Increase to insurance liabilities – EIOPA publishes revised UFR methodology

Increase to insurance liabilities - UFR methodology

On 5 April, EIOPA published its new methodology that will be used to derive the Ultimate Forward Rate (UFR) from January 2018.

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The UFR is determined as the sum of a long-term interest rate plus the (country specific) inflation target long term inflation rate. The discount rate curve used in the calculation of technical provisions uses observable market data as far as possible (known as the last liquid point) and then extrapolates from that point to the UFR.

Recalculation of the UFR as a concept has not been universally accepted, with many arguing that the view on long-term interest rates should not be subject to regular change. By basing the long-term interest rate assumption on the average of annual observed real rates since 1961, this effectively means the UFR will be subject to annual revisions, albeit with a 15 basis point cap as noted below.

This annual update adds another area of interest-rate sensitivity into the calculation of technical provisions, something the UK life sector has long been critical of regarding the risk margin calculation.

The calculation applied by EIOPA suggests that the UFR should be reduced from its current 4.2% to 3.65% (for both euro and sterling). However, any change will be capped to no more than 15 basis points per year, meaning that the UFR applying to the calculation of the risk-free interest rates from January 2018 (published in February 2018) will be 4.05%.

A reduction in the UFR will increase the valuation of an insurer’s insurance liabilities, although the impact will vary across both jurisdictions and insurers, mainly due to differences in the last liquid point, which affects the speed of convergence.

This is clearly demonstrated in EIOPA’s analysis, which shows that the country most affected by a change in UFR is Sweden, where the extrapolation process for the Swedish krona starts at 10 years maturity and the UFR is reached at 20 years. Sterling sits at the other extreme, with hardly any impact. For sterling the last liquid point is 50 years and the UFR is not reached until year 90, meaning that the majority of future liability cash flows fall within the observable part of the risk free curve, so changes in the UFR have minimal impact. For the euro, the last liquid point is 20 years and the UFR is reached at 60 years. The mitigating effect of transitional provisions (where permitted) will also influence the impact.

EIOPA’s analysis, based on 336 firms, suggests that the impact on technical provisions will be less than 1% and on SCR coverage ratios will also be around 2%. However, this also reveals that that two firms would move into non-compliance with the SCR capital requirement.

If real interest rates continue to remain at low levels over future years, further decreases in the UFR can be expected. For example, even if the trend of negative returns over the last seven years ends, we would need an unrealistic positive real return for 2017 of 25% to prevent the UFR for 2019 from reducing further. Insurers should therefore plan on the assumption of a 3.9% UFR from 2019, with further reductions towards 3.65% thereafter.

Given that the capping of the reduction in UFR, a question that all EU insurers should be prepared for, in particular from equity analysts, is “What would be the effect on your liabilities and solvency position based on a UFR of 3.65%?” This is similar to the question of what impact the transitional provisions have made. Indeed, some EU insurers did provide UFR sensitivities in their recent market disclosures.

Additionally, the effect of the reduction in UFR should be shown in the (now fairly common) results bridges showing changes between year-ends. Some pre-planning and thought in relation to these aspects will clearly be beneficial.

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