David Worsfold
European insurers were not happy in the middle of last year when the European Insurance and Occupational Pensions Authority (EIOPA) launched its first major stress tests of the continent’s life insurers for two years and the first since the formal start of the Solvency II regime.
Leading European insurance groups, led by Allianz, were very critical of the timing and some of the assumptions EIOPA was adopting, including using its preferred ultimate forward rate of 2%, compared to the current UFR of 4.2%.
They must be relieved that the publication of the results a week before Christmas has attracted so little coverage of comment given their reservations. There is actually little in the 74-page report to frighten boards, investors or policyholders. However, UK life insurers should be taking a careful look at some sections as they don’t always come out as well as might be imagined.
This stress tests assessed insurers’ vulnerabilities and resilience to two severe market developments: A prolonged low yield environment and a “double-hit” scenario. The “low-for-long” scenario reproduced a situation of entrenched stagnation driving down yields at all maturities for a long period, while the “double-hit” scenario reflected a sudden increase in risk premiums combined with the low yield environment. The severity of these scenarios went beyond the Solvency II capital requirements.
The exercise involved 236 insurance undertakings from 30 European countries, with market coverage of 77% in terms of the relevant business (life technical provisions excluding health and unit linked) and included medium- and small-sized firms.
Many of the findings – and warnings – will be familiar, including EIOPA’s frequently aired concerns about guaranteed return products. However, it is the regulator’s assessment of the generous transitional arrangements for Solvency II that should raise a few eyebrows among UK life insurers – and at the Prudential Regulation Authority.
Most insurers would also like to see greater clarity around the transitional arrangements, how they will be firmed up, especially for technical provisions and, crucially, how they will be phased out sometime in the next decade. At some stage, most insurers are going to have to re-calculate their provisions and this will have a major impact on their solvency margins and balance sheets.
Just how big that impact might be was revealed in the report. 
Figure 1: SCR ratios for different EU countries with and without LTG and transitional arrangements.
It shows that in the EU and European Economic Area as a whole, solvency margins could decline from 196% to 136% once the transitional and other long term guarantee measures are eliminated.
In the UK, that potential decline looks more like a dramatic collapse: from 142% to 51%. The message from that has to be that there is no time to be lost in starting the transitional process. Just because there is on paper another ten to fifteen years doesn’t mean that regulators are not going to start taking a keen interest in how UK insurers intend to avoid that cliff-edge drop in solvency.
Fortunately, there is no suggestion that EIOPA will be in any hurry to press ahead with phasing out these transitional arrangements as it takes the opportunity to congratulate itself on their success: “Furthermore, they also confirm that the LTG [long term guarantee] and transitional measures provide the financial stability cushion intended, potentially acting in a countercyclical manner, but supervisory vigilance is required in order to avoid a misestimate of the risks due to the longer-term type of concerns implied by the scenarios tested”.
In their defence, UK insurers will point to other data in the report as demonstrating that they have plenty of room for manoeuvre. In particular, they will find comfort in the analysis of Tier 1 capital which shows they have unrestricted own funds sitting at 91.8% of total eligible own funds, above the European average of 90% which EIOPA is unusually positive about: “The quality of own funds was generally high with Tier 1 unrestricted own funds accounting for 90% of the total.” 
Figure 2: Percentage of Tier 1 own funds for different EU countries.
These rare hints of contentment at EIOPA hasn’t stopped it coming up with a shopping list of actions it wants national regulators to take – or at least prepare to adopt if any of its stress-test scenarios moves closer to reality.
- To ensure that undertakings align their internal risk management processes to the external risks faced
- To review and assess undertakings’ models regarding the behaviour of management and policyholders
- To review the clauses of guarantees, their typologies, and the optionalities they carry to assess if the valuation of the technical provisions can be considered proportionate and prudent
- To request a reduction in the maximum guarantees or in unsustainable profit participations offered
- To request a cancellation or deferral of dividend distribution when the viability of the business model is at risk
- To ensure that the vulnerabilities identified at solo level are appropriately recognised and dealt with at the group level
Insurers and their boards would be wise to review their own position so they have robust answers ready for when the PRA comes calling with the EIOPA stress test report in hand.