Solvency II review proposal for long term valuation: Significant risk to destroy values!
On first sight this may sound more like a lobbyist statement than a prudent actuarial position. Why does AAE not support the proposal of EIOPA to reduce the risk-free interest rate significantly after 60 years (see also articles in the March issue of “The European Actuary”)? Let me explain step by step why EIOPA’s advice concerning the extrapolation is not justified and even contradicts many actuarial principles and is not aligned with the existing Solvency II framework.
AAE supports proposed valuation for the first 20 years!
Without any doubt a negative interest rate stress is necessary and we affirm the “mark to market” approach for liquid markets. Although there is an ongoing discussion that bond markets are extremely distorted and not efficient because of one dominant market player (see P. Lane: impact of 150 bp for 10 year bonds in 2018), this is reality and has to be reflected in the risk-free interest rate curve. But we should always keep in mind one fundamental observation: the level of distortion depends on the current liquidity and debt situation of the EU and can produce artificial volatility (P. Lane: just 60bp for 10 year bonds in 2014). And will these interventions continue in the long term? This question can certainly not be answered easily but to ignore this problem is extremely dangerous and may lead to wrong conclusions.
Valuation beyond year 20?
No deep and liquid markets can be observed beyond year 20, and therefore the “mark to market” approach can then no longer be applied. According to the Omnibus II directive there is a strong requirement to be near the Ultimate Forward Rate (UFR) after 60 years (difference max 3 bp). Also the significantly lower volume of bonds/swaps available between years 20 and 60 might be reflected in the extrapolation method. In the past, the Smith Wilson model worked well but certainly there are other approaches possible. But every extrapolation method must ensure that the curve will be very close to the UFR at term 60.
UFR not prudent enough for valuation?
Some politicians criticize that the UFR is at 3.6% (2021) by far too high. But there is a big misunderstanding: the UFR is the 1 year forward rate and translates into an interest rate of 2.15% for a 60 year term or even 1.4% for 40 years. Furthermore, EIOPA has introduced an algorithm to adjust the UFR according to expected market inflation and growth. If political decision makers feel uncomfortable with the current long term valuation then they have to discuss the UFR itself and not try to solve that problem through the backdoor by changing the extrapolation target.
Why close to UFR with extrapolation in 60 years?
The European Commission has set two fundamental requirements for the Review 2020: Stabilization and control of macro prudential effects as well as reduction of volatility (which needs a fixed value at the end of the extrapolation period). The current opinion of EIOPA, however, leads to a reduction of the risk-free interest curve at term 60 (in mid-2020 1.85% instead of 2.15%) and increases volatility significantly.
Impact of EIOPA proposal?
The Solvency Capital Requirements (SCR) will increase pressure on insurers to switch asset portfolios to safer assets. This is often an irreversible process: “Lock in” effects for long duration instead of investment in sustainable and “green” assets. Besides, will insurers still be willing to provide products even with low guarantees for annuities? Is that acceptable under the target of “intergenerational fairness”? Combined with the demographic change this will increase the risk for pension gaps and contradicts the role of Solvency II as a safeguard for clients. Instead, I would rather prefer to see a clear political statement in support of long-term investments and of insurance products for old age pension plans like the Pan-European Pensions Product in order to avoid old age poverty in Europe.
Obviously, there is no need to change the Omnibus II directive convergence target at year 60. Decision makers have to be aware that there is no sound actuarial or financial-mathematical reason for that. Nobody can predict what the economic situation will be like in 60 years. And to avoid irreversible effects, my advice would always be: do not change a well-working framework which is now in place for only five years! A comprehensive impact study on the EIOPA proposal will clearly disclose the huge problems we’re facing.
This blog is written in a personal capacity.
16 March 2021