Europe's Insurers Welcome EIOPA's Assessment On Long-Term Guarantees, But Solvency II Uncertainty Remains

Primary Credit Analysts: Rob C Jones, London (44) 20-7176-7041; rob.jones@standardandpoors.com Miroslav Petkov, London (44) 20-7176-7043; miroslav.petkov@standardandpoors.com Secondary Contact: Mark Button, London (44) 20-7176-7045; mark.button@standardandpoors.com

Table Of Contents
Matching Assets To Long-Term Liabilities Can Be Problematic What Is EIOPA Recommending? Five Elements To Get The Measure Of LTG Insurers' Volatility Existing Business Models May Need Big Changes How The Proposals Could Effect Standard & Poor's Analysis Of European Insurers Progress, Then, But Still Some Way To Go Related Criteria And Research

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Europe's Insurers Welcome EIOPA's Assessment On Long-Term Guarantees, But Solvency II Uncertainty Remains
The recent assessment by EIOPA (the European Insurance and Occupational Pensions Authority) of the potential effect of Solvency II regulation on long-term guarantees (LTGs) on life insurance products, (together with recommendations for their treatment) is a welcome step toward the finalization of the new solvency regime. Standard & Poor's Ratings Services, however, believes numerous hurdles remain, leaving even a planned 2016 implementation of Solvency II far from certain. EIOPA's report has in many respects been well received by the industry. It demonstrates the need for measures to reduce volatility of solvency levels in stressed financial market conditions and provides the trilogue parties (the European Council, Parliament, and Commission) with data on which to base their negotiations. However, many in the industry believe EIOPA should go further with its measures. In a letter to European Commissioner Michel Barnier, Insurance Europe (the Europe wide-industry association) and the forums of Europe's insurance CEOs, CFOs, and CROs jointly conclude that the measures "do not address the underlying issues and concerns, particularly the volatility and pro-cyclical incentive features." Overview The European Insurance and Occupational Pensions Authority (EIOPA) has made a number of recommendations in respect of long-term guaranteed life insurance products under the forthcoming Solvency II regulations. We believe EIOPA's proposals should result in less volatile regulatory capital positions for insurers. They should also afford insurers more time to address any regulatory shortfalls when Solvency II is introduced. Although EIOPA's proposed measures should limit volatility, solvency ratios may be far from stable, with such volatility being transparent to all market participants. While uncertainty still surrounds the implementation of Solvency II, there may be negative rating implications for insurers that use political indecisiveness as a reason to avoid taking economically justified actions.

We consider the current Solvency I regime as not fit for purpose, which makes the implementation of Solvency II an urgent priority for Europe (see "Q&A On The Future Of Solvency II: Pragmatism Is Likely To Prevail," published May 15, 2013, on RatingsDirect). In our opinion, the biggest obstacle to its implementation is the uncertainty as to what the regulation has in store for LTG products. Without a swift resolution by the current European Parliament (elections are due to take place in May 2014), further delays are likely.

Matching Assets To Long-Term Liabilities Can Be Problematic

Solvency II's design is founded on market-consistent principles. As the past five years have illustrated, market-based

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Europe's Insurers Welcome EIOPA's Assessment On Long-Term Guarantees, But Solvency II Uncertainty Remains

