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Regulatory insight

8 March 2018

Towards an amendment to Solvency II?

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Towards an amendment to Solvency II? EIOPA, the European Insurance and Occupational Pensions Authority, has recently published two sets of

recommendations to change the calculation of the required capital within the Solvency II Directive. This article reviews

some important elements of these proposals and discusses the possible impact on European insurance companies.

In particular, we focus on the following topics:

1. Increased solvency capital requirement for interest rate risk

EIOPA proposes to change the upward and downward stress test for the risk-free curve. The downward stress

will become much more severe. This will lead, ceteris paribus, to a larger solvency capital requirement for

interest rate risk. A three-year transition period is proposed to mitigate the impact.

2. Treatment of government guarantees (like NHG) for residential mortgage investments

EIOPA proposes to acknowledge the risk-mitigating effect for Dutch residential mortgage loans which are

guaranteed by the Dutch National Mortgage Guarantee scheme (“Nationale Hypotheekgarantie” or NHG).

Currently, such a partial guarantee is not recognized under Solvency II, whereas partial guarantees are

accounted for under Basel III. This will significantly lower the solvency capital charge for such mortgage loans.

3. Treatment of regional authorities and local governments (RGLA)

A better alignment of Solvency II with the treatment of RGLA under Basel III is proposed. This may cause a

higher capital charge for investments in RGLA in France, Finland, Portugal and Poland. Guarantees by RGLA

will also be acknowledged under Solvency, in line with Basel III.

4. Loss-absorbing capacity and deferred taxes (LAC DT)

EIOPA signals that supervisors have divergent practices to assess how likely future profits are, in order to

demonstrate the probable utilization of deferred taxes. EIOPA therefore proposes nine key principles that

should be used to further align the supervisory practice.

5. Reduction of reliance on credit rating agencies

EIOPA proposes a simplified calculation method for the credit risk module. This simplified method may be used

if a single credit rating agency already covers 80% of the debt portfolio.

We start this article with a short overview of the legislative process up to this point. We then give more information

about the above five topics and discuss the possible impact for insurance companies.

Timeline

The Solvency II Directive (2009/138/EC) was adopted in November 2009, and amended by Directive 2014/51/EU of

the European Parliament and of the Council of 16 April 2014 (the so-called “Omnibus II Directive").1 On 10 October

2014, the European Commission adopted the Delegated Regulation 2015/35/EU containing implementing rules for

Solvency II.2 On 20 September 2015, the European Commission adopted the Delegated Regulation 2016/467 amending

the previous Delegated Regulation, particularly concerning the calculation of regulatory capital requirements for

different categories of assets held by insurers.3 All of these texts entered into force on 1 January 2016.

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After a consultation phase during 2017, EIOPA published a first set of advice on 30 October 2017.4 A second,

comprehensive, set of advice was published on 28 February 2018.5 All advice has been sent to the European

Commission at the end of February 2018. Implementation is possible by 1 January 2019 at the earliest.

1. Increased solvency capital requirement for interest rate risk6

EIOPA mentions that the current approach for calculating the solvency capital requirement (SCR) for interest rate risk

leads to a severe underestimation of the actual risks. For example, in reality interest rates have moved more than in

the SCR stress scenario (which should only happen once every 200 years). The current approach also fails to stress

negative rates, although negative rates can continue to decrease in practice. Users of internal models for the SCR

calculation typically adopt alternative, more realistic, approaches in practice. This has led to a broad consensus in the

insurance industry that the current standard formula has severe shortcomings.

EIOPA therefore advises to model interest rate risk in the standard formula using an approach which is widely used by

internal model users. In particular, the increased term structure for a given currency shall be equal to:

rtup(m) = rt (m)*(1+ sm

up) + bmup

where rt (m) denotes the risk-free rate in the corresponding currency, m denotes the maturity and smup and bm

up are

specified by EIOPA.7 The minimum shift bmup starts at 2.14% for a maturity of 1 year and decreases to zero for a

maturity of 60 years. The relative change smup starts at 61% for a maturity of 1 year and decreases to 20% for a maturity

of 90 years.8

A similar approach is used to specify the decreased interest rate curve:

rtdown(m) = rt (m)*(1- sm

down) - bmdown

In this case, the minimum shift bmup starts at 1.16% for a maturity of 1 year and decreases to zero for a maturity of 60

years. The relative change smup starts at 58% for a maturity of 1 year and decreases to 20% for a maturity of 90 years.9

As an example, Figure 1 shows the base risk-free euro curve published by EIOPA at the end of January 2018 (the central

blue line) and the (current and new) stressed interest rate curves.10 The red line shows the curve of an upward stress

test using the new methodology and the green line shows the new curve of the downward stress test. The yellow and

dark blue lines show the upward respectively downward shocked curve based on the current methodology.

