Solvency II Directive measures to aid European economic recovery

While the European Commission’s most recent opinion on the review of the Solvency II Directive is broadly in line with the final European Insurance and Occupational Pensions Authority (EIPOA) opinion issued in December 2020, some measures have now been amended. These amendments are designed to strengthen the capacity of European insurers to contribute to the economic recovery post-Covid-19 through the release of up to €90bn capital in the short term.

Long-term equity investment, risk-free rate curve and interest rate risk

The long-term equity class introduced in 2019 is subject to a reduced capital charge of 22% instead of the traditional 39% or 49%, where the symmetrical adjustment1 would also be modified to +/-17%; dependent on numerous qualifying criteria that have restricted the use of this category. The Commission proposes to clarify these criteria and even to make them more flexible. In particular, by lifting the “ring-fencing” condition that has been widely criticised by the market with the aim of reducing the Solvency Capital Requirement (SCR) by €10.5bn at European level.

Adjustments are also proposed to the method of extrapolating the risk-free rate curve, which overcome the limitations of the current approach and partially correct the overestimation of rates beyond the last liquid point. This approach will have a negative impact on capital, which will be more pronounced for portfolios with long-term guarantees.

The Commission also proposes to take account of the downward stressing of negative interest rates, necessary in the current economic environment. There are also plans to stress the Ultimate Forward Rate2 (UFR) level in deviating rate curve scenarios.

The cumulative impact of these two measures would lead to an increase in the SCR of between €20bn and €25bn and a decrease in own funds of between €35bn and €70bn at European level, with a gradual implementation between the date when the amendment3 comes into force and 2032.

Volatility adjuster

The volatility adjustment (VA), applied to risk-free rates to prevent pro-cyclical market behaviour, is currently determined 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 and the second aims to reward portfolios of “illiquid” liabilities. Again, the measure will be accompanied by additional reporting requirements.

Risk margin reduction

The Commission recommends a further reduction in the allowance factor on forecast SCRs proposed by EIOPA and a reduction in the cost-of-capital rate from 6% to 5%. These measures would reduce the size of the risk margin by more than €50bn across the sector in the EU, again with a greater benefit for insurers with long guarantees.

Strengthening the proportionality principle and quality of supervision

The proportionality principle has been strengthened by raising the thresholds which the Solvency II Directive does not apply to €50m of technical provisions, and between €5m and €25m of premiums written. Secondly, the review introduces a new concept of “low risk profile undertakings” which may apply all the simplifications offered by the regulations.

In addition, the Commission again proposes a requirement to have the Solvency II economic balance sheet and the SFCR report audited by an approved external auditor, except for “low risk profile undertakings”. Plus, the Solvency and Financial Condition Report (SFCR) will now have two main sections; one addressed to policyholders and one to analysts. The Commission also proposes to introduce requirements for long-term climate change scenario analysis, in line with the objectives of the European Green Deal.

In conclusion, the welcome changes proposed by the Commission will potentially have a very positive impact for long-term portfolio players and offer a more economic approach to rates, both for the calculation of technical provisions and the SCR. Plus, significant adjustments to the risk margin and improved quality of oversight and reporting offer a stronger platform for economic recovery.