Regulatory outlook for 2020: impact for pension funds and insurance companies

By 7 minute read

2020 is likely to become a very busy year for pension funds and insurance companies from a regulatory point of view. The Dutch regulator (DNB) has drawn up a extensive agenda, with topics ranging from close supervision of pension funds with low funding ratios to new topics like cyber and technology risks. Preparations for the scheduled pension reform should also be going underway, leading to increased attention from DNB. On the insurance side, the 2020 review of the Solvency II framework is now well under way. The consultation period for the proposals by the European regulator (EIOPA) is currently coming to an end. After collecting all feedback, the final proposals by EIOPA are due halfway this year, leading to final amendments to the Solvency II regulations by the European Commission.

Dutch pension funds – Regulatory agenda of the Dutch Central Bank

In December 2019, the Dutch Central Bank (DNB) announced the following regulatory topics for Dutch pension funds. The main topics are briefly discussed below.

The financial position of many Dutch pension funds continues to worry due to low interest rates which lead to very high liabilities. Recently, the Minister of Social Affairs and Employment has avoided cuts of pension rights for most pension funds by invoking Article 142 of the Pensions Act (citing special circumstances). Nevertheless, DNB will ensure that funds continue to comply with laws and regulations concerning their financial position. This means that the premium contribution and any changes to the premium system must fit within the legal framework. In addition, DNB will monitor that pension funds that may be confronted with a cut of the pension rights in the future will continue to adequately reflect their financial position in the run-up to a potential pension rights cut. Finally, DNB wants to ensure that any right cuts are implemented in a controlled, correct and balanced manner.

Dutch pension funds should also prepare for the upcoming pension reform. A principle agreement on the reform of the second pillar pension was reached in 2019. DNB will pay attention in its supervision to the agility and resilience of pension institutions in order to be able to respond to the announced reform. In this context, DNB will for example pay attention to the agility of (IT) systems and the improvement of data quality with regard to pension administrations.

DNB also expects pension funds to work on managing data quality, ESG and cyber risks, and relatively new technological risks and digitization, such as artificial intelligence and dependence on longer outsourcing chains. The implementation of IORP II is also a central topic. With a selection of large funds, DNB will supervise the proper functioning of the organization of key functions. Medium-sized and small funds must motivate their staffing of key positions and submit them to DNB for approval. Finally, in 2020 DNB will continue to gain experience with supervision aimed at pension administration organizations.

European Insurance companies – 2020 review of Solvency II

The 2020 review of the Solvency II requirements for European insurance companies is now well under way and has already led to specific recommendations by EIOPA (the European regulator) and the European Commission in the coming year. In the beginning of 2019, the European Commission has asked EIOPA to issue their proposals. Subsequently these proposals were shared with the industry in a consultation phase with a deadline of 15 January. Last week the industry, including Aegon, responded to the EIOPA proposals. The reaction of Insurance Europe can be found here. EIOPA will now use this input and conduct an overall impact assessment before sending their final proposals to the European Commission by June 2020. In addition, EIOPA is currently carrying out a field test on revised and new templates for Solvency II reporting and disclosure. After 1 July 2020, the European authorities will work on concrete legislative proposals which then also have to be implemented in national law. All in all, it will be years after 2020 before this review is finalized.

The current proposals by EIOPA mainly focus on the following topics:

Construction of the Solvency II discount curve for the liabilities

The Solvency II discount curve for the liabilities now starts to diverge from the market rate after 20 years (the so-called last liquid point, or LLP). EIOPA, however, argues that currently enough liquidity exists in the euro swap market for maturities up to 50 years. A last liquid point of 50 years leads to a much lower discount rate for long-term liabilities, since the effect of the ultimate forward rate (UFR) method would then only be visible for ultra-long maturities (of more than 50 years). See the figure below for an illustration.

Figure 1: Impact of a different last liquid point (LLP) on the Solvency II discount curve for the Eurozone (as of 31 December 2018). Source: EIOPA.

EIOPA also considers an alternative approach, where a blend of market and UFR rates is used. This would lead to a smaller effect on the final discount curve than simply moving the last liquid point to 50 years. In the consultation phase, feedback from the industry is requested about the different options on the last liquid point for the euro (including the alternative extrapolation method).

Required capital for interest rate risk

This topic was already raised by EIOPA in the 2018 review of the standard formula under Solvency II, but was then postponed by the European Commission to the 2020 review. This is an important topic, since EIOPA proposes to increase the interest rate shocks which should be used in the standard required capital calculation. EIOPA states that the current calibration underestimates the interest rate risk and does not take into account the possibility of a steep fall of interest rates as experienced during the past years and the existence of negative interest rates. EIOPA therefore advises to model interest rate risk in the standard formula with an alternative (relative shift) approach. This new approach would lead to a much lower solvency ratio for many life insurers.

Volatility adjustment

The volatility adjustment (VA) allows insurance companies to add part of the spread on fixed income investments to the liability curve. This way, spread movements on the asset side are partly reflected in similar movements on the liability side, with the aim of reaching more stable own funds. Currently, the VA does not reach that result though since the actual spreads on assets are not well reflected in the (reference portfolio of) the VA. Various modifications to the VA are mentioned in the current proposals of EIOPA, but none of the EIOPA-proposals really seem to help for the Dutch industry since the actual spread on mortgages is not included in the proposals. No definitive proposals are made at this point; feedback is requested from the industry about different issues related to the VA.

Matching adjustment

The matching adjustment (VA) is conceptually related to the VA and stimulates insurance companies to set up matching asset portfolios alongside their long-term annuity books. The MA is now mostly used in the UK, and to a lesser extend in Spain. For the Dutch market, assets and liabilities do not always meet the criteria for the application of the MA. For that to happen, eligibility criteria would have to be relaxed, but that is largely out of scope in EIOPA's advice. On the contrary, EIOPA advises that an additional requirement is introduced to clarify the eligibility of restructured assets for the MA.

Currently, possible diversification benefits are not taken into account for portfolios which apply the MA. EIOPA proposes to change this, which will lead to a capital relief. An impact analysis by EIOPA shows that this (positive) effect will be quite significant for Spanish insurers under the MA, but more limited for UK insurers. For Dutch insurers, this proposal does not offer any capital relief, because the MA is not used by them.

The risk margin

The risk margin is an additional technical provision, on top of the best-estimate value of the insurance liabilities. The sum of the risk margin and the best estimate liabilities should be equal to the amount required to transfer the liabilities to another undertaking. Critics of the current (cost-of-capital) approach have been vocal, stating that the risk margin under Solvency II is too large and too sensitive to interest rate movements for life annuity providers. Nevertheless, the analysis carried out by EIOPA has not yet resulted in a proposal to change the calculation of the risk margin.

Other changes

The current proposals by EIOPA contain various other topics such as reporting and disclosure, group supervision and macro-prudential policy and recovery and resolution. We refer to EIOPA's full document for a broad overview and all details.

David van Bragt

About David van Bragt

Investment Solutions Consultant