European Union: Solvency II Disclosures - The Dawn Of A New - And Transparent - Era

This year, the majority of insurers across the EU are releasing their first sets of public, audited Solvency II-basis results and disclosures ("SFCRs"). Insurers reporting on a solo basis released their SFCRs towards the end of May. Group disclosures must be released by the end of June, although some groups chose to release both group and solo results together.

This is a landmark event because, for the first time, and from now on, a comprehensive picture of the European insurance industry, firm by firm, is being provided using the Solvency II valuation and capital basis. This goes much further than the previous snapshot of the industry as a whole provided by EIOPA's December 2016 report on the long-term guarantee ("LTG") measures and measures on equity risk (the "LTG report").

This client briefing explains the information that is published in SFCRs and highlights some trends emerging from the SFCRs released so far. We plan to issue an updated analysis once individual group figures are available in full.

Solvency II public reporting – what has been disclosed?

The SFCR contains narrative disclosures on the insurer's business and performance, organisation and governance, risk management, risk profile, Solvency II valuation methodology and approach, capital resources ("own funds") and capital requirements. Where relevant, the SFCR explains the difference in capital requirement between the insurer's own model and the Solvency II standard formula.

The disclosures are supplemented by balance sheet and P&L data, the impact of the LTG and transitional measures, and information on any group undertakings.

The SFCR disclosures thus include:

  • The Solvency II balance sheet and valuation methodologies, judgements and assumptions, and differences from those used for the insurer's financial statements.
  • The effect on solvency of the matching adjustment, volatility adjustment and the transitional measures on the risk-free interest rate and technical provisions.
  • The insurer's own funds, capital management, restrictions on the use of capital, and the use of the transitional measures on own funds.
  • The insurer's SCR split by risk module or risk category (for internal models).
  • Where the SCR is calculated using an internal model, the scope and use of the model; methods used; the nature and appropriateness of data; and the main differences from the standard formula.
  • Risk exposures and concentrations across risk categories together with stress testing and sensitivity analysis.
  • Organisational, governance and (where applicable) group structures.

Long-term guarantee (LTG) and transitional measures

The LTG and transitional measures were introduced by the 2014 Omnibus II Directive, which provided for public disclosure of the impact of those measures. They have the following key effects:

  • The matching adjustment (MA) – in essence the liquidity premium that featured in the UK's former ICAS regime – is designed to avoid changes in asset spreads unduly affecting the own funds of insurers that hold bonds, along with other assets with similar cash flow characteristics to maturity, where the cash flows on those assets are matched to cash flows on the insurer's liabilities. The MA adjusts the risk-free interest rate term structure in line with the spread movement on the relevant assets. The MA primarily affects the valuation of technical provisions, and therefore the insurer's own funds.
  • The volatility adjustment (VA) is designed to avoid pro-cyclical investment behaviour by adjusting the risk-free interest rate term structure to mitigate the effect of exaggerated bond spreads. The VA is calculated by EIOPA based on reference portfolios of assets for relevant currencies. The VA primarily affects the valuation of technical provisions, and therefore the insurer's own funds. The VA and MA cannot be applied together.
  • The transitional measure on risk-free interest rates permits insurers to smooth the transition to the Solvency II risk-free interest rate term structure (including VA where applicable) linearly over 16 years. It cannot be applied where the MA is used.
  • The transitional measure on technical provisions permits insurers to spread the move to the Solvency II value of technical provisions (including the impact of the VA where applicable) linearly over 16 years.

The LTG and transitional measures therefore have a dual policy role in the Solvency II framework:

  • Recognising the long-term, often illiquid characteristics of insurance liabilities: the LTG measures seek to insulate insurers' long-term liabilities from short-term market volatility, and to align the discounting of liabilities with the return on backing assets where an insurer intends to hold these assets to maturity.
  • Financial stability: Adjustments to the discount rate smooth short-term balance sheet volatility and so are intended to dis-incentivise pro-cyclical investment behaviour. Transitional measures provide a phasing-in period for insurers to adjust to new levels of capital, recognising that insurers have substantial long-term back books that were not priced on a Solvency II basis.

What does the public reporting tell us so far?

