12 March 2013

Insurance Europe: The package of measures to avoid artificial volatility and pro-cyclicality

The European insurance industry supports the goals of Solvency II: ensuring high levels of policyholder protection, harmonising requirements across Europe, encouraging and requiring transparency and high standards of risk management and leading to a strong and efficient European insurance industry. However, vital issues still need to be resolved to take into account the long-term nature of the insurance industry. Unless the right steps are taken, Solvency II risks creating artificial volatility (in Own Funds) and pro-cyclicality.

One of the main findings from QIS5 was that the way the excessive volatility seen in the financial markets since 2008 is reflected in the Solvency II balance sheets distorts companies’ true solvency positions. The current Solvency II framework makes insurance business appears far more volatile than it really is, with major unintended consequences for policyholders, markets and the industry.

The insurance industry is the largest institutional investor in Europe, investing heavily in long-term assets. Not addressing the issues of artificial volatility and pro-cyclicality risks insurers shifting from longer-term to shorter-term assets, leading unnecessarily to a range of unintended adverse macro-economic impacts:

• limiting the insurance industry’s traditional role of investing in and assisting growth in the European economy
• reducing the insurance industry’s traditional role as a stabiliser in financial markets, and thereby reducing systemic risk and market volatility

Unless these issues are resolved, consumers may also suffer because companies stop selling long-term guaranteed products and/or increase policyholders’ charges due to unnecessarily high capital requirements for these products. Products with long-term guarantees provide essential social benefits, such as retirement provision, in many countries.

A Working Group on Long-Term Guarantees, set up by the European Commission in 2011, developed a package of measures comprising three key elements, each of which plays a crucial role in reventing artificial volatility and pro-cyclicality:

• Counter-cyclical premium
  • enables the industry to cope during distressed market conditions
  • must be predictable so the industry can use it in forecasting the impact of known issues and must include sufficient discretion and control for EIOPA to react to unexpected situations
• Matching adjustment
  • mechanism to recognise the significant benefits where investment strategies and product features mitigate the impact of spread movements
  • must not be artificially limited to very few products and must apply across Europe
• Extrapolation methodology
  • extrapolation methodology must avoid creating volatility in the value of long-term liabilities
  • need to ensure extrapolation starts where bond markets are no longer deep, liquid and transparent (eg after 20 years for the Euro under current conditions) and reaches the Ultimate Forward Rate appropriately early (ie 10 years)

It is imperative that all these measures are included and implemented appropriately within the Solvency II framework.

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