2014 EIOPA Stress Test

Questions and Answers

The European Insurance and Occupational Pensions Authority (EIOPA) has published the results of the 2014 EIOPA Stress Test Exercise. The exercise was conducted by EIOPA in conjunction with the national competent authorities responsible for insurance supervision in these Member States.

The purpose of the 2014 Stress Test Exercise was to develop criteria for the identification and measurement of systemic risk and an adequate stress testing regime which includes an evaluation of the potential for systemic risk that may be posed by financial institutions to increase in situations of stress. This stress testing regime shall help to identify those financial institutions that may pose a systemic risk. These stresses were calibrated with the consultation of the European Systemic Risk Board (ESRB).

Participation in the exercise was sufficiently representative to be able to draw inferences of a systemic nature.

The exercise has two elements involving two different samples:

General Questions about the Stress Test

What are the objectives of the exercise?

The main objectives of the exercise are:

• To explore overall resilience of the insurance sector;
• To identify its major vulnerabilities;
• To reveal areas that require further supervisory focus (especially in relation with the upcoming Solvency II regime); and
• To follow-up on EIOPA's Opinion on Supervisory Response to the Prolonged Low Interest Rate Environment.

How many companies and groups participated in the exercise?

A total of 167 entities, 60 insurance groups and 107 individual undertakings, representing 55% of Gross Written Premium at the EU level participated in the Core Module. The core module sample includes 29 members of the so-called "Top-30" group which involves the largest and internationally more active European insurance groups.

A total of 225 undertakings representing 60% of Gross Technical provisions at the EU level participated in the Low Yield Module.

With regards to the Maltese participation, 9 individual undertakings participated in the Core Module; of which 4 individual undertakings also participated in the Low Yield Module.

Will Member States release the national results of the stress test?

It was decided by EIOPA that the stress test results of the individual participants should not be disclosed under any circumstances. The primary reason is to avoid giving misleading information to the market, since the Solvency II specification utilised for the test was not the final specification that will be implemented in 2016. While it is possible to draw broad conclusions from the exercise, the fact remains that firms are still preparing for Solvency II and have not yet full adjusted their balance sheets to the new regime.

As outlined at the launch of the exercise, the objective is to examine the resilience of the insurance sector as a whole and to identify its vulnerabilities.

The exercise does not set out to define capital levels for firms.

What are the differences in vulnerabilities banks and insurers are exposed to?

A key vulnerability of the European insurance sector is the so-called 'double hit'. Insurers are large investors in government and corporate bonds, equity and real estate. Insurers are therefore particularly vulnerable to the risk of an abrupt fall in global asset prices, as a result of a reassessment of risk premia, and an aggravation of sovereign debt crisis. In addition insurers are vulnerable to prolonged low risk free interest rate levels. Low risk free yields increase the value of their long-term liabilities and compress margins between guaranteed returns in life policies and matching long-term low risk investments. Hence insurers face risks at both their assets and their liabilities side of the balance sheet. These risks are fully captured by the two proposed financial market scenarios.

How many firms failed the test and how big is the capital shortfall?

The aim of this exercise was to assess participant's resilience and vulnerabilities to the stress scenarios imposed as part of the exercise and was not a pass/fail exercise.

A by-product of the exercise is an evaluation of where entities stand in terms of the SCR¹ using the end-2013 balance sheet and the technical specifications available at the launch of the exercise. This gives an indication of firms' positioning but is not precise in that some firms will utilize internal models and a greater proportion may utilize Long Term Guarantee (LTG) / Transitional measures. Consequently, it is not fully correct to put a number on any sort of capital shortfall. A rough estimate of the total capital shortfall of all the European participants of the exercise would be in the region of €3 billion.

How did the Maltese participants fare in the stress test?

The solvency ratios pre-stress for the Maltese participants are above 100%. In view that as part of the stress test technical specifications, the recalculation of the SCR post-stress was optional, the solvency ratio post-stress for the Core Module Stress Test and the Low Yield Module do not provide a clear indication of the solvency position of the participants.

The aim of the stress test was to assess the participant's resilience to the stress scenarios imposed and was not a pass/fail exercise. In this regard if the calculations resulted in a solvency ratio less than 100%, no supervisory action would be taken. However, in instances where the post-stress calculations resulted in a solvency ratio of less than 100%, the MFSA is closely monitoring these undertakings.