If we now compare the old and the new methodology (so dark blue versus green line, and yellow versus red line), we

see that the applied stress is much larger for the decreased interest rates. The additional stress is approximately 64

basis points (averaged over maturities from 1 to 60 years) in this case. The effect is smaller for the increased interest

rates: on average 15 basis points more. The impact is especially large for short and intermediate maturities.

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Figure 1: Impact of the proposed new interest rate risk methodology for the risk-free euro rate (as of 31 January 2018)11

These changes could well lead to an increased focus on interest rate hedging, because - ceteris paribus - interest rate

risk will be penalized more severely. Exposure to a downward interest rate shock will especially require more capital,

which can lead to a larger demand in the market for receiver swaps or swaptions. Given the potentially big impact of

these changes, EIOPA advises that the new approach is gradually implemented over a period of 3 years, in particular

for the downward shock.

2. Treatment of government guarantees (like NHG) for residential mortgage investments12

On another note, EIOPA also advices to adjust the treatment of Dutch residential mortgage loans which are guaranteed

by the National Mortgage Guarantee scheme (“Nationale Hypotheekgarantie” or NHG). The NHG scheme is

administered by the Homeownership Guarantee Fund (Waarborgfonds Eigen Woningen, or “WEW”). The WEW

guarantees approximately €190 billion in mortgage loans. The NHG scheme provides a partial guarantee.13 Currently,

such a partial guarantee is not recognized under Solvency II, whereas partial guarantees are accounted for under Basel

III.14 EIOPA now advices to recognize partial guarantees when the counterparty risk module is used for residential

mortgages. This would further reduce the required capital for Dutch NHG mortgages.15

For example, in an earlier article (see Van Bragt, 2016) we have analyzed a Dutch mortgage pool with a loan-to-value

of approximately 86%.16 The required capital for counterparty risk is equal to 4.6% in this case. This mortgage pool,

however, consists of approximately 64% NHG mortgages. When we take into account the effect of this guarantee, the

required capital becomes much smaller: only 2.7%. On the overall balance sheet, such a small capital charge becomes

even smaller due to large diversification benefits.

To illustrate this point, we have repeated the earlier analysis in Van Bragt (2016) with the proposed new rules. In this

analysis, we consider a stylized life insurer who allocates 10% of its assets to mortgages.17 We then study the effect of

adding mortgages on the Solvency II ratio. The results are shown in Table 1.

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Table 1: Impact of lower capital charges for NHG mortgages on the Solvency II ratio when allocating assets to mortgages.

N.B. The mortgage pool in this example consists of approximately 64% NHG mortgages.18

Table 1 shows that when we sell sovereigns and buy mortgages, the solvency ratio decreases only slightly (by 1%-

point) when we implement EIOPA’s advice for NHG guarantees. Under the current rules (i.e., when the NHG guarantee

is ignored) the decrease in solvency ratio is approximately 2%-points. Similar effects are visible when we fund

mortgages with credits, all assets or equity. The attractiveness of Dutch NHG mortgages under Solvency II thus further

increases when EIOPA’s advice is implemented.

3. Treatment of regional governments and local authorities (RGLA)19

EIOPA also wishes to harmonise the treatment, in terms of credit risk, of regional governments and local authorities

(RGLA) under Solvency II and Basel III. Currently, the lists of eligible RGLA do not match for all countries in the Solvency

II and Basel III directives. The table below, taken from the advice, shows EIOPA’s analysis.

Table 2: Overview of RGLA (per country) which qualify for a 0% risk weight under Solvency II and the banking framework (Basel III).20,21

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Synchronising these lists could have a major impact on French RGLA. The French regions, départements and

communes are eligible under Solvency II to a shock of 0% in the credit risk module. However, in the banking context,

the same exposures are treated with the full capital charge for credit risk. So, if in the harmonization process the Basel

III list becomes leading, the capital charge for French RGLA will increase under Solvency II. For Finland, Portugal and

Poland there can also be some impact. For the other countries, there is already alignment between the two sets of

regulations and there should not be any effect.

