slaughter and may The matching premium

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1 slaughter and may BRIEFING MARCH 2012 Introduction Solvency II is intended to introduce greater levels of harmonisation in the prudential regulation of insurers across Europe. This includes greater harmonisation in the way in which firms calculate their insurance liabilities. This move to harmonisation has caused concerns for certain segments of the insurance industry in the UK, principally annuity providers, who have found that the default approach to the discounting of liabilities would significantly increase their reserving requirements. The proposed solution to this issue is the so-called matching premium or matching adjustment. Although there is still some way to go until the full Solvency II package is finalised, recent indications from both the European Commission and the European Parliament are that some version of this matching premium solution will be present in the final regime. What is the issue? The UK regime Under the current UK regulatory regime, life insurers make provision for their insurance liabilities by calculating the present value of future net cash flows under the relevant policies. This involves applying a discount rate to those cashflows which is calculated by reference to the expected investment return on the assets which they hold to meet the relevant liabilities. For long term liabilities with predictable cash-flows, such as annuities, this typically involves holding long-dated gilts or bonds with cash inflows to match the cash outflows under the policies. The way in which the discount rate is currently calculated allows insurers potentially to offset the effect of falls in the value of assets held to match insurance liabilities with corresponding reductions in the value of those liabilities. For bonds, as asset values fall, the spread on the bond and therefore the rate of return will increase. Provided that credit risk has been taken into account, this increased rate of return can be used to increase the discount rate for the corresponding insurance liabilities. During the course of discussions over Solvency II, the difference between the actual increase in spread and that needed to reflect increased default risk has become known as the illiquidity premium. The holder of the assets can take advantage of this illiquidity premium where it is able to hold the relevant assets until maturity (i.e. to treat them as illiquid) and can therefore effectively disregard changes to market value other than those which reflect credit risk. There has been some debate over whether the illiquidity premium can really be separated from increases in credit risk. The position of the UK industry is that increases in spreads are frequently greater than that needed to reflect changes in credit risk and that the illiquidity premium is therefore a valid concept. The risk-free rate The Solvency II Directive provides that the best estimate of insurance liabilities is to be calculated using a relevant risk-free interest rate term structure (Article 77(2)). Under the current version of the directive, the relevant riskfree interest rate term structure is to be specified by the Commission in implementing measures (Article 86(b)).

2 Under the draft level 2 the basic risk-free interest rate term structure is to be derived and published for each currency by EIOPA, based on interest rate swap rates adjusted to take account of the credit risk and the basis risk of the corresponding interest rate swaps (or, for maturities where those rates are not available, based on government bond rates adjusted to take account of credit risk). If these centrally derived rates were applied without any adjustment, the rate used by annuity providers (as well as other insurers) to discount their liabilities would not include any allowance for illiquidity premium and would therefore not allow falls in asset values to be balanced by decreases to insurance liabilities. This would have significant capital consequences for writers of annuity business in the UK. solution Overview The draft consolidated level 2 released by the Commission in November 2011 addresses the issue outlined above by allowing a matching premium to be added to the basic risk-free rate for certain categories of insurance business and subject to a number of restrictions. provisions are in Article 42bis, Article 42ter and Article 50quater of the draft Level 2. The matching premium is intended to capture the spread on assets over and above that resulting from (i) default risk and (ii) downgrade risk. So, as spreads increase and asset values fall, the matching premium rate will increase, allowing insurers to reduce the best estimate of their insurance liabilities at the same time as they are having to reduce their asset values. This is prudentially acceptable because where the assets will be held to maturity their market value is only relevant to the extent that the fall in value reflects default risk or downgrade risk which is why the matching premium does not capture the spread which results from these risks. Downgrade risk is relevant because the matching premium provisions require the assets to have a certain credit quality if they fall below this they will have to be substituted, and therefore will not be held to maturity. Article 42ter paragraph 4 provides that the fundamental spread (i.e. the spread reflecting default risk and downgrade risk) should be no lower than 75% of the long term average of the spread over the basic risk-free interest rate of assets of the same duration, etc. Since the matching premium is the difference between the actual spread over the basic risk free rate of the assigned assets and the fundamental spread over the basic risk free rate of those assets, the setting of this floor (potentially) restricts the amount of the matching premium. Restrictions and requirements can only be applied to a portfolio of insurance obligations where the underlying insurance contracts do not give rise to future premium payments (as with single premium annuity products) and either (i) include no options for the policy holder or (ii) only include a surrender option where the surrender value does not exceed the value of the assets covering the insurance obligations at the time the surrender option is exercised. Other restrictions include: the undertaking must assign and ring-fence a portfolio of assets to cover the relevant insurance obligations the future cash-flows of the assets must be fixed and must match the future cash-flows of the obligations, in the same currency the assets must be of a sufficient credit quality, as detailed in the level 2 measures 02

