In the latest installment of “The Standard Formula” Back to Basics series, podcast host and Europe financial institutions head Robert Chaplin is joined by colleague Mary Bonsu to provide listeners with a deeper understanding of technical provisions, including the various elements of technical provisions and how the provisions are calculated, among other topics.
“Technical provisions are crucial, as they form the fundamental basis for assessing the financial stability of insurance and reinsurance plans.”
In this episode of “The Standard Formula” podcast, Rob Chaplin, host and head of Skadden’s Europe Financial Institutions Group, is joined by colleague Mary Bonsu. Rob and Mary delve into the complexities of technical provisions under Solvency II, shedding light on crucial elements such as best estimate of liabilities and risk margins. They discuss factors influencing these elements, such as financial guarantees, future management actions and risk-free interest rate term structures. The conversation also touches on methods to mitigate short-term volatility, and contrasts Solvency II with IFRS 17.
Key Points
- Understanding Technical Provisions: Technical provisions, an essential aspect of financial stability for insurance and reinsurance plans, reflect the current amount a firm would have to pay for another entity to assume its insurance and reinsurance liabilities. The calculation is based on various factors, including expected future cash flows, potential risk and regulatory requirements.
- Risk Margin Challenges: The risk margin calculation, a key component of technical provisions, “represents the extra reserve that insurers must hold above their best estimate of liabilities, but below their solvency capital requirement, or SCR.” Risk margin is sensitive to interest rate fluctuations. Critics argue that low interest rates may inflate the risk margin, impacting insurers, especially those with long-term business.
- Solvency II vs. IFRS 17: While both Solvency II and IFRS 17, the insurance accounting standard, estimate future cash flows as the foundation of their liabilities, they differ in several areas, such as interest rate structures, risk margin inclusion, transitional relief, and the contractual service margin concept.
Voiceover (00:01):
From Skadden, The Standard Formula is a Solvency II podcast for UK and European insurance professionals. Join us, as Skadden partner Robert Chaplin leads conversations with industry practitioners and explores Solvency II developments that matter to you.
Rob Chaplin (00:18):
Welcome back to The Standard Formula Podcast. Today, I'm joined by my colleague, Mary Bonsu. Together, in this episode of our Solvency II Back to Basics series, we'll be exploring the topic of technical provisions, looking at its key elements and related matters.
(00:37):
Mary, let's start by unpacking exactly what technical provisions are.
Mary Bonsu (00:42):
Thank you, Rob. I'm really excited to dive into today's topic. Technical provisions are crucial, as they form the fundamental basis for assessing the financial stability of insurance and reinsurance plans. The value of the technical provisions is meant to represent the current amount a selling firm would have to pay to another reinsurance undertaking for that other buying firm to immediately take on the seller's insurance and reinsurance liabilities. Therefore, technical provisions can be seen as an insurer's main reserves. They are distinguished from the solvency capital requirement, which sits as a buffer on top to guide against adverse deviation in market, operating, or other conditions on at least a one-in-200 basis.
There is a specific methodology for calculating technical provisions, based on various factors including expected future cashflows, potential risk and regulatory requirements. It's not just a simple formula anymore, as it was under Solvency I. It's a comprehensive approach that takes into account the specific risk profile of each insurer. Together, the best estimate of liabilities and risk margin represent the technical provisions under Solvency II.
(01:51):
Rob, please unpack that for us.
Rob Chaplin (01:54):
Thanks, Mary. Let's take a closer look at the elements of technical provisions.
(02:00):
First, the calculation of the best estimate of liabilities. The best estimate of liabilities represents the probability weighted average value of future cashflows under insurance contracts over their lifetime. This estimate considered uncertainties in cashflows, including but not limited to timing, policy holder behavior and expenses. More specifically, various factors are taken into consideration in calculating the best estimate of liabilities, such as financial guarantees and options, future management actions and ordinarily discounting, using the risk-free interest rate term structure, to allow for the time value of money. The best estimate is calculated gross of reinsurance and amounts receivable from SPVs, which are instead regarded as an asset held against it.
(02:57):
Can you talk us through financial guarantees and options please, Mary?