indicators (such as credit spreads) can periodically over- or under-state underlying economic risk. This need not be problematic for insurers with a close matching of assets and liabilities. However, in much of Europe there is a dearth of investments with sufficient duration to match very long-term life insurance liabilities. Furthermore, many of these liabilities include insurance policies with high levels of guarantee, giving rise to significant reinvestment risk. With interest rates currently at low levels, this is an economic risk that insurers are having to address. In addition, we consider that some of Solvency II's design features--the use of credit-spread volatility as a basis for credit-risk capital requirements, for example--may actually amplify market volatility. Life insurers' main concern is that the design does not sufficiently recognize the industry's demonstrated willingness and ability to hold bonds to maturity. The proposed "classical" matching adjustment goes some way toward this for products that have strict asset liability management, no lapse risk, and therefore minimal risk of forced asset realization. The insurance industry sought to extend this principle more broadly with an extended matching adjustment, which has been rejected by EIOPA. While we acknowledge the merits for such an adjustment, we recognize that it would have added a layer of complexity to an already complex design. In its overall package of proposals, EIOPA has sought to offset heightened volatility with new transitional measures and extended recovery periods. However, the mitigating effect of the package will be made fully transparent in detailed public domain regulatory returns. This may be problematic, in our view, unless the coverage of the Solvency Capital Requirement (SCR) at 100% is communicated consistently by national supervisors as a target rather than a minimum, and is understood as such by investors, intermediaries, and policyholders. The problems for insurers may manifest themselves in higher risk aversion generally, and pro-cyclical behavior in the midst of volatility.

What Is EIOPA Recommending?

The recommendations include a package of measures to ensure that short-term market movements are appropriately taken into account under Solvency II rules with regard to long-term business. These measures aim to reduce the sensitivity of Solvency II balance sheets to short-term market movements by reflecting the long-term nature and illiquidity of the relevant insurance liabilities. The need for these measures is clear based on data from year-end 2011, when risk-free rates were very low and spreads were at very high levels in some markets. For life insurers included in EIOPA's report, without any measures, the aggregate SCR coverage was just 53% (against the 100% target), and minimum capital requirement (MCR) coverage was just 132% (against the 100% minimum). Since 2011, conditions in financial markets have moderated, but remain strained. Overall, we believe that EIOPA's proposed package is economically justified. We recognize that the current economic environment continues to throw up considerable challenges to the insurers of long-term business. Indeed, many insurers may need to take comprehensive action to operate under the Solvency II regime. The proposed package may still see Solvency II regulation undermine some insurers' business models, in particular those that allow for an investment spread in their product pricing strategies (see "The Low-Interest-Rate Fog Over Global Life Insurers May Be Lifting," published July 25, 2013). Given the widespread consequences of those measures, we expect intense lobbying and political pressure to further dampen solvency volatility.

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Europe's Insurers Welcome EIOPA's Assessment On Long-Term Guarantees, But Solvency II Uncertainty Remains

Five Elements To Get The Measure Of LTG Insurers' Volatility

As part of the assessment, EIOPA considered five measures, the appropriateness and effectiveness of which were tested under 13 scenarios. Some 427 European insurers, representing 59% of the life industry and 25% of the non-life industry, provided data. Below is a high-level overview of the package of measures proposed by EIOPA:

Volatility balancer (VB)

This replaces the Counter Cyclical Premium (CCP) previously proposed. The VB will lead to an adjustment to the discount rate when credit spreads expand beyond the increase in default risk. The key advantage of the VB is that it will be formulaic and automatic, allowing insurers to incorporate it into their capital management process. This would address a major criticism that the wider industry had of the CCP, since its use was to be triggered at EIOPA's discretion. Also, the VB design allows for national adjustments, in addition to currency adjustments, to take account of country-specific financial crises. However, only 20% of the relevant spread is added to the discount rate because this produced similar outcomes to the CCP. If the VB makes it into the finalized version of Solvency II, insurers will want to see this proportion increased as a result of political negotiations.

Matching adjustments
The "classical" matching adjustment (CMA) operates through an increase of the discount rate of a portfolio of liabilities, which satisfy certain requirements. In particular, it requires liabilities to be closely matched to a ring-fenced portfolio of assets. EIOPA's recommendation is to apply CMA only to highly predictable insurance liabilities. In order to avoid providing an incentive for companies to seek exposure to illiquid or higher credit risk assets, the Authority recommends certain limits (including a 33% limit on 'BBB' rated corporate bonds and none lower than 'BBB'), which insurers feel are too constraining. EIOPA tested, but did not support, the introduction of the Extended Matching Adjustment (EMA). The EMA had fewer restrictions than the CMA and would have been applicable to a wider group of insurance liabilities that are exposed to lapse and material mortality risks. EIOPA recognizes that a major stumbling block for the CMA is the potential for insurers to "fall off a cliff" following a credit downturn, when their lower credit quality portfolios may no longer qualify them to use the CMA. The disqualification of the CMA might then lead to a significant reduction in solvency ratios that would compound volatility. We believe insurers would likely seek to avoid that risk by positioning matching asset portfolios very conservatively.

