The Solvency II regime was implemented as of January 2016. Already numerous consultations and revisions have been started on the Solvency II regulation. In May 2016 EIOPA published a consultation paper on the Ultimate Forward Rate (UFR) methodology. On the 5th of April 2017 EIOPA published the results of the consultation and presented the changes to the UFR methodology. The revised methodology will be implemented as of 2018 (subject to approval of the European Commission), where the UFR will decrease from 4.20% to 4.05%. We will briefly assess how the changes in the UFR could impact insurers via the calculation of the Best Estimate.
Solvency II prescribed that the risk free term structure, which is used to discount the Best Estimate liabilities, shall be derived from financial instruments for which a deep, liquid and transparent (DLT) market exists.
For maturities where such markets do not exist, the forward rates corresponding to the financial instrument should be extrapolated to the UFR to obtain the risk-free term structure.
For Eurozone based insurance companies the risk free term structure is calibrated on the basis of risk free swap rates (adjusted for credit risk) observed in a DLT market. The observed swap rates are extrapolated to the UFR by using the Smith-Wilson method. For the Eurozone the UFR is currently set at 4.2%, calculated as the sum of the long-term real interest (interest adjusted for inflation) of 2.2% and the expected inflation rate of 2%.
The Solvency II regulation prescribes that the UFR shall be stable over time and only changes as a result of adjustments in long-term market expectations. Given the current low interest rate environment it can be argued that the market has indeed changed compared to the market at the time the UFR was set at 4.2% (introduced in 2012, but already calibrated in 2010 as part of the QIS5), which can also be observed from the market (see below graph).
Although the opposing views on changing the UFR methodology, such as the timing of the UFR change and that a changing UFR will fail the purpose of long-term stability and introduces artificial volatility in the insurance market, the EIOPA Board of Supervisors has unanimously agreed to the proposed changes in the UFR methodology.
The decision of EIOPA results in the following main adjustments to the UFR methodology, where EIOPA tried to balance between UFR stability and the change in the interest rate environment:
- The UFR will change on an annual basis, based on changes in the expected real interest rate.
- Taking into account the current market conditions, the UFR for the Eurozone is determined as 3.65% instead of 4.2%.
- However, the revised UFR methodology will be phased-in annually, meaning that the annual UFR cannot change with more or less than 15bps.
- The revised methodology will be implemented from 1 January 2018, where the UFR will equal 4.05%.
The graph below shows the risk free term structure without Volatility Adjustment (VA) of February 2017 for the different UFR levels that are expected in the future years due to the revised methodology, taking into account the current market conditions and limited annual changes of 15bps to the UFR.
To assess the impact of a change in the UFR on the valuation of the liabilities we consider three fictive portfolios of insurance liabilities. For these portfolio we have calculated the Best Estimate for the different UFR levels that are expected in the future years, taking into account the current market and limited annual changes of 15bps to the UFR.
The first portfolio we consider has a long (modified) duration of 34 years, whereas the second portfolio has a duration of 28 years, the third portfolio has a relative short duration of 14 years. Note that the duration is calculated on the basis of the discounted cash flows by using the risk free term structure with a UFR of 4.2%. The impact on the Best Estimate for different levels of the UFR is provided in the below table.
From the above table we conclude that the changes to the UFR methodology could impact the insurer significantly via the Best Estimate calculation, but this highly depends on the duration of the portfolio. As a change in UFR only affects the valuation of liabilities with a maturity beyond 20 years, the impact is limited for insurers with relative short term liabilities.
As the Best Estimate liabilities are increasing as result of the changes in the UFR levels, the Own Funds and SCR ratio are increasing accordingly, due to their dependence on the value of the Best Estimate liabilities. Hence, the insurers and their capital positions are negatively affected by the revised UFR methodology.
Given that the UFR could change annually under the revised UFR methodology, in particular insurance companies that hold long term portfolios should be proactive and be prepared for changes in the risk free term structure and assess the impact of expected future changes in the UFR.