LTG Symposium: introduction


Gideon Benari Gideon Benari, Editor, Solvency II Wire The treatment of long-term guarantees (LTG) remains key to the successful implementation and application of Solvency II. It raises questions about market consistent valuation of assets and liabilities and has far reaching implications for long-term investment in the wider economy, beyond the more immediate effect on insurance firms. Solvency II brings much needed reform to the regulation of the insurance industry in Europe, introducing a market consistent and risk based framework. Under the new regulation insurers will be required to value the whole of the balance sheet on a market consistent basis and to hold enough capital to meet their liabilities based on this valuation. Because the present value of future liabilities is calculated based on current market prices there is a danger that if these prices do not reflect economic reality the valuation of the liabilities will be distorted. In other words, extreme circumstances today could warp the value of liabilities that will only have to be paid long into the future. And because the present value of future liabilities determines the amount an insurer has to set aside to meet the liabilities this distortion could result in one of two negative outcomes: undercapitalisation or overcapitalisation. Undercapitalisation means insurers may not be able to meet their future obligations. Overcapitalisation means insurers will be less able to attract long-term funds. While the former will affect policyholders and insurance firms, the latter will affect the wider economy because of the role of the insurance industry as a long-term investor. The problem for policymakers is how to provide adequate protection for consumers without detracting from this vital role of the insurance industry.

The symposium

Sundial LTG SymposiumThe LTG conundrum began to crystallise after the effects of the global downturn and the European sovereign debt crisis became apparent. The results of QIS5, published in March 2011, also showed the potential effect on the balance sheet of insurers. Firms realised that adverse market conditions would severely increase the amount of regulatory capital they would have to hold in respect of long-term guarantee products. Matters escalated after the ECON vote on in March 2012 with the Parliament’s proposal to move the LTG package of measures to the Level 1 text of Omnibus II. So far there has been little public debate on LTG, a topic on which so far there has also been little academic work. On 23 June 2012 a group of leading academics published an article, which acknowledges the case for adjusting the rules, but strongly criticising the underlying principles of the measures under proposal (see below for detailed explanation). The LTG Symposium brings together three responses in an attempt to both clarify the issue and expand the scope of the debate. In the opening response Olav Jones, Deputy Director General, Insurance Europe argues the case for the insurance industry and why it has supported a broader package of LTG measures. Seamus Creedon, Solvency II Project Manager, Groupe Consultatif offers an actuarial perspective. Lastly, the measures are examined from a macro-prudential perspective in an article by Francesco Mazzaferro, Head of ESRB Secretariat and Jeroen Brinkhof, member of ESRB Secretariat. The symposium will conclude with a reply to the three articles. A number of related articles will be included in the symposium to broaden its scope and address more technical aspects.

The LTG problem

So why is it so important to get the LTG measures right? The insurance industry is a major long-term investor in the economy, with around €7,700 billion of assets under management and €1,100 billion of new premiums to invest each year. The majority of these investments is a result of offering products with long-term guarantees such as annuities and endowments, which pay substantially fixed amounts over a defined period of time in the future. Because of the stable and defined nature of these liabilities insurers can invest in assets that have long maturity dates with fixed interest payments to meet these obligations (primarily bonds issued by corporations and governments and other forms of debt). In reality this asset-liability matching is done across large portfolios. The key to understanding the problem which has been created by market consistency is understanding how these long-term liabilities are valued.

Valuing liabilities

Although in practice the process is more complex, in principle liabilities are valued by matching them to a portfolio of assets with similar cash flows and duration. The assets should not involve any element of credit risk. The market price of the assets today then gives the present market-consistent value of the liability. But because the matched assets in respect of illiquid liabilities may be held to maturity it is argued that the insurer does not have to worry about price fluctuations (only outright default) and therefore, that a premium may be added to the risk-free yield on liquid assets to further discount the value of the liability. It is the further discounting to the risk-free rate (what in the past was called the ‘illiquidity premium’) which is the cause for much of the contention in the Solvency II LTG debate.

The proposed measures for discounting liabilities

There has been a fair amount of confusion about the proposed measures, in part because they have been given different names over the pasts few years. Latest official texts suggest the following nomenclature and these will be used throughout the symposium (note that some of the previously published article use old names). Broadly speaking there are three measure for discounting liabilities currently under discussion in the Omnibus II trilogue. It is worth noting that at the time of publication there is still uncertainty on how the final measures will work (see Solvency II Wire 12 August & 26 August 2012). Matching Adjustment (previously Matching Premium) – reduces the amount of capital that needs to be held for long-term liabilities that are ‘matched’ by a portfolio of assets with similar duration and cash flows. This is to be a permanent measure that can only be applied to specific assets and liabilities that meet a strict set of criteria. Counter-Cyclical Premium (CCP) – reduces the discount rate used to value liabilities in times of excessive market volatility. This temporary measure will apply to all liabilities in the portfolio (other than those benefiting from a Matching Premium). It is proposed that the CCP will be introduced by EIOPA. Extrapolation – an extrapolation of the risk-free interest rate where market data is no longer considered deep, liquid and transparent. This is a permanent measure. It is not possible to over emphasise the importance of this debate. Not only does it now appear to be the deciding factor in completing the Omnibus II trilogue negotiations, but the repercussions of the decisions will be felt far into the future by the insurance industry and consumers alike. Link to Symposium index page.]]>