Solvency II Volatility Adjustment benefit to be reduced for UK insurers

EIOPA published CP-14-042 ‘Consultation paper on a Technical document regarding the risk free interest rate term structure’ on 1st November. 

This sets out how EIOPA intends to calculate:

• the Risk Free Rate (particularly where market information is not available), including the credit risk adjustment, extrapolation method, last liquid point, convergence point and ultimate forward rate; and
• the fundamental spread and risk correction spread for Matching Adjustment and Volatility Adjustment respectively

One of the key points for UK insurers is that it is proposed that the assets assigned to Matching Adjustment portfolios should be excluded from the representative portfolios for calculating the volatility adjustment.  Therefore, the proportion of corporate bonds in the UK representative portfolio has reduced from 50% to 30%, which will mean a lower Volatility Adjustment for UK insurers. 

Given the significant effort required to get approval to use the Matching Adjustment (see our earlier blog) and the loss of diversification and transitional benefits, for many annuity writers, the cost-benefit analysis may have favoured using the Volatility Adjustment over the Matching Adjustment.  Those analyses will now have to be re-visited. 

On the positive side, it should now make it easier for companies planning to use the Volatility Adjustment to justify its use as more portfolios (including with-profits funds) will contain the 30% of corporate bonds on which the Volatility Adjustment is calculated.

The paper also states that the calculation of the fundamental spread and the risk correction spread will be consistent (i.e. using the same approach and the same data).  It consults on a number of technical details, including:

• the use of data providers;
• the level of granularity for the collection of data and hence calculation of spreads;
• how it will determine the cost of downgrades and probability of defaults; and
• how to calculate government bond spreads.

The full consultation paper can be found on EIOPA's website.