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Economic Solvency: the transferability of insurance liabilities is changing due to M&A

Economic Solvency

Increased M&A activity in a changing economic climate could drive misalignments between the old economic view and the current economic environment.

Jeroen Gielen

Senior Manager

KPMG Nederland

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Introduction

Although Solvency II was once designed as an economic framework, the result is a framework based on a combination of market principles and politics. The most obvious example is the use of an Ultimate Forward Rate (UFR) in the interest rate curve. From this perspective, it makes sense for a regulator to ask the insurance industry for an economic view on their balance sheet, in parallel to the regular Solvency II reporting. The aim of developing an economic view is to ensure the transferability of an insurer's liabilities, irrespective of its Solvency II position. In 2016, the topic has been introduced by DNB in their good practice for the capital management policy, with the explicit request to include an economic view in the risk management system of insurers. DNB did not prescribe what this 'economic view' should be, but only shared some general principles. With these principles, insurers have developed their own methodology of an economic solvency framework, and thresholds were defined in the capital management policy based on this economic framework.

Since 2016 a lot has changed. Not only has the economy evolved, with the continuous low interest rates as most notable example, but also the insurance market itself has changed, given the increase in M&A activity and new players entering the market. The result is that the economic view developed a few years ago may no longer align with the current economic climate. We know several examples of insurance companies which had to take action, because limits on their economic solvency levels were inadequate in this changing environment.

Some examples of where we believe the old 'economic view' is not aligned with the current economic environment are:

  • Economic discount curve – The principles of DNB emphasize the possibility of including a well substantiated illiquidity premium in the term structure for the valuation of liabilities. Given the recent transactions, the market participants seem to include a higher spread in the economic discount curve than what most insurers felt appropriate a few years ago.
  • Risk margin – With respect to the risk margin, most insurers have chosen to adjust the Solvency II risk margin via either the CoC rate and/or applicability of diversification effects. The size of risk margin typically moves in line with the development of the liabilities and as time goes by, the risk margin will be reduced to a minimum during the term of the liabilities. Recently, we see that market practice has changed to a capital generation approach, by explicitly valuing the future release of SCR and RM.
  • UFR – Under DNB's principles, the curve needed for maturities beyond the last liquid point typically does not include any form of UFR extrapolation such as the one used under Solvency II. We see however in the market that using an UFR has economic value: insurers do not remove the UFR and typically price the UFR drag.
  • Contract boundaries – Using Solvency II contract boundaries does not reflect any (positive) value from renewals or conversions. In case an insurer can demonstrate that renewals are profitable, it is fair to include this value in the economic framework.

This misalignment is not just an academic discussion: if the capital management policy includes limits based on the old economic framework, it means the company is managed based on outdated thresholds. We have seen examples where companies had to take action after breaching these previously determined economic solvency limits, which may not have been breached if the economic solvency was better aligned with the current economic situation.

What can be done?

Over the past two years the Dutch insurance market has experienced a lot of dynamics, especially due to the increased M&A activity for life insurance portfolios. It is important to understand that the economic environment is subject to change and the consequent developments should be monitored closely, in order for your economic framework to align with the actual transferability.

In case you want to discuss your economic solvency framework, feel free to reach out to us. We can help you make your economic framework more [truly] 'economic'.

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