Looking back on the experience of the past decade's exceptionally low interest rates and occasional spikes in spreads – and possible recovery of both interest rates and spread levels – we as policy makers and supervisors should draw lessons and make improvements not just to our supervisory practices but also to the regulatory framework.
Such changes should ensure sound solvency positions and help insurance undertakings manage their Asset Liability Modelling (ALM) risks better.
The Dutch Central Bank, therefore, advocates a more market-orientated approach to the UFR.
For maturities far out on the curve – especially those past 50 years – market interest rates may not be a reliable basis for discounting liabilities.
However, the current last liquid point for the euro area stands at 20 years and there is a lot of analysis out there already that makes it clear that this is not the right estimate for this last liquid point. 30 years may be considered much better (for comparison, the Sterling LLP stands at 50 years).
Moving the last liquid point into the future would provide proper incentives for insurers to hedge their interest rate risk and makes it easier to do so.
"The Dutch Central Bank advocates a more
market-orientated approach to the UFR."
After all, a risk-free discount rate that is more in line with markets would also make it easier to align the discount rates of insurers’ assets to those of their liabilities.
Perhaps equally importantly, it would remove to a large extent the trade-off insurers are now facing between their economic and Solvency II positions.
Moving the last liquid point would likely come with short term costs. It would increase the value of liabilities, but here, rising interest rates might provide a solution by ensuring something of a soft landing.
After all, the difference between market rates and the UFR would shrink, thereby reducing the increase in value of liabilities that would come from moving the last liquid point. Therefore, when interest rates begin to meaningfully rise, the next few years may be the right time to make alterations to the UFR.
In terms of the volatility adjustment, DNB would be in favour of curtailing the VA in the next Solvency II review to prevent the so-called volatility adjustment overshoot where own funds increase when spreads increase as a result of basis risk (differences between the VA portfolio and insurers own portfolio) and duration mismatches between assets and liabilities.
"Moving the last liquid point would increase the value of liabilities, but rising
interest rates might provide a solution by ensuring a soft landing."
The required adjustment should be based on the simple principle that own funds should not increase as a result of the application of the VA. The maximum compensation provided by the VA should be the loss an insurer incurs on its asset as a result of spread increases.
This solution does not solve all concerns involving the VA, for instance the extent to which is represents economic reality, but it does reduce volatility in own funds and prevents the outcome of own funds increasing with spread headaches.
Reducing volatility in own funds would help asset managers manage their balance sheets.
We feel that putting on ’economic reality-tinted’ glasses and looking at an insurer’s balance sheet in that way is not only very important, but that in fact the Solvency II framework requires this from insurance companies: Pillar II of Solvency II after all has a requirement for good risk management practices, and a requirement to assess material risks facing the undertaking in an ORSA.
We therefore argue it should be part of your ORSA to look at the economic balance sheet. This is particularly true when the SCR ratio is declining and when you take away ‘crutches’ like the VA or the UFR; such a bare-bones economic assessment might in some case yield sobering but useful insights into the true state of the balance sheet.
"We argue it should be part of your ORSA to look at the
economic balance sheet."
In this case, if you are thinking about a transfer of liabilities or a run off of your portfolio it is not necessarily and not just the Solvency II position that matters for the markets or for those who want to take over that portfolio; the economic valuation of your balance sheet is in all likelihood a more important indication. Therefore, it is extremely important to consider these issues.
The monetary policy circumstances of the past years have shown the importance of properly managing both interest rate risk and spread risk for insurance companies.
However, in managing these risks, insurers are faced with volatility and trade-offs that result not just in market shocks but from the design of Solvency II framework with perhaps the UFR and VA as clearest exponents of this, in particular from a Euro-denominated perspective.
As prudential supervisors and regulators, we can’t change the monetary policy stance, nor can we alter shocks or movements in markets.
"The monetary policy circumstances have shown the importance of properly managing both interest rate risk and spread risk for insurance companies."
But we can ensure that the prudential framework and supervisory practice do not cause additional headaches for those managing insurers assets and liabilities, but instead that they support and promote sound, long term balance sheet management.
This is best for all involved – asset manager, insurer, investor, as well as the policy holder.
Promoting the importance of an economic perspective on insurers’ balance sheet is one area in which supervisors can and should improve.
This is certainly an aspect that the Dutch Central Bank will continue to focus on within the context of the Solvency II framework and in the discussion on how to review that framework in the years to come.
Dr Olaf Sleijpen is a Management Board Member, European Insurance Occupational Pensions Authority and Director of the Supervision Policy Division, De Nederlandsche Bank.
