The new capital requirements for insurers are a difficult compromise between market valuation and feasibility, says UvA professor Roger Laeven.
Starting on 1 January 2016 insurers from EU-countries will have to comply with a new solvency standard, known by the name of Solvency 2. After many years of disagreement between regulators, politicians and the insurance sector, the outline of this standard is taking shape. As is already common practice with balance sheet valuations, market valuation is taken as a basis for the calculation of solvency capital requirements for insurers.
Roger Laeven, professor of Risk and Insurance at the University of Amsterdam’s School of Economics, is on the frontlines of this process. As a scientific advisor he participates in discussions on this topic with regulators and politicians in the Netherlands and Europe. Laeven considers the discussion to be based initially on false premises. ‘From the outset it was assumed that insurers should value their assets and liabilities according to their market value. For obvious reasons this was not feasible. It is no coincidence that the development of Solvency 2 has shown a return to a smaller role for market valuations.’ All in all Laeven is optimistic about the new regulatory framework. ‘Until now solvency capital requirements have largely been based on the volume of sold products. In the future, risk-based solvency capital requirements will apply. That’s a significant improvement.’
One of the critical issues in measuring solvency is which term-structure of interest rates insurers must use to calculate the value of their insurance liabilities. The obligations that insurers commit to differ to a great extent. For example, obligations on life insurance may lie more than forty years in the future. The question is how much money insurers must have today to be able to fulfil an obligation forty years in the future. Obviously this amount is lower than the agreed payment because interest is accrued on the received premiums. But how much lower does this amount have to be? Should insurers be allowed to calculate the return that they expect to earn over those forty years or is it better to use a fixed rate? Or should a more prudent measure be used whereby the lowest feasible return is used?
Laeven is adamant that it is the last case. ‘Insurers provide strict guarantees to their clients. A guarantee of this kind requires an assessment of the return that is always feasible, the risk free return. This return is calculated from the swap rate, and does not include a compensation for default risk. This return is lower than the return on government bonds and certainly lower than what can be earned on stocks in the long term.’ Considering that insurers do not invest in the swap rate but in stocks and bonds, they must use a much lower interest rate than they may earn in practice. This puts pressure on their solvency, or in other words; when insurers use the risk free interest rate to calculate their solvency they will charge their clients a higher premium than what may have been required in retrospect.
Therefore, the developers of Solvency 2 have made some concessions. ‘The new requirements allow insurers to use a higher interest rate for some portfolios’, Laeven says. ‘This is permitted when investments, such as government or corporate bonds, are matched to long term liabilities with the same period of expiration. Using these slightly higher rates of interest instead of the risk free interest rate is favourable for the solvency of insurers.’
According to Laeven there are risks associated with valuations of this kind. ‘It is conceivable that some bonds will default or that the liabilities develop in a different way than expected and that the portfolio gets restructured. The true solvency may then be lower than the solvency that was measured. Ideally you would not want to deviate from the risk free interest rate for this reason, because it should always be possible to liquidate or transfer an insurer solvently.’
However, in practice insurers need such kinds of solutions to some extent to function properly. ‘Without these concessions insurers would not be able to offer long-term guarantee products. These products are beneficial to consumer’s welfare and there is demand for them. I can live with this solution as long as it is encapsulated in guarantees and default risk is accounted for. Then I call this a “shortcut with limited risk.”’
Laeven is less positive about another concession made in Solvency 2. Insurers may use a moving average interest rate. This cushions the effect of market fluctuations on solvency. Laeven would have preferred to see insurers defend themselves against movements in the market in a different way. ‘The same goal can be achieved by demanding that surpluses are increased in good times when interest rates are high and decreased in bad times when the returns are low. This also protects insurers against interest rate shocks without obfuscating real effects.’
The new solvency rules have significant consequences for the insurance sector. ‘Despite the concessions that have been made it may be difficult to keep selling certain products at the scale at which they are being sold now, such as long-term life products’, Laeven claims.
Also, small insurers are expected to have more difficulties in dealing with the increased regulation, despite being offered a ‘light’ version of Solvency 2. ‘This would enable another wave of market consolidations, Laeven predicts. ‘This is unfortunate because it is not clear whether a small insurer with a steady consumer base and a small number of strong and transparent products is really in a weaker position than a large insurer.’