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21 March 2014 Cap 'too high' on Solvency II credit risk adjustment

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A proposed 35-basis point cap on the Solvency II credit risk adjustment is set too high to prevent volatility in insurers' balance sheets, actuaries warn, saying the limit will only take effect in times of severe market stress.

The cap is part of an overhaul by the European Commission of how the adjustment is calculated, according to sources familiar with a draft version of the delegated acts sent to Member States. The Commission also proposes to halve the size of the adjustment and weaken its link to short-term fluctuations in swap markets.

Insurers say the changes represent a half-step in the right direction and warn a more generous calibration is necessary to stop artificial volatility from undermining their balance sheets. "They have introduced a cap, but set it too high because they were looking at the way markets moved during the financial crisis, in conjunction with a methodology that is too volatile", says a UK-based insurance executive. "As it now stands, the adjustment might jump around considerably, and threatens to introduce too much noise in our balance sheets", the executive adds.

The credit risk adjustment (CRA) is a deduction for credit-risk applied to the benchmark swap curve to calculate the risk-free rate used to value insurers' liabilities. The greater its value, the lower the discount rate and the higher the discounted present value of future liabilities.

The Commission is expected to include in the Solvency II delegated acts the outline of a formula to calculate the adjustment, after proposals for a fixed number in Omnibus II were dropped. The latest draft, dated March 14, builds on an earlier version of the document circulated in January, which said the CRA would be based on a stable average of the spread between short-term swap and overnight rates and would be no lower than 10bp.

The Commission proposes to use the one-year average of the spread between three-month swap rates and overnight index swap rates. It also applies a 50 per cent scaling factor to the spread to reflect only the part that arises from default risk and not market risk. Finally, the Commission holds to the 10bp floor, but adds a 35bp cap, creating a corridor 25bp wide in which the adjustment can fluctuate.

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