Questions about the Core Module Stress Test

What does the Core Module Stress Test consist of?

The core-module is a stress test with focus on financial resilience, which is based on market stress-scenarios and on single-factor-insurance stresses. It consists of:

1. Baseline/pre-stress scenario – a starting point (a pre-stress) evaluation of the companies' balance sheets, available assets and liabilities, eligible own funds and Solvency Capital Requirements cover. This evaluation was based on the balance sheet values as at 31^st December 2013.

2. Core Adverse market scenario 1 (CA1) according to which the EU equity market as a whole is assumed to be the source of distress

3. Core Adverse market scenario 2 (CA2) according to which the non-financial corporate bond market is assumed to be the source of distress

Both CA1 and CA2 contain the following shocks: equity, sovereigns and corporate bonds shocks; real estate assets prices' and interest rates stresses

4. Separately to the CA1 and CA2, 15 single factor insurance stress test scenarios were applied. These factors include: 5 pre-defined and 2 to-be defined-by-participants Natural Catastrophes scenarios; 2 non-life stresses, 4 life stresses (2 longevity and 2 mortality shocks) as well as 2 mass lapse events i.e. when a massive number of clients refuses to renew their policies in the same time, which in its turn negatively impacts insurance balance sheets.

What are the key findings of the Core Module Stress Test?

1. Under the most severe "double hit" stress scenario:

• 56% companies would have a sufficient level of capital, compared to 78% in the less severe scenario tested
• Overall available assets would decrease by 42%

2. The insurance sector is more vulnerable to a "double hit" (i.e. asset values decrease and lower risk free rate) scenario

3. Insurance specific stresses show vulnerability to mass lapse, longevity, natural catastrophe and provision deficiency

How will EIOPA use the results of the Core Module Stress Test?

EIOPA will use the results of the exercise for its participation in the colleges of supervisors in order to assess a group's risk profile and vulnerabilities, as benchmarked against the stress test samples.

EIOPA will also use the overall stress test results for its participation in the ESRB and other relevant bodies where systemic risks are considered and discussed.

Questions about the Low Yield Module

Why does the EU Stress Test 2014 include the Low Yield Module?

This module was designed to follow up on EIOPA's Opinion on Supervisory Response to a Prolonged Low Interest Rate Environment published on 28 February 2013. The aim was to develop a framework for the quantitative assessment of the scope and scale of the risks posed by a prolonged low interest rate environment.

What are the main findings of the Low Yield Module?

1. Low yield environment has most impact on:

• Countries with a significant mismatch in duration and returns between assets and liabilities (i.e. liabilities are "longer" than assets and/or guarantee rates are above the return rates of assets)

• Life insurance business with long-term guarantees

2. 24% of the total European undertakings would not meet the SCR under the "Japanese-like" scenario, while 20% of total undertakings would not meet the threshold in the "Inverse" scenario.

3. A continuation of current low yield conditions could see some undertakings exposed to this risk having problems in meeting promises to policyholders in 8- 11 years.

Which Member States are more vulnerable to the low interest rate environment and which are less?

Those countries plotted in the left-lower quadrant are exposed to a low yield scenario characterised by constrained interest rates. Most of the countries with a material business providing long-term guarantees have fallen in that quadrant. The further from the central point of the XY-axes the higher mismatch of IRR, durations or both of them.

The mismatch of Internal Rate of Return (IRR) and durations for Malta does not imply that there are any particular solvency concerns for the Maltese participants.

Why are the individual results of the Low Yield Module not available?

In order to avoid unintended financial stability consequences the results of the Low Yield Module are presented in EIOPA report at a country level and it is up to the NSAs to complete the national analysis but respecting the consensus of not disclosing individual firm results for the reasons already explained as part of the above.

Footnote

1. SCR is the regulatory capital required to ensure that the insurance and reinsurance undertaking will be able to meet its obligations over the next 12 months. The SCR corresponds to the Value-at-Risk of the basic own funds of an insurance or reinsurance undertaking subject to a confidence level of 99.5% over a one-year period.

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