EIOPA’s note includes essential information about the impact of the latest Council position on the long term guarantee (LTG) measures.
1. The most important results are set out in Appendix 1. The appendix presents results for four scenarios. Most relevant are the first scenario (EIOPA report OF 20%) which shows the impact of EIOPA’s recommendation and the fourth scenario (Compromise #4 Combined) which shows the impact of the Council position.(1) For each scenario two types of figures are presented:
– SCR (Solvency Capital Requirement): this figure denotes the SCR ratio being the amount of own funds divided by the SCR. A figure of 100% means that the own funds are just sufficient to meet the SCR.
– Surplus: this figure denotes the surplus of own funds above the SCR (i.e. own funds minus SCR). The figures are in billion euro. A figure of 0 means that there is no surplus above the SCR i.e. the own funds are just sufficient to meet the SCR.
2. The figures shows the huge impact of the LTG measures as reflected in the Council position. The package provides a capital relief of 277 billion euro. For life insurance alone the relief is 264 billion euro relative to the surplus assets insurers would have to hold in the absence of the LTG measures.(2) The figures also show with how little capital life insurers will be allowed to have under Solvency II: The Solvency Capital Requirement of life insurers amounts to just 4.5% of their assets.(3) In other words, an unrecoverable drop in asset values of just 4.5% would leave them unable to meet their insurance commitments.
3. Comparing EIOPA’s recommendation with the Council position on the volatility adjustment reveals a difference in capital relief of about 21 billion euro.(4) Combining all proposals of the Council on LTG measures grants additional capital relief of up to 47 billion euro.(5)
4. The figures of the first scenario show that some national markets (Greece, Portugal, Spain, Ireland, UK) were undercapitalised in 2011 because even with EIOPA’s LTG package they could not meet the solvency requirements.(6) Under the Council proposal all of these markets except Portugal appear to be in a satisfactory situation. The Council proposal conceals the financial problems of these national markets as well as the need for supervisory action to address the problems.
5. In addition, the Council proposal gives rise to level playing field issues. For example, while the Council proposal effectively hides issues in the Greek insurance market (SCR coverage ratio lifted from 24% to 102%), the situation in Portugal still appears to be alarming (SCR coverage ratio lifted from 56% to only 75%). But is it plausible that the situation in the Greek market is significantly better than in the Portuguese market?
6. Appendix 2 compares the amount of the volatility adjustment of EIOPA’s recommendation and the Council position. The Council position results in volatility adjustments that are more than three times higher than under EIOPA’s recommendation. The adjustment is an add-on to the risk-free rates that insurers use to discount their obligations to policyholders.
Applying such an add-on is economically equivalent to assuming that insurers do not need as much compensation, in the form of higher returns, for the risk on their investments as financial markets are asking. The justification is that financial markets are overestimating the long-term risks.
For example, the adjustment of 82 basis points for most members of the Euro zone under the Council proposal means that insurers need 0.82% less compensation on their investments than what markets are asking.
Since this number is derived from a “typical investment portfolio” that one would hope represents prudent investment strategies by insurers, 0.82% likely to be a considerable proportion of the total compensation for risk (or “risk premium”) that financial markets would ask for the same investments.
The speculative nature of these assumptions becomes even more apparent in relation to the adjustments calculated for Greek and Cypriot investments. Under the Councils proposal, the insurers of these markets will effectively be betting that the financial markets overestimate the risk premium by a huge 6.89% and 4.19% respectively.
Our view is that the markets might be a bit wrong, but not that wrong. If you believe the Council, then you believe markets are catastrophically inefficient (and we should ask insurers to set the prices instead)
7. Appendix 3 compares the amount of the matching adjustment of EIOPA’s recommendation and the Council position. Again, the adjustment represents the part of the market risk premium that insurers are allowed to consider irrelevant.
The most revealing result is shown in the small table at the end of the appendix: The Council proposal increases the average matching adjustment from 1.51% to 1.86%.
A more specific example relating to the larger table in the appendix: if insurers invest in BBB rated financial bonds denoted in euro with a duration between 5 and 10 years, then the matching adjustment is 6.04%. Under EIOPA’s proposal the corresponding matching adjustment was only 2.79%.(7) Again this shows the speculative nature of the matching adjustment of the Council position and the incentive it gives for insurers to ignore the market warnings and invest in risky assets.
8. It is also worth note that EIOPA originally suggested that it would be more transparent to represent this market overestimation of risk as an extra item in insurers own funds rather than an artificial adjustment to their liabilities as the Council wants.
The fact is that the value of an insurers promises is not affected by the markets perception of the risk on their assets.
EIOPAs proposal effectively recognises that part of the market depreciation of assets will be recovered in the long run by representing it as an amount of extra capital (or “own funds”) to set off against future losses.
The Council’s approach would bury this amount in the complex maths involved in calculating the value of technical provisions and the solvency capital requirement making it much harder for investors to separate the true value of liabilities from the “correction” applied for market overestimation of risk on assets.
1 The second scenario (EIOPA report OF 65%) shows the impact of EIOPA’ recommendation, but with a calibration of the volatility adjustment of 65% instead of 20%. The third scenario (Compromise #4 TP 65%) shows the impact of the Council position, but restricted to the changes in relation to the volatility adjustment. Differences between the second and the third scenario result from the fact that EIOPA applied the volatility adjustment to own funds while the Council proposes applying it to technical provisions directly.
2 Comparison of the figures on page 32 of the EIOPA LTGA report for the scenario without LTG measures (overall surplus: -90 billion euro; surplus life insurance: -145 billion euro) to scenario four of the note (overall surplus: +176.9 billion euro; surplus life insurance: +119.2).
3 From the fourth scenario we can deduce that life insurers need to hold 189 billion euro to cover their SCR (because 119.2 billion euro covers 163%-100%=63% of the SCR). According to the EIOPA LTGA report life insurers hold 4209.5 billion euro of assets (page 135).
4 Comparison of the overall surplus of the first scenario (130 billion euro) and the third scenario (151 billion euro).
5 Comparison of the overall surplus of the first scenario (130 billion euro) and the fourth scenario (176.9 billion euro). We note that both scenarios may not be fully comparable because the first scenario does not seem to take account of the transitional measures.
6 Negative surplus in the first scenario.
7 Please note that the matching adjustment is not 479.6 bps according to EIOPA’s recommendation because the cap of 279.4 bps applies.