EIOPA also advices to treat guarantees of RGLA similarly as guarantees by the central government.22 Again, this would

be a similar approach as under Basel III. Since guarantees of the central government of member states are solvency

free, this would imply that guarantees by RGLA also become solvency free.23 To give an example: a loan that is

guaranteed by a municipality (“gemeente”) in the Netherlands is currently not solvency free under Solvency II. This

would change if the advice is adopted, and such loans would become solvency free as well (as is the case under Basel

III).

4. Loss-absorbing capacity and deferred taxes (LAC DT)24

Solvency II is a post-tax supervision framework, in the sense that Solvency II losses also result in fiscal losses. Such

fiscal losses can result in tax reductions if fiscal profits are available to utilise/offset these fiscal losses.25 Because the

Solvency II required capital calculation focusses on a very negative stress scenario, the mitigating impact of taxes can

be substantial.

In the first advice, EIOPA examines the prevailing practices in the different countries. Results are presented of a

quantitative study of all insurance firms which supplied valid data for this analysis. This study analyses the determining

factors of loss-absorption capacities and deferred taxes (LAC DT) according to a certain number of factors (interest

rates, tax rates, total assets) and for all contributing countries. EIOPA reports that almost 40 % of the variation in the

LAC DT across the different countries can be explained by differences in the balance sheet of the insurance firms,

differences in the tax regime and the size of the firms. The fact that a firm is in a particular jurisdiction may explain an

additional 35% of the variation in LAC DT.

However, EIOPA signals that supervisors have divergent practices to assess how likely future profits are, in order to

demonstrate the probable utilisation of LAC DT. In the second advice, EIOPA therefore aims to increase convergence

in supervisory practices - and thus capital requirements - for similarly risky insurance firms. This is done by discussing

nine different key principles that should be used to align the supervisory practice.26

5. Reduction of reliance on credit rating agencies27

EIOPA also proposes the introduction of a new simplified calculation method for the credit risk module. This simplified

method may be used if a single credit rating agency already covers 80% of the debt portfolio.28 In this case, securities

not covered by the agency can be treated as equivalent to BBB.

The reason for this simplification is that increasing the number of credit agencies, in the hope of obtaining more rated

securities, typically only increases the number of ratings of securities that have already been rated. Therefore,

complete coverage of all securities would require a large number of credit agencies to be consulted, with all associated

costs.

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Conclusions This article reviews some important proposals by EIOPA regarding changes in the Solvency II framework. We discuss

the possible impact of these changes on European insurance companies. All sets of advice have now been sent to the

European Commission. Implementation is possible by 1 January 2019 at the earliest.

EIOPA advises to change the calculation of the solvency capital requirement for interest rate risk. This can have a major

impact, because our analysis shows that the downward interest rate stress will become much more severe than

before. This will lead, ceteris paribus, to a larger solvency capital requirement for interest rate risk. To mitigate the

impact, EIOPA proposes a three-year transition period.

EIOPA also proposes to acknowledge the risk-mitigating effect of an NHG government guarantee for Dutch mortgage

loans. This will significantly lower the solvency capital charge for these mortgage loans. The attractiveness of Dutch

mortgages under Solvency II will thus further increase when this advice is implemented. EIOPA also recommends to

align the treatment of regional authorities and local governments (RGLA) under Solvency II with the treatment of RGLA

under Basel III. This may cause a higher capital charge for investments in RGLA in France, Finland, Portugal and Poland,

because RGLA in these countries are currently not on the Basel III list. EIOPA also advices to treat guarantees of RGLA

similarly as guarantees by the central government.

Regarding the topic of loss-absorbing capacity and deferred taxes (LAC DT), EIOPA signals that supervisors have

divergent practices to assess how likely future profits are, in order to demonstrate the probable utilization of deferred

taxes. EIOPA therefore proposes nine different key principles that should be used to further align the supervisory

practice.

On another note, EIOPA proposes a simplified calculation method for the credit risk module. This simplified method

may be used if a single credit rating agency already covers 80% of the debt portfolio. This may limit the costs for rating

agencies for insurance firms.

