Beware of excessive LTG measures
Most of the critics of the EIOPA Long-Term Guarantees Assessment argue that the proposed measures do not go far enough in providing capital relief for the insurance industry. However, Sven Giegold, MEP and member of the ECON committee, argues that more consideration must be given to the systemic implications of such relief – especially if it is to be given on a permanent basis.
Solvency II is a comprehensive reform and harmonisation of European insurance regulation that introduces market-consistent balance sheets and risk-oriented capital requirements. It was agreed by the European Parliament and the Council in 2009.
Since then the financial crisis has negatively affected European insurers in at least two ways. First, insurers’ investments in corporate bonds, equities and, particularly over the last few years, government bonds, have lost significant value. Second, interest rates have fallen drastically and may stay at a low level for longer than expected making it difficult for insurers to earn guaranteed interest income.
Since 2011 the European Parliament and the Council have been discussing Long-Term Guarantees (LTG) measures that provide relief to the troubled industry. The controversial trilogue negotiations were interrupted in September 2012 to allow an impact assessment of the measures by EIOPA. EIOPA’s report on the impact assessment was published on 14 June.
The measures tested include a Classical Matching Adjustment that is beneficial in particular for the UK and Spanish annuity market; the Counter-Cyclical Premium (CCP) that especially helps insurers in Italy, Spain and Portugal that are affected by losses on sovereign debt; and the risk-free yield curve extrapolation methodology (the Extrapolation), that supports in particular insurance markets with long-term insurance contracts and highly-rated sovereign debt such as Germany.
Figures from the EIOPA report show that the combined measures would provide a relief to the industry in 2011 in the range of €200 billion. This amount is substantially greater than the total amount of new premiums for EU life insurers (€163 billion) for that year. It should be noted that, as for the banking stress test, the figures of the assessment were provided by the industry.
It is desirable and necessary to take measures in order to avoid that temporary financial market distortions, especially with respect to government bond spreads, trigger pro-cyclical supervisory actions; such as a requirement to raise capital just when markets are at their most disrupted.
However, such measures should not grant permanent capital relief that could disguise unrecoverable losses or the risk of under-provisioning in the face of continued low interest rates and economic growth.
CCP / Volatility Balancer
EIOPA recommends replacing the Counter-Cyclical Premium (CCP) by a new measure called the Volatility Balancer. The CCP was supposed to be a crisis management tool that is only activated in times of stressed markets. The Volatility Balancer is a permanent measure. It would be contradictory to the overarching policyholder protection and financial stability objectives of Solvency II to grant permanent capital relief to insurers. The measure should either be temporary or – as suggested by the ESRB (in its letter of 29 June 2012) – symmetric. This is so that insurers establish additional provisions in periods of market exuberance that they can release to absorb asset losses in downturns.
With respect to the Extrapolation of discount rates it is regrettable that the most important element of the extrapolation, the Ultimate Forward Rate (UFR), that significantly determines the level of the extrapolated rates, was not tested in the assessment. The setting of the UFR (the expected long-term level of future interest rates) requires democratic legitimation as it represents a collective bet on long-term economics. It should not be left to the discretion of an authority, but should rather be specified in the Regulatory Technical Standards of Solvency II, which are drafted by the Commission.
EIOPA recommends against the introduction an Extended Matching Adjustment (EMA) proposed by Council. This decision is welcome. The EMA is prudentially unsound as it incentivises insurers to hold illiquid assets against policies with potential early surrender options. The very wide range of policies covered exposes insurers and their policyholders to the risk of runs (policyholders demanding to cash out their policies and insurers being forced to sell illiquid assets rapidly, at a discount).
EIOPA does however recommend several modifications of the Matching Adjustment of much more restricted application, as supported by the European Parliament. The recommendation on the inclusion of mortality risk goes beyond both the latest European Parliament and Council positions and raises concerns about the soundness of the measure. Quite simply it contradicts the fundamental assumption underlying the Matching Adjustment that insurers can keep their bonds to maturity. This is not possible with respect to mortality risk where early payments may need to be made and leads to insufficient provisions and endangers the protection of policyholders.
Furthermore, allowing BBB rated assets (just one notch above “junk” status) under the Matching Adjustment goes beyond the ECON report on Omnibus II that excluded such investments to avoid insurers taking on too much credit risk.
Since it is a permanent measure, the Matching Adjustment should be designed to be not only subject to very prudent restrictions but also truly symmetrical.
We support introducing Transitionals for the calculation of technical provisions that phase in the rules of Solvency II over several years. These are preferable to measures that distort the realistic assessment of insurance liabilities permanently.
Transparency and consistency
EIOPA’s recommendation to ensure full transparency about the impact of the LTG measures on each insurer’s solvency position is welcome. It must be an essential part of an acceptable compromise on the measures.
The application of the LTG measures in the national markets must be monitored, and EIOPA should report annually to the Parliament about the capital relief granted and the coordinated supervisory actions taken to address the underlying problems. Of these, the risk of unrecoverable losses and the risk of continued low interest rates are of particular importance.
We also support the recommendation to avoid Member State options in relation to the introduction of the LTG measures as this will contribute to a consistent application of Solvency II and promote the Union’s internal insurance market.
The whole debate on the LTG measures has been principally driven by demands from the insurance industry. EIOPA’s report therefore also reflects some of these demands. The debate about how best to frame insurance regulatory policy in the general interest is dominated by the industry, while other stakeholders such as consumer protection groups or academics are only feebly represented. The risk of regulatory capture, often raised by the regulators themselves, should be discussed in the framework of the review of the ESAs.
The author is an MEP for the Group of the Greens/European Free Alliance. The views expressed are the author’s own.