Extrapolation
Because of the shortage of investments for matching liabilities beyond a certain duration, EIOPA proposes the use of extrapolation. The Authority recommends the use of a long (say, 40 years) extrapolation period between the last liquid point--20 years for the euro--and an "ultimate forward rate" set at 4.2%. It considers that long extrapolation periods are more aligned with market-consistent principles and provide less volatile SCR coverage ratios compared with 10-year extrapolation periods. However, we believe this is likely to lead to higher liabilities in the current environment because discount rates for longer durations will be lower. One of the industry's main criticisms of this approach is that it ignores any market information beyond the last liquid point.

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Europe's Insurers Welcome EIOPA's Assessment On Long-Term Guarantees, But Solvency II Uncertainty Remains

Increased recovery period

For insurers with long-term liabilities (that is, more than 12 years), EIOPA recommends an extension of the recovery period to seven years following any decline in an insurer's SCR coverage to less than 100% during a financial crisis. (The standard recovery period can be up to 30 months.) The aim of this measure is to help insurers to deal with the difficulties of managing long-term business by affording them more time to take the necessary remedial actions. EIOPA recognizes there is a risk that this may see insurers purposefully delaying the implementation of these actions. Therefore, the close supervision of insurers (by their respective national supervisors) during this extended period will be critical, in our view.

Transitional measures
EIOPA proposes to use a discount rate that moves from a Solvency I basis to a Solvency II basis over a period of seven years. The reason for this is to give insurers more time to adapt to operating on a market-consistent basis. Our main concern here is similar to that over the increase in the recovery period; it may lead to insurers delaying taking the necessary risk management actions. Also, EIOPA acknowledges that the transitional measures present major application challenges, in particular due to the need to calculate two full Solvency II balance sheets. However, EIOPA's proposal also offers a simplified approach.

Existing Business Models May Need Big Changes

In assessing the impact of EIOPA's recommended measures, we consider similar factors: Whether the measures have an economic rationale, whether they can be consistently applied, and the complexity and the technical difficulties of the practical application of those measures. As a whole, we view positively that the proposed package is not a departure from general economic principles. However, we recognize that these measures may throw up significant challenges for some insurers' existing business models. These insurers may need to make considerable changes to their product design, pricing, investment, and capital management once Solvency II regulations are finalized. We deem it appropriate that some of the recommended measures will provide insurers with more time to take necessary actions to deal with the complexities of managing long-term business. However, we will view negatively those insurers who use the extra time to delay taking actions that are economically justified. We see it as constructive that the effect of most of EIOPA's recommendations will be transparent to all market participants. Investors, intermediaries, and policyholders may not view favorably insurers that rely on LTG measures to cover their SCR. If the market reaction to EIOPA's recommendations is negative, this could lead companies, especially listed companies, to adopt capital management policies that do not utilize EIOPA's recommended measures, potentially harming their competitive position and reducing their investment risk appetite. EIOPA has expressed its desire to reduce complexity. However, we consider that the package it proposes is still sufficiently complex for there to be concerns and uncertainty around its consistent application. Moreover, there is still considerable uncertainty regarding the final Solvency II LTG package of measures. Our concern is that the measures may be finalized too late for the industry to adequately prepare for their implementation and their

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Europe's Insurers Welcome EIOPA's Assessment On Long-Term Guarantees, But Solvency II Uncertainty Remains

business implications.

