Revised UFR methodology and the impact it has on the insurance market
Following up the results of the consultation and changes to the UFR methodology EIOPA published on the 5th of April 2017, the revised methodology has been implemented by EIOPA as of January 2018. This implies that the UFR decreased from 4.2% to 4.05%. Given the current market low-interest rate environment, the revised methodology, which is expected to be approved by the European Commission this April, is aiming for a balanced situation between UFR stability and the changes in the interest rate environment. The new methodology will be reflected in the Q1 numbers of insurers.
As of January 2018, each currency will have a “Target UFR” calculated on an annual basis. This will be compared to the Previous UFR. The change in UFR will be decided upon based on the following:
Each year, the New UFRs are announced by the end of March and are implemented as of 1st of January of the following year. The Target UFR is similarly calculated for each currency as the sum of the expected real rate and a country specific expected inflation rate.
The impact this change has on the Best Estimate depends on the duration of the liability. This is because the change in the UFR only affects the valuation of the liabilities with a maturity beyond 20 years, which implies that the impact is limited for an insurer with relatively short term liabilities. This is illustrated in the graph below in which the yield curve evolution based on the New UFR has been compared to a potential yield curve evolution, should the UFR not have changed from last year. Therefore, for longer maturities, the New UFR is reflected in the yield curve through a slightly flatter pattern, while the Old UFR would have resulted in heavier discounting. Based on this, the valuation of the liabilities (especially with a long term duration) will show a higher present value based on the New UFR. As the Best Estimate liabilities are increasing as a result of the change in UFR level, the Own Funds and SCR ratio are decreasing accordingly, due to their dependence on the value of the Best Estimate liabilities.
To assess this impact on the valuation of the liabilities we consider a fictive portfolio of insurance liabilities. The valuation of these liabilities is done based on three different yield curves, with different UFR levels (December Old UFR, January Old UFR, January New UFR). For the same value of the total liability, the (modified) duration of the liabilities differs under each of the three scenarios, as it is calculated based on the discounted cash flows by using the risk free term structure with the specific UFR. Thus, the impact on the Best Estimate for each of the scenarios is provided in the following table:
Based on the results presented above, we conclude that the change in the UFR impacts the insurer's Best Estimate liabilities, mainly through the duration of the liability portfolio. As a result of the current trend of increasing market interest rates the liabilities decrease, however, for liabilities with long durations this impact is offset by the change in UFR, resulting in a relatively small net increase in Best Estimate liabilities. Capital positions are of course negatively affected by the UFR change, but the upside is that going forward the impact of the UFR-drag will also decrease.
In March, a similar change in the UFR effective January 1st, 2019 will be announced, taking the UFR to an expected level of 3.90%, for which insurance companies and in particular the ones holding long term portfolios must be prepared.