All in all, EIOPA has performed a comprehensive review of the current Solvency II methodology. Some

recommendations may have a significant impact, especially the new proposal with respect to the required capital

calculation for interest rate risk. However, the question remains whether EIOPA’s advice will be adopted by the

European Commission and (if so) when the recommendations are converted into new legislation.

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References

CRD IV / CRR (2013), Capital Requirement Directive (CRD IV) and Capital Requirements Regulation (CRR), “Regulation

(EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on Prudential Requirements for

Credit Institutions and Investment Firms and Amending Regulation (EU) No 648/2012”, Official Journal of the

European Union, L 176, Volume 56, 27 June 2013. Available at http://eur-lex.europa.eu/legal-

content/EN/ALL/?uri=OJ:L:2013:176:TOC.

EIOPA (2017), “EIOPA’s first set of advice to the European Commission on specific items in the Solvency II Delegated

Regulation”, 30 October 2017. Available at https://eiopa.europa.eu/Publications/Consultations/EIOPA-BoS-17-

280_First_set_of_Advice_on_SII_DR_Review.pdf.

EIOPA (2018), “EIOPA’s second set of advice to the European Commission on specific items in the Solvency II

Delegated Regulation”, 28 February 2017. Available at https://eiopa.europa.eu/Publications/Consultations/EIOPA-

18-075-EIOPA_Second_set_of_Advice_on_SII_DR_Review.pdf.

EU (2009), “Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the

taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II)”, Official Journal of the European

Union, 17 December 2009. Available at http://eur-

lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:335:0001:0155:en:PDF.

EU (2014), “Directive 2014/51/EU of the European Parliament and of the Council of 16 April 2014 amending

Directives 2003/71/EC and 2009/138/EC and Regulations (EC) No 1060/2009, (EU) No 1094/2010 and (EU) No

1095/2010 in respect of the powers of the European Supervisory Authority (European Insurance and Occupational

Pensions Authority) and the European Supervisory Authority (European Securities and Markets Authority)”, Official

Journal of the European Union, 22 May 2014. Available at http://eur-lex.europa.eu/legal-

content/EN/TXT/PDF/?uri=CELEX:32014L0051&from=EN.

EU (2015), “Commission Delegated Regulation (EU) 2015/35 of 10 October 2014 supplementing Directive

2009/138/EC of the European Parliament and of the Council on the taking-up and pursuit of the business of

Insurance and Reinsurance (Solvency II)”, Official Journal of the European Union, 17 January 2015. Available at

http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=uriserv%3AOJ.L_.2015.012.01.0001.01.ENG.

EU (2016), “Commission Delegated Regulation (EU) 2016/467 of 30 September 2015 amending Commission

Delegated Regulation (EU) 2015/35 concerning the calculation of regulatory capital requirements for several

categories of assets held by insurance and reinsurance undertakings”, Official Journal of the European Union, 1 April

2016. Available at http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32016R0467&from=EN.

EY (2016), “CRD V/CRR II - Revisions to the Capital Requirement Directive and the Capital Requirement Regulation”,

December 2016. Available at

http://www.ey.com/Publication/vwLUAssets/CRD_CRR/$FILE/CRD%20CRR%20Revisions%20Dec%202016%20appro

ved%20for%20external%20distribution%20121216.pdf.

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Van Bragt, D. (2017), “Capital Requirements for Mortgage Loan Investments under FTK, Solvency II and Basel III”,

Regulatory Insight, Aegon Asset Management.

Available at https://www.aegonassetmanagement.com/globalassets/asset-management/netherlands/news-

insights/documents/2017/regulatory-insight-supervision-mortgage-investments.pdf.

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About the authors

This article is written by David van Bragt of Aegon Asset Management and Rémi Lamaud of La Banque Postale Asset

Management (LBPAM). David van Bragt is a senior consultant in the Investment Solutions team at Aegon Asset

Management. Rémi Lamaud is Head of Regulation and ALM at LBPAM. The authors advise institutional investors about

ALM, LDI, risk management and regulatory developments.

Strategic partnership and Investment Solutions cooperation

Aegon Asset Management and La Banque Postale Asset Management have a strategic, long-term partnership since

2015. La Banque Postale Asset Management is the 5th asset manager in France with € 218 billion assets under

management (as of October 2017) on behalf of both retail and institutional clients. Among this strategic partnership

there is a strong collaboration between the Investment Solutions teams of La Banque Postale Asset Management,

Aegon Asset Management and TKP Investments. The Investment Solutions teams focus on balance sheet related

subjects such as regulation, capital optimization and asset-liability management. This collaboration provides synergies

in research and knowledge sharing on investment solutions for our clients.