Mary Bonsu (03:00):
Of course. Thanks, Rob.
(03:02):
In calculating the best estimate of liabilities, firms must consider the financial guarantees and contractual options embedded within their insurance and reinsurance policies. These calculations must be grounded in realism, leveraging current and credible information or factoring potential future changes in financial and non-financial conditions.
Rob Chaplin (03:23):
Firms are also permitted to make certain assumptions relating to future management actions. The Commission Delegated Regulation, knowns as the Regulation, provides specific criteria for determining the quality of data used to make those assumptions and what assumptions can be made. In certain circumstances, management actions can effectively reduce the measure of an insurer's potential liabilities or cashflows. This is particularly relevant to with-profits business, a kind of guaranteed life savings business that includes discretionary entitlements, as managers may adjust the proportion of assets held in particular investments, change future bonus rates or adjust the smoothing applied to with-profits policies in response to adverse market conditions. The assumptions of future management decisions may only be taken into account if they are realistic. This entails consistency with current practices, adherence to legal obligations and coherence with each other.
Mary Bonsu (04:27):
Moving on to the risk-free interest rate term structure, which is used for discounting, the risk-free rate is determined for each currency and maturity. The risk-free rates are derived on the basis of SWAP rates for the relevant currency. EIOPA calculate and publish the risk-free rates each month, without matching volatility or transitional adjustments.
Rob Chaplin (04:49):
Now, turning to the other key element of the technical provisions, the risk margin. The risk margin represents the extra reserve that insurers must hold above their best estimate of liabilities, but below their solvency capital requirement, or SCR. Key components of the risk margin calculation include projecting future SCRs for non-hedgable risks, discounting these projections using the risk-free rate and applying a fixed cost of capital rate. Assumptions are detailed, including scenarios where the entire portfolio of obligations is transferred to a reference undertaking, which then must hold eligible owned funds equal to the SCR and technical provisions.
(05:35):
Back to you, Mary.
Mary Bonsu (05:36):
Thanks, Rob. It's worth noting that the calculation of technical provisions is not without its challenges. Factors such as interest rate fluctuations and the design of the risk-free margin can impact the final outcome. EIOPA provides guidance on selecting appropriate projection methods for future SCRs, offering options ranging from approximating individual risks to calculating the risk margin as a percentage of the best estimate of liabilities. However, issues have arisen particularly regarding the sensitivity of the risk margin to interest rate fluctuations. Critics argue that the risk margin may be inflated when interest rates are low, impacting insurers, especially those with longterm business-like annuity providers. Evidence suggests that some insurers are transferring risk outside of the EU to mitigate this impact, leading to concerns about a concentration of risk among a small number of particular types of carrier with lesser total assets covering the liabilities, as noted by the Prudential Regulation Authority.
(06:42):
In April 2022, the UK government proposed significant reductions to the risk margin, arguing that it was larger than required to serve its purpose, IE to provide the sufficient buffer above the best estimate of liabilities. Such that, if the carrier failed, there would be adequate reserves to fund a transfer of insurance liabilities to another carrier. To that end, on the 17th November 2022, the government announced its final proposals. The risk margin is to be reduced using a modified cost of capital method, by around 65% for life carriers and 30% for non-life carriers. Previously, the cost of capital rate was set at 6%, but this was substituted by the Insurance and Reinsurance Undertakings (Prudential Requirements) Risk Margin Regulations 2023, which came into force on the 31st December 2023, and set the cost of capital rate at 4% for both life and non-life companies.
Rob Chaplin (07:39):
Let's dive into the intricacies of calculating technical provisions as a whole. Firms may rarely bypass separate calculations of the best estimate of liabilities and the risk margin if future cashflows can be reliably replicated in a financial instrument. Instead, the technical provisions linked to those cashflows are determined by the market value of the corresponding financial instrument.
Mary Bonsu (08:07):
That's right, Rob. But let's look at what reliably replicated truly entails. It's not merely about finding any financial instrument, but rather one that trades on an active, deep, liquid and transparent market, ensuring a valid market value.