3 once an insurer has opted to apply the matching premium it cannot choose to revert to an approach not including the matching premium. As mentioned above, the draft level 2 requires the assigned portfolio of assets to be ring-fenced and separately managed. It is not clear whether this will constitute ring-fencing in the more general sense under Solvency II. If it does, this would mean that any own funds attributable to the excess in the value of the assigned portfolio of assets over the value of the portfolio of insurance obligations could only be used to meet a notional SCR for that portfolio of obligations. Any surplus own funds over and above the notional SCR would have to be deducted from the total own funds of the undertaking available to meet the undertaking-level SCR. An adjustment would also need to be made to the SCR calculation for the undertaking to reflect the lack of diversification between the ring-fenced fund and the rest of the undertaking. The draft level 2 also states that the ring-fencing of the portfolio of assets must be without any possibility of transfer. It is not clear whether this will literally mean that once assets have been put into the portfolio they cannot be transferred out for the lifetime of the relevant insurance obligations, even if there are valid portfolio management reasons for seeking so to do. What happens if the matching premium becomes negative? It is possible for the matching premium to become negative. Recital 26 of the draft level 2 explicitly states that this is intended to be the case and that the methodology would be expected to produce a negative matching premium in market situations similar to those in 2005 and 2006, in the run up to the financial crisis, when assets were overvalued compared to their actual credit risk. This means that if asset values increase to the point where the spread is less than the default risk, the matching premium would be a negative amount and the resulting discount rate for the relevant liabilities would be less than the basic risk free rate. Since under the draft level 2 it is not permissible for an insurer to opt out of using the matching premium once it has opted in, it would be compelled to apply this lower discount rate in these circumstances. Arguably, this should not be a cause of concern for insurers since although the lower discount rate would result in the best estimate of their liabilities increasing, at the same time the value of the assets which they are holding to meet the liabilities would have increased, compensating in capital adequacy terms for the increase in liabilities. Where does Omnibus II fit in? Omnibus II was originally intended to make amendments to the Prospectus Directive and the Solvency II Directive to reflect the new European supervisory structure and, in the case of Solvency II, to change the date for transposition by Member States. By the time the Commission proposal was published in January 2011 it had been extended to make additional changes to Solvency II, principally to allow the Commission to propose transitional measures in a number of areas. Almost inevitably, however, it has since been used by the Council and in particular the Parliament as an opportunity to make other changes to the Solvency II Directive and, in the case of the Parliament, to wrest some legislative power away from the Commission by elevating provisions expected to appear in the Commission s level 2 delegated act to the level 1 directive. One such set of provisions are those relating to the matching premium, which the Parliament has, in the set of amendments to Omnibus II approved at the ECON vote on 21 March 2012, proposed including in the level 1 directive. 03

4 Key changes to the matching premium under the ECON proposals The proposed language dealing with the matching premium solution in the Parliament amendments to Omnibus II appears to be based on the matching premium provisions in the November 2011 consolidated draft level 2, but with a number of amendments. Importantly, the Parliament has proposed the introduction of a fairly significant caveat to its approval of the inclusion of the matching premium concept in the final Solvency II package. It suggests that EIOPA should make an assessment of the operation of a number of provisions of the directive, including the matching premium provisions (referred to here as the matching adjustment ), between 3 and 5 years after the application date of the Directive. If the review of the matching adjustment provisions concludes that they are not appropriate, then the Commission is required to adopt a delegated act to replace the provisions with an alternative version including a taper which would phase out the application of the matching adjustment over a seven year period from the application date of the Directive. This review clause is clearly problematic for a number of reasons and it is to be hoped that it will be removed from the final version of Omnibus II during trialogue discussions. The principal problem with the clause is the lack of certainty prospectively which it would create for the industry. In addition, the proposed timing for the review by EIOPA and subsequent tapering do not fit well together, as the five year window for EIOPA to review the operation of the matching premium appears to have been drafted to overlap with the seven year tapering under the transitional version of the provisions. This would be almost unworkable in practice. As well as the possible phasing out of the matching premium, the amendments to the Omnibus II proposal voted on by the ECON include a number of other changes to the matching premium provisions set out in the draft level 2. The most significant of these are: a requirement for public disclosure by the undertaking of the application and effect of the matching adjustment the matching premium can only be applied in relation to activities carried on in the Member State where the undertaking has been authorised undertakings which apply the matching adjustment cannot also apply the counter-cyclical premium or the symmetric adjustment mechanism. This appears not to distinguish between those obligations to which the matching adjustment is applied and the rest of a firm s obligations (unlike the draft level 2, which only prevents the different adjustments from applying to the same set of obligations). It is not clear whether this is intentional or merely the result of infelicitous drafting undertakings which apply a matching adjustment must submit an annual statement to supervisors describing what the impact would be of the reduction of the matching adjustment to zero and, if this would result in non-compliance with the SCR, an analysis of how the undertaking would re-establish compliance in such a situation. It is not clear whether it is intended that undertakings can take into account the expected increase in the value of their assets in scenarios where the matching adjustment is reduced to zero. the appropriate credit quality for the assigned portfolio of assets is to be determined in regulatory technical standards to be developed by EIOPA the basic formula for the calculation of the matching adjustment is the same as that set out in the draft level 2. However, the simplified calculation contained in Article 50quater of the draft level 2 does not seem to have been included nor is it obvious that scope is given for a simplification to be introduced at level 2. 04

