislative process to amend the Directive can begin.