Compromise proposal on Omnibus II On 25 November 2013 a compromise proposal on the Omnibus II Directive was published. This was based on a provisional agreement from the European Parliament, the European Union Commission and the Council of the European Union earlier in the month. The Directive still needs to be approved at a plenary vote by the European Parliament and this is scheduled for 3 February 2014. However, this agreement is a significant step forward on the path to implementation of Solvency II. Solvency II is now scheduled to come into force on 1 January 2016 so companies have just over two years to prepare. This is not a lot of time given that regulators will have the power to start approving items such as internal models, the use of the volatility and matching adjustment and transitional measures from as early as April 2015. As a first step, we would expect companies to analyse the impact on their balance sheet of the changes proposed in Omnibus II and where sensible, make optimal use of the proposed transitional measures. Solvency II still represents a significant challenge for many companies across Europe. Regulators have been encouraging companies to maintain the focus on Solvency II via the interim measures but having a specific implementation date makes it more real for companies. Companies will undoubtedly look to update their Solvency II plans but for many there will be significant challenges around skilled resources, systems and capabilities. Here, we look at the key changes proposed by Omnibus II and the impact they will have on the industry. As described below, it includes a number of compromises but on balance, we would support the efforts to move to a risk based supervisory regime across Europe. Volatility adjustment A volatility adjustment, proposed by EIOPA in its technical findings on the Long Term Guarantee Assessment (LTGA), has been introduced to replace the counter-cyclical premium (CCP). The main concerns of the industry around the CCP were: The use of the CCP significantly increases capital requirements in some countries and could result in a limited or negative impact on the solvency ratios The lack of a smooth trigger process could result in increased short-term balance sheet volatility. The volatility adjustment has addressed these issues. It will be available permanently and no capital will need to be held against the risk of changes to it. The adjustment will be based on the spread between the interest rate which could be earned from assets included in a reference portfolio for that currency, and the rates of the relevant basic risk-free interest rate term structure. This spread will then be reduced to reflect the spread which is attributable to the risks inherent in the assets held, providing the risk-corrected currency spread.
Country specific adjustments can also be applied when national spreads widen compared to the spreads on the currency specific reference portfolio. In EIOPA s LTGA report, EIOPA recommended that only 20% of the spread (excluding the portion linked to default risk) was taken as the volatility adjustment. However, this has been increased to 65% which is widely welcomed by the industry. The EIOPA LTGA report recommended that the impact of the volatility adjustment be allowed for through a special own funds adjustment in the base case whereas for the purpose of the calculation of the SCR, the volatility adjuster would not have been allowed for. This proposal has not been adopted, the adjustment directly impacts technical provisions and hence the base own funds. We also expect it to impact the stressed own funds calculation. The move to the more predictable volatility adjustment is welcomed by the industry. However, details on the reference portfolio to be used and the method to calculate the reduction in spread attributable to the risks inherent in the assets are not detailed in Omnibus II. As a result, there will still be uncertainty around the impact this will have on balance sheets until Level 2 and 3 texts become available. Matching adjustment Some significant changes have been made to the matching adjustment criteria, which will be warmly welcomed by writers of immediate annuities. The key changes are: The matching adjustment now also applies to non-life annuities such as those in respect of payment protection orders The floor applied to the fundamental spread has been reduced to 35% from 75% for assets other than EU sovereign debt, this will significantly increase the benefit of the matching adjustment The matching adjustment for BBB rated bonds is no longer being capped at that for A rated bonds Removal of limits on the proportion of BBB rated bonds and ability to hold sub-investment grade assets (the matching adjustment is capped at that for investment grade bonds). The first change above, eligibility of non-life annuities for the matching adjustment, is an important win for companies with payment protection order annuities. While such liabilities are currently relatively small, they will grow in significance over time as more claims are settled in this form. The long duration of such liabilities will mean that the matching adjustments will have a material beneficial impact. The other three changes above will be particularly welcomed by UK annuity writers who hold significant amount of corporate bonds. Other changes include: The requirement for the assets to be ring-fenced has been removed and replaced with the requirement for the assets to be identified, organised and managed separately from other activities of the undertaking. Assets in this assigned portfolio of assets cannot be used to cover losses arising elsewhere in the business. Notwithstanding the dropping of the ring-fencing term, it is still possible that this revised description can result in a loss of diversification benefit and additional costs for insurers. Extending the eligibility criteria so that liabilities subject to immaterial mortality risk can also be included. This extension will be valuable for the likes of Dutch insurers who offer funeral insurance, many Spanish insurers and certain UK bulk annuity business.