        (I)    The MA and transitional measure on technical provisions are significant contributors to solvency in the UK industry.

As expected, the MA and transitional measure on technical provisions contributed significantly to the capitalisation of those insurers, mainly in the UK, with long-term, illiquid annuity business on balance sheet. For those organisations using the measures, the reported effect on technical provisions (in percentage terms) was broadly in the low single digits for either measure, with a consequential reported increase in eligible own funds in some cases exceeding 40%. This is broadly consistent with EIOPA's comment in its LTG report that:

"A slight relative increase of technical provisions may lead to a significant relative reduction of own funds, in particular for life insurance undertakings. For a typical life insurance undertaking the ratio of own funds and technical provisions is 1/10. Therefore, an increase of technical provisions of 1% would lead to a reduction of own funds of 10%." 1

        (II)    The impact of VA is much more limited for the UK industry.

For those insurers we reviewed, the VA had a much smaller (single digit percentage) impact on own funds. Given that the VA and MA cannot be applied together a more complete picture is likely to emerge as further group results become available. However, this initial observation is consistent with EIOPA's LTG report findings, which showed that the VA increased UK insurers' SCR solvency ratios from 141% to 147%, whereas the MA increased SCR solvency ratios from 73% to 140%.2

        (III)    Transitional relief for the risk margin contributes substantially to insurers' overall capital.

There has been much discussion of the effect of the risk margin in the UK industry in the last two years. Some insurers have disclosed that the risk margin, adjusted for the effect of the transitional measure on technical provisions, has been equivalent to, and in some cases in excess of, around 50% of the SCR. Since 2015, the PRA has said clearly and repeatedly that, while the concept of risk margin is sound, its design is leading to disproportionate and excessively interest rate-sensitive outcomes, which in turn are risking pro-cyclical effects.3

Implications for firms

As expected, the disclosures to date have confirmed the importance of the LTG and transitional measures to the UK life industry. This pattern reflects the significant volumes of life business with investment guarantees written in the UK, and is broadly comparable with the findings previously released by EIOPA in its LTG report.

The PRA has made clear its view that reliance on transitionals and on the LTG package generally is both appropriate and, because this is acceptable-quality capital, no bar in principle to the payment of dividends. Consequently, there remain good reasons to conclude that the UK industry is currently well-capitalised on the Solvency II basis. Indeed, EIOPA's LTG report highlights that " from National Supervisory Authorities indicates that there is no specific case yet, where undue capital relief was observed for an undertaking due to the application of the LTG measures or measures on equity risk." 5

That said, we would expect to see increasing levels of capital management activity in the life sector over the coming years and a continued review of strategic options and business models in this light. We expect this to be a strong supervisory focus for the PRA, as the transitional measure on technical provisions steadily amortises and eventually winds down towards 2032. In the shorter term, careful, on-going capital planning and liability management will clearly be needed to accommodate this amortisation and avoid any significant time mismatch with the run-off of liabilities.

Finally, against a background where the operation of the risk margin is incentivising firms to offshore longevity risk - a trend evidently, to judge from recent public statements, of increasing concern to the PRA6 - the SFCR disclosures underscore the case for a reform of the risk margin. We know from Sam Woods' recent evidence to the TSC, and as further stated by David Rule in his speech given at the ABI on 21 February 2017, that the PRA board has considered whether unilaterally to introduce such reform at a UK level, but concluded - apparently on fine balance - against doing so. If, however, the EIOPA/European Commission review process now underway does not lead to such reform on an acceptable timetable, the PRA may well conclude that balance has tilted.


1 LTG report section II.2

2 LTG report sections III.2 and III.3

3  For example, Sam Woods' written evidence to the Treasury Committee commented that: "Although the fundamental regime is sound, there are nevertheless adjustments that need to be made to address issues in important areas, with the most obvious being that the design of the Risk Margin is excessively volatile due to its sensitivity to risk-free interest rates." [Written evidence submitted by the Prudential Regulation Authority (SOL0051)]

4 For example, Sam Woods' speech on Insurance Supervision at the PRA to the London Business School on 20 March 2017

5 LTG report section II.3

6 For example, written evidence submitted to the Treasury Committee by the Prudential Regulation Authority (SOL0051)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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