Simˈpōzēəm

“A related concern is whether life insurers and pension funds can maintain a long-term investor perspective. […] A partial retreat of institutional investors from the long-term and/or illiquid segment of the credit market could reduce the private and social benefits the sector generates through long-term investing, and the extent to which it mitigates the pro-cyclicality of the financial system.”1It is concerns over the serious and unintended consequences of Solvency II for long-term investment and products, and debate over how to address those concerns that are the main cause of delay in finalising the framework. The solutions under discussion have strong justifications. It is therefore vital to clarify misunderstanding of how they affect the valuation of liabilities.
The problem with current market consistency

Four assumptions challenged
Four key assumptions made by a current market-consistent framework do not hold and must be addressed to ensure Solvency II works as intended. We analyse each assumption below. The first assumption of the classical framework is that all liabilities can be priced in the market. This assumption does not hold for insurance because there is no liquid market for most insurance liabilities and therefore for liability valuations. To cope with this shortcoming of the classical market-consistent framework a Risk Margin was developed for Solvency II to capture the uncertainty in future liability cashflows in a way that is in line with a market-consistent approach. Second, the classical framework holds that the market price is always appropriate. The underlying assumption here is that markets are always rational. However, during economic crises we have seen prices that are either not reliable due to very limited participants in the market and/or that cannot be justified on an economic basis (e.g. AAA bond spreads increasing to 200bp). For companies with fully liquid liabilities this may not matter because – whether or not the price is valid – they are fully exposed to it. For insurance companies with very few highly liquid liabilities, the excessive volatility in the market does not reflect the solvency position, given the limited vulnerability to such short-term volatility. If this issue is not addressed, many insurance companies could exit long-term business. The proposed introduction of a Counter-Cyclical Premium (CCP) in Solvency II creates a mechanism that can cope with extreme and temporary market pricing in an appropriate way. A third assumption is that all assets are always available for sale, implying that the credit risk for insurers is always driven by movement in spreads and actual defaults are irrelevant. However, we contend that where insurance companies can protect themselves from the impact of spread movements (because of features of their liabilities), then it is actual defaults that impact their balance sheet and risk exposure not the movement in spreads. This matters because, as many studies have shown, there is little or no direct connection between volatility in current spreads (and therefore values) and long-term default experience2. The Matching Adjustment mechanism is needed to ensure that the correct risk is measured for insurance companies both in terms of the valuation of their balance sheet to avoid artificial volatility and, in measuring the credit SCR, to ensure it reflects default risk and not spread risk. Lastly, a classical market-consistent framework assumes that the market can provide a risk-free curve to value liabilities of any duration. In reality the market can only reliably provide data for the risk-free curve for a limited duration (e.g. up to about 20 years for the euro and as low as about ten years for some European countries). Insurance liabilities are often well beyond these periods. The current Solvency II proposal includes an Extrapolation methodology to extend the interest rate curve beyond the point where the market is deep and liquid so that liabilities of all maturities can be valued.Why does this matter so much?
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The impact on the valuation of claims liabilities has been misunderstood
The Matching Adjustment ensures that where liabilities are not exposed to the risk of movements in credit spread, the changes in asset values due to spread movements do not create artificial volatility in own funds. In order to illustrate how this mechanism works, it is easiest to consider the value of liabilities as having two components:- The best estimate value of projected claims and any profit sharing.
- The impact of any risk mitigation features incorporated within the liabilities.


Several questions/remarks that I hope the other contributors will be able to answer:
Isn’t it precisely because the stakes are high as mentioned in the introduction that the regulation has to be strict?
It is possible to choose to ignore the market when it behaves “ irrationally” but how about forced sales during these periods of “market irrationality” (due to mass lapse for instance eg Korea during the Asian crisis in 1998)? Mark consistency is bit like democracy it is a poor system but it is the best we have.
This feels like a plea to bend the SII principles in order to fit old products into the new framework how about adapting products to the new regime. Empirical evidence in financial services and other heavily regulated industries such as pharmaceutical, telecom… suggest that the negative impact of regulation is generally overestimated ex-ante and that market innovation contribute to reduce if not cancel out the negative consequences that had been anticipated.
Also there is no mention of extrapolation it would have been interesting to see how the starting point for the extrapolation of the curve at 20 years for the EURO can be justified on the basis that the euro denominated bond market is not deep and liquid enough when the extrapolation for GBP starts at 50 years . For memory the EURO denominated bond market is the biggest in the world (EUR200b issued a month and EUR 17,000b of outstanding debt).