5 What are the consequences for implementation of the matching premium provisions appearing at level 1 rather than level 2? Is it more legally robust? There has always been some concern about the inclusion at level 2 of matching premium provisions which appear to change the effect of the level 1 rather than simply expanding on it. The concern has been whether such provisions could, in principle, be subject to challenge as ultra vires the powers of the Commission in making those level 2 measures. There are two counter-arguments to this concern. The first is the argument that the matching premium is in fact consistent with the level 1 text. The argument is that the level 1 requires the best estimate to be calculated based on the relevant risk-free interest rate term structure and that for certain types of business e.g. annuities the relevant structure should include a matching premium. Since default risk is taken into account in calculating the matching premium, the argument goes, this is still a risk-free rate. The weakness to this argument is that the wording of the level 1 text suggests that a single interest rate term structure is to be applied to all liabilities, rather than a rate partly based on the particular situation of individual undertakings. Nevertheless, the absence of a specific formula or methodology for arriving at the relevant risk-free rate in the level 1 text allows some flexibility at level 2 in detailing what the rate should be, including the possibility of variations between different types of business. The second argument, which perhaps works best in conjunction with the first, is that the Commission does in fact have the power to make limited amendments to the level 1 text in its delegated act. This is on the basis that Article 290(1) of The Treaty On The Functioning Of The European Union provides that a legislative act can delegate to the Commission the power to adopt non-legislative acts to supplement or amend certain non-essential elements of the legislative act. Although the essential elements of an area are to be reserved to the primary legislative act, this does appear to open up the possibility of the level 2 measures departing from the strict wording of the directive in appropriate areas. Regardless of these arguments, elevating the matching premium provisions into the level 1 would put beyond doubt the legality of the provisions and leave no room for legal challenge. Does it allow more national discretion? The level 2 delegated act is expected to be a regulation which will have direct effect in all Member States without requiring transposition. The ability of national supervisors to provide guidance expanding on or clarifying the regulation is extremely limited. If the matching premium provisions are made by way of the level 2 delegated act, therefore, industry should not expect much in the way of formal guidance on interpretation from the FSA. In theory, the FSA has more discretion in implementation where the provisions are set out in the level 1 directive. However, it has publicly stated (in CP11/22) that it intends to take a copy out approach to the directive which is in any event maximum harmonising, reducing the scope for departure from the text. The FSA is therefore likely to transpose the matching premium provisions into the Handbook more or less word for word if they appear in level 1. If not in transposition, it is possible that having the matching premium provisions at level 1 might at least give the FSA greater flexibility in its supervision of firms. There are a number of elements of the matching premium provisions which are not entirely clear, such as the requirement that the relevant portfolio of assets must be 05

6 ring-fenced without any possibility of transfer. Arguably, the FSA may feel it has more scope to interpret these provisions purposively if they are in a level 1 directive rather than a level 2 regulation. Next steps The plenary session of the European Parliament to vote on the Omnibus II proposal is scheduled for September Before then, trialogue discussions will take place between the Parliament, the Council and the Commission in an attempt to arrive at an agreed text to be approved by the Council and the Parliament. There is therefore still scope for the remaining wrinkles in the Parliament s proposals to be ironed out or, indeed, for other changes to the matching premium solution to be made. Slaughter and May 2012 This material is for general information only and is not intended to provide legal advice. For further information, please speak to your usual Slaughter and May contact. bzd6.indd312