More information

Sander van der Wel, Head of Financial Institutions

Aegon Asset Management Netherlands

T. + 31 (0)6 19 30 33 32

E. sander.vanderwel@aegonassetmanagement.com

Frank Drukker, Sr. Business Development Director

Aegon Asset Management Netherlands

T. + 31 (0)6 10 13 28 25

E. frank.drukker@aegonassetmanagement.com

Disclaimer Aegon Investment Management B.V. is registered with the Netherlands Authority for the Financial Markets as a licensed fund management

company. On the basis of its fund management license Aegon Investment Management B.V. is also authorized to provide individual portfolio

management and advisory services.

The content of this document is for information purposes only and should not be considered as a commercial offer, business proposal or

recommendation to perform investments in securities, funds or other products. All prices, market indications or financial data are for illustration

purposes only.

Although this information is composed with great care and although we always strive to ensure accuracy, completeness and correctness of the

information, imperfections due to human errors may occur, as a result of which presented data and calculations may differ. Therefore, no rights

may be derived from the provided data and calculations.

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Notes

1 See EU (2009) and EU (2014). 2 See EU (2015). 3 See EU (2016). 4 See EIOPA (2017). 5 See EIOPA (2018). 6 See EIOPA (2018), pp. 125-162. 7 See EIOPA (2018), p. 159. Note that the risk-free rate is extrapolated to the ultimate forward rate (UFR) for longer maturities. 8 For maturities which are not specified by EIOPA, the value of bm

up and smup shall be linearly interpolated. For

maturities shorter than one year the value smup and bm

up shall be equal to 61% and 2.14% respectively. For maturities longer than 90 years, the value of sm

up shall be equal to 20%. For maturities longer than 60 years, the value of bmup

shall be equal to 0%. A similar approach should be used for the downward shock. 9 See EIOPA (2018), p. 160. 10 See https://eiopa.europa.eu/regulation-supervision/insurance/solvency-ii-technical-information/risk-free-interest-rate-term-structures for the published risk-free and stressed curves. Note that that we here consider interest rate curves without volatility adjustment 11 Source: EIOPA, Aegon Asset Management. 12 See EIOPA (2017), pp. 35-38. 13 This is due to several reasons. First, the payment in case of a default only covers the difference between the nominal value of the mortgage loan and the value of the property. Second, the guaranteed amount decreases over time because the assumption is made that the mortgage loan is repaid within 30 years. This implies that the guarantee becomes weaker over time for non-amortizing loans. Third, as of 2014 an own risk clause of 10% applies. 14 See CRD IV / CRR (2013) for a detailed specification of the standard capital requirements under Basel III. 15 This different approach has no impact if the spread risk (instead of the counterparty default risk) module is used for residential mortgages. The standard formula for spread risk is based on the rating of the instruments. Partial guarantees already have an impact on the rating, so no adjustments are needed here. 16 The mortgage pool of the AeAM Dutch Mortgage Fund is used as the reference portfolio in this case. 17 See Van Bragt (2016) for more information about the assumptions made in this analysis. 18 Source: Aegon Asset Management. 19 See EIOPA (2017), pp. 22-43. 20 Source: EIOPA. 21 Pääkaupunkiseudun Yhteistyövaltuuskunta (the Helsinki Metropolitan Area Council) does not exist anymore. 22 See EIOPA (2017), p. 41. 23 To qualify, the guarantee by the RGLA should be fully, unconditionally and irrevocably. 24 See EIOPA (2017), pp. 71-105 and EIOPA (2018), pp. 304-340. 25 In the case of “carry-forward”, a loss in a given year is used to mitigate tax payments in case of future profits. In the case of “carry-back”, tax payments in previous years can be corrected to account for the occurring loss. Carry-forward and carry-back are typically restricted to a limited number of (forward or backward) years. In the Netherlands, carry-back is first applied with respect to the previous year. Then, carry-forward is possible for 9 future years. 26 See EIOPA (2018), p. 334 and further. 27 See EIOPA (2017), pp. 14-21. 28 Structured notes, collateralized securities and derivatives are excluded from the simplified calculation.