How The Proposals Could Effect Standard & Poor's Analysis Of European Insurers
We will continue to monitor the emergence of Solvency II and whether, and to what extent, the final measures may affect the insurance market and the competitive positions of individual companies. Also, we will consider whether they may lead to substantial changes to insurers' investment, capital, and risk management policies. We recognize that because of the uncertainty that surrounds the final rules, it's difficult for insurers to start taking any necessary preparatory steps. Nevertheless, there may be negative implications for our ratings on those insurers that rely on political indecisiveness to avoid taking economically justified actions. We will also consider the implications for an insurer's competitive position, if, under Solvency II, it is no longer able to offer a major business line. This could be because the current product design is not economic under new measures, or its redesign would not be compelling to prospective clients. Some of the proposed LTG measures are complex and it's likely that not all insurers will be able to take advantage of them. Such insurers may find themselves at a competitive disadvantage relative to those peers who can fully utilize them. EIOPA's LTG proposals should not have a direct bearing on our assessment of European insurers' capital adequacy because we plan to continue using our globally consistent capital model. However, under Solvency II, the regulatory capital position of insurers will require closer monitoring than is necessary under Solvency I. It's possible, therefore, that some insurers that have lower credit ratings may be more constrained by their SCR than the capital requirements under our model (see "Uncertainty Continues For European Insurers As Solvency II Requirements Remain Undecided," published Sept. 7, 2010). Some of EIOPA's proposed measures should result in less volatile regulatory capital positions. They should also afford insurers more time to address any regulatory shortfalls when Solvency II is introduced and following future financial crises. This makes it less likely that we would need to take negative rating actions solely due to challenged regulatory positions. However, we recognize that the regulatory position of insurers utilizing the matching adjustment may be exposed to a credit cliff in a future crisis, through the loss of the matching adjustment benefit. Losing the matching adjustment may exacerbate the effect that such a financial crisis would have on an insurer's regulatory position. We will monitor the potential impact of a credit crisis on these insurers' regulatory positions, and will seek clarity on how they propose to manage their credit portfolios to minimize that risk. Financial crises would also likely sway our assessments of insurers' capital adequacy under our capital model. However, the magnitude is likely to differ because typically, our capital model is based on insurers' International Financial Reporting Standards balance sheets, which for most insurers are currently not market-consistent. Nevertheless, short-term market fluctuations could have a material influence on our assessment of credit that we recognize for life insurance value in force. The extent of this influence would depend on an insurer's embedded value (EV). Currently, the majority of insurers use Market Consistent Embedded Value (MCEV) with an allowance for a

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Europe's Insurers Welcome EIOPA's Assessment On Long-Term Guarantees, But Solvency II Uncertainty Remains

liquidity premium, which aims to offset the short-term effects on risk-free discount rates in hostile financial markets. Moreover, our capital adequacy assessment under our new criteria takes into account prospective capital adequacy, including future earnings, dividends, and other expected capital flows and expected changes in the risk profile. That way, we partly offset the effect of short-term market movements but aim to reflect the expected capital position over the next two years. Our analysis will aim to reflect any inconsistencies in the application of the LTG measures. We anticipate that over time, such inconsistencies will be ironed out and we note that this may have a negative effect on the regulatory positions of those insurers that have adopted a more aggressive interpretation of the measures.

Progress, Then, But Still Some Way To Go

We expect politicians to be pragmatic when finalizing the design of Solvency II. Against an economic growth agenda, we expect them to further mitigate threats to the pricing and availability of traditional life insurance products and consequent threats to insurers' ability to continue long-term investing. This may come about naturally through further delays in implementation, broader transitional rules, longer transition and recovery periods, or through other means. Solvency II is far from a done deal.

Related Criteria And Research

The articles listed below are available on RatingsDirect. Q&A On The Future Of Solvency II: Pragmatism Is Likely To Prevail, May 15, 2013 Uncertainty Continues For European Insurers As Solvency II Requirements Remain Undecided, published Sept. 7, 2010
Additional Contact: Insurance Ratings Europe; InsuranceInteractive_Europe@standardandpoors.com

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