Revision of the Solvency II standard formula approach

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The standard formula approach under Solvency II is used by most European insurance companies to calculate the required solvency capital. The European Committee has now finalized several changes to the standard formula. This article reviews some important changes and discusses their possible impact. In 2020 a global review of the Solvency II framework will follow, with a broader scope than the standard formula.

Written by David van Bragt, Senior Consultant Investment Solutions and RĂ©mi Lamaud, Head of Regulation and ALM at La Banque Postale Asset Management.

Treatment of government guarantees (like NHG) for residential mortgage investments

The risk-mitigating effect for Dutch residential mortgage loans which are guaranteed by the Dutch National Mortgage Guarantee scheme ("Nationale Hypotheekgarantie" or NHG) is acknowledged. This will significantly lower the solvency capital charge for these mortgage loans. To illustrate this, we consider a stylized life insurer which allocates 10% of its assets to mortgages. We then study the effect of adding mortgages to the Solvency II ratio (the initial Solvency II ratio is 150%). The results are shown in the following table.

Table 1: Impact of lower capital charges for NHG mortgages on the Solvency II ratio when allocating assets to mortgages. 52% of the mortgages have an NHG guarantee in this example. Source: Aegon Asset Management, as of 31 December, 2018.

Table 1 shows that when we sell sovereigns and buy mortgages, the solvency ratio decreases only slightly (by 0.7%-point) if we use the new treatment for NHG guarantees. Under the current rules (i.e., when the NHG guarantee is ignored) the solvency ratio is approximately 1.2%-points lower. Similar effects are visible when we fund mortgages with credits, all assets or equity. The attractiveness of Dutch NHG mortgages under Solvency II thus further increases under the new Solvency II rules.

Guarantees by regional authorities and local governments (RGLA)

Guarantees by RGLA will be treated similarly to guarantees by the central government. Because guarantees of the central government of EU member states are solvency free, this implies that guarantees by RGLA in member states also become solvency free. To give an example: a loan that is guaranteed by a municipality ("gemeente") in the Netherlands was not solvency free under Solvency II. This changes under the new rules, and such loans become solvency free as well (as is the case under Basel III).

Reduction of reliance on credit rating agencies

A simplified calculation method for the credit risk module becomes possible for unrated instruments. This simplified method may be used if rated fixed-income instruments cover at least 80% of the debt portfolio. In this case, vanilla (fixed or callable and unstructured) securities not covered by a credit agency can be treated as BBB-rated debt. This modification is probably most welcomed by small or mid-sized insurance companies which do not use an internal ratings method.

Treatment of long-term and unlisted equities

The new regulations allow insurers to create a long-term equity portfolio with a capital charge of 22%, like strategic participations. These equity investments must be ring-fenced and held for more than 5 years. In addition, unlisted equity that meets certain specifications (e.g. shares of companies which have their head office in the EEA) may be classified as type 1 equities, leading to a base capital charge of 39%. These securities were previously classified as type 2 equities, with a base capital charge of 49%.

Look-through approach

It becomes possible to use the reported allocation to calculate market risk if a look-through or target underlying asset allocation is not available for an investment class. All market modules must be evaluated, however, including interest rate risk and credit risk. The upper limit for applying this approach is 20% of the total asset allocation. Mutual funds or unit-linked investments for which the market risk is fully borne by the policy holders are excluded from the 20% limit.

Capital requirements for interest rate risk

The standard solvency capital requirements for interest rate risk are not changed at this moment. This topic generated much discussion during this standard formula review and has been postponed to the global Solvency II review that starts in 2020.

Next steps

The amendments will now be subject to a scrutiny period of 3 months by the European Parliament and the Council. The new regulations that are discussed here will then enter into force 20 days after publication in the Official Journal of the European Union.

  • The review of the standard formula under Solvency II is now completed and may have a significant impact on European insurance companies.
  • Government guarantees backing Dutch NHG mortgage loans will be acknowledged, in line with Basel III.
  • Required capital for interest rate risk is not changed now, but will be part of the global Solvency II review that starts in 2020.
David van Bragt

About David van Bragt

Investment Solutions Consultant