A significant industry concern largely not addressed is the requirement for cash-flows from eligible assets to be fixed and not capable of being changed by the issuer or third parties. While this has been relaxed for assets with make-whole provisions, insurers have significant holdings in other assets (e.g. hybrid debt with call dates and mortgage books with prepayment risk) that may not be eligible for the matching adjustment. The extended matching adjustment has not been included in the final Omnibus II text. This would have benefitted firms across Europe and, although the volatility adjustment (described in previous section) has been increased, this is not expected to have as significant an impact on the balance sheet as the extended matching adjustment. Transitional measures Transitional measure on the risk free interest rate The transition of the Solvency I interest rate to the Solvency II yield curve for business sold before 1 January 2016 will now take place over 16 years rather than 7. The transition will occur via an adjustment to the Solvency II yield curve equal to a moving weighted average of the difference between the Solvency I and Solvency II rates. The single Solvency II rate will need to be calculated such that it gives the same value of best estimate liabilities as under the full Solvency II yield curve. It is not yet clear how this rate will be stressed under the standard formula interest rate stress. The volatility adjustment can still be applied to the Solvency II component of the transitional rate, but the matching adjustment cannot. Transitional measure on technical provisions The transition from the Solvency I reserves (net of reinsurance) to the Solvency II reserves (net of reinsurance) will also take place over 16 years rather than 7 and will occur linearly over this period. The volatility adjustment can still be applied but it is not clear whether the matching adjustment can. The amounts of the technical provisions used to calculate the transitional deduction may be recalculated every 24 months, or more frequently where the risk profile of the undertaking has materially changed, subject to prior regulatory approval. As per the LTGA technical specification, the transitional measure on technical provisions may be determined separately for each bucket of obligations (or homogeneous risk groups ). General comments The articles confirm that if a firm wishes to use one of the above transitional measures then prior approval from the supervisory authority will be required and only the use of one transitional measure is permitted per company. Companies which would not comply with the SCR without the application of transitional measures will be required to inform their supervisor and, within two months, submit a plan to re-establish compliance. Following this, annual reporting of the measures taken and the progress made to re-establish compliance will be required. Supervisors have the right to revoke the use of transitional measures if compliance with the SCR at the end of the transitional period looks unlikely. These transitional measures can only be applied to business sold before the Solvency II regulations come into force. This will make calculations more complicated for companies who choose to adopt the measures as different interest rates and methodologies will apply to different parts of the business. One issue caused by the application of the transitional measures is that they only apply to the liability side of the balance sheet; assets would move in line with economic conditions but the liabilities would only partially do
so because of the weighting to a past discount rate. On the other hand, the transitional measure on technical provisions effectively allows the risk margin to be introduced over time. Companies will need to analyse their balance sheet carefully in the run up to Solvency II implementation to decide the optimal solution in relation to the transitional measures. The long transitional period looks to be a compromise to allow companies more time to adapt to the new legislation and hence avoid short term financial instability. Other transitional measures Additional transitional measures are also included in Omnibus II and these remain largely unchanged from those in the previous version. They include grandfathering provisions for basic own fund items that were issued prior to Solvency II coming into force and which are not classified as Tier 1 or 2 own funds. The following items can be used for up to 10 years from the introduction of Solvency II: Basic own funds that could have been used to meet up to 50% of the solvency margin can be treated as Tier 1 basic own funds Basic own fund items that could have been used to meet up to 25% of the solvency margin can be treated as Tier 2 basic own funds. There are two transitional measures relating to the Standard Formula SCR. These are: The stress to equities can be phased in over seven years for equities purchased prior to Solvency II coming into force. The stress will increase linearly from the level of the duration based equity risk sub-module, 22%, to the level of the full stress. The concentration and spread risk stresses applied to any debt issued by EU central governments or banks in the domestic currency of another EU country will effectively be zero until 2017 (i.e. the same level as if the debt had been issued in the domestic currency of that central government or bank). These will phase-in to the full specified stress by 2020. Third country equivalence The main changes in Omnibus II for third country equivalence relates to the group solvency assessment for groups with headquarters within the EU which have subsidiaries outside the EU. Omnibus II now states that temporary equivalence can be granted to third countries for a period of 10 years and this can be renewed for periods of 10 years. In such cases, EU headquartered groups will be able to use the local regulatory requirements of equivalent regimes when calculating the group capital position. It is hoped this change will provide a level playing field for EU based insurers compared to those not in the EU. However it is not yet specified which countries will be granted this temporary equivalence. Reporting requirements The changes in the latest Omnibus II text have also resulted in additional reporting requirements. These will be quite burdensome for firms as they will involve results with and without the inclusion of the matching adjustment, volatility adjustment and transitional measures. In particular the Solvency and Financial Condition Report, which is publically disclosed, must contain: A description of the matching adjustment and the portfolio of obligations and assigned assets to which the matching adjustment is applied and quantification of the impact of not applying the matching adjustment on the financial position of the firm
A statement on whether the volatility adjustment is used and quantification of the impact of not applying this adjustment on the financial position of the firm A statement confirming whether the transitional measure on risk free interest rates or the transitional measure on technical provisions is used, and quantification of the impact of not applying this transitional deduction on the financial position of the firm. The report to supervisors must include a regular assessment of the sensitivity of technical provisions and eligible own funds to: The assumptions underlying the extrapolation of the risk-free interest rate term structure The assumptions underlying the calculation of the matching adjustment, changes in the composition of the assigned portfolio of assets and reducing the matching adjustment to zero The assumptions underlying the calculation of the volatility adjustment and reducing the volatility adjustment to zero. The assessment of compliance with the capital requirements in the Own Risk and Solvency Assessment must be completed with and without the use of the matching adjustment, volatility adjustment and transitional measures. As part of a company s risk management process, where the company applies the matching adjustment or volatility adjustment, they must set up a liquidity plan projecting incoming and outgoing cash-flows in relation to the assets and liabilities subject to these adjustments. Other changes Extrapolation of the yield curve The Omnibus II text describes the high level principles for the extrapolation of the yield curve. The recitals indicate that the last liquid point to be used for the Euro is 20 years and the convergence period is 40 years after this point. An outstanding issue which is not addressed in Omnibus II is the level of deduction from the swap curve for credit and basis risk. We will have to wait for the implementing measures to understand how this will be determined. Powers of the supervisory authorities Supervisory authorities will have the power to approve ancillary own funds, undertaking specific parameters, full and partial internal models, the use of the matching adjustment and volatility adjustment and the use of transitional measures from 1 April 2015. This allows some time for supervisors and companies to ensure internal models are approved in time for Solvency II coming into force or for contingency plans to be executed. Appropriateness of external credit assessments An additional requirement has been added for companies to themselves assess the appropriateness of external credit assessments as part of their risk management. EIOPA will develop draft implementing technical standards on this area. On the face of it, it does not appear efficient for companies to individually assess external credit assessments and so it remains to see how much of a burden this will be for firms.