(08:22):
However, reliable replication is not always feasible. Some scenarios pose challenges, such as when cashflows are contingent on an unobservable risk or lack readily available price information. External factors further complicate matters, especially when they are no observable financial instruments offer reliable market values.
Rob Chaplin (08:44):
Shifting gears now to contract boundaries. The Regulation provide a roadmap for determining which cashflows should be included when calculating technical provisions. The Regulation lays down rules dictating the inclusion of obligations from the recognition date, typically the inception of the coverage period. However, navigating these boundaries is not always straightforward, especially concerning unilateral rights of insurers or reinsurers, and the exclusion of certain future reinsurance cover.
Mary Bonsu (09:15):
Now, let's pivot to the matching adjustment, particularly for UK life annuity writers, a crucial mechanism within Solvency II. The matching adjustment is a limited way of using a discount rate linked to the assets held. This adjustment to the discount rate allows for a closer alignment between the credit adjusted market rate of return on assets held and the valuation of certain life and insurance and reinsurance obligations, potentially reducing an insurer's technical provisions and bolstering balance sheet stability. For more in-depth coverage on the matching adjustment, please tune into our previous episode, Understanding the UK's Matching Adjustment Regime.
(09:55):
The matching adjustment is not the only mechanism included within the Solvency II regime to combat the potential effects of short term volatility on longterm insurers. The volatility adjustment is also an alternative option. The rules relating to the volatility adjustment are set out in Articles 77D to 77E of the Solvency II Directive, technical provision 8.1 to 8.5 in the PRA Rule Book, and in Articles 49 to 51 of the Regulation. Like the matching adjustment, the volatility adjustment is an adjustment to the risk-free rate for each relevant currency. The purpose of the adjustment is to prevent per cyclical investment behavior by mitigating the impact of short term volatility of bond spreads on the solvency position of insurers and reinsurers.
Rob Chaplin (10:43):
Further amelioration of the basic technical provisions regime is TMTP, or in full, The Transitional Measures on Technical Provisos. TMTP allows for a gradual transition over 16 years for liabilities pre-dating Solvency II's inception in 2016, resulting in a full shift to Solvency II standards by 2032. In the UK, as part of post Brexit moves towards Solvency UK, certain simplifications to TMTP are coming and which will apply equally to books of business subject to portfolio transfers and reinsurance transactions.
Mary Bonsu (11:24):
Finally, let's touch on the divergence between Solvency II and IFRS 17. IFRS 17, the insurance accounting standard, came into place for annual reporting periods beginning on or after the 1st January 2021. Unlike Solvency II, the Prudential Regulatory Regime, which hones in on an insurer's capital resources, IFRS 17 focuses on how well a company's doing throughout the reporting period.
(11:52):
While both standards estimate for future cashflows as the bedrock of their liabilities, they differ in several ways. Solvency II does not allow the IFRS 17 simplification options, since they deviate from the cashflows approach prescribed by Article 77-2 of the Solvency II Directive. The Solvency II interest rate structures are set centrally, IFRS 17 offers more wiggle room in calculating discount rates. There is no direct equivalent under IFRS 17 to the risk margin. There is no transitional relief under IFRS 17, unlike its Solvency II counterpart. IFRS 17 introduces the contractual service margin concept, a profit expectation emergence from insurance contracts. Finally, the contractual service margin concept does not exist understand Solvency II, so that while day one gains are immediately recognized for solvency purposes, such gains are generally eliminated at the recognition date and recognized over the term of the reinsurance contract under IFRS 17.
(12:56):
Despite efforts to align both standards, such as the EIOPA consulting on the 2020 review of Solvency II, where Europe considered whether the calculation of technical provisions could be more closely aligned with IFRS 17, disparities still linger as it was concluded that key IFRS 17 concepts are incompatible with Solvency II.
Rob Chaplin (13:17):
Thanks, Mary. That brings us to the end of today's episode. Thank you to our listeners for joining us. We hope you will continue to tune in for future episodes. In case you missed it, our last episode covered investment rules and our next topic will be capital requirements. If you have any questions or comments on any of the topics we spoke about today, or Solvency II in general, do please feel free to contact us. Thank you. We hope you'll join us next time.
Voiceover (13:48):
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(14:01):
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