Background
One aspect of Solvency II that has attracted press coverage in the UK is the valuation of annuity liabilities. The concern first surfaced in the summer of 2009, when CEIOPS released Consultation Paper 40, concerning the risk-free interest rate term structure. That paper dealt with the discount rate to be applied in determining the present value of future cash flows under (re)insurance contracts for the purpose of calculating technical provisions. Concerns were raised at the time about the absence of any reference in that paper to a “liquidity premium” (also known as an “illiquidity premium”). The press coverage suggested that the lack of an illiquidity premium would increase the cost of providing annuities in the UK market, which would in turn be passed on to new annuitants without any off-setting increase in consumer protection.
Toward the end of 2009 CEIOPS released its final advice in relation to the above Consultation Paper. This time it included an annex dealing specifically with the issue of illiquidity premia. CEIOPS’s view at that stage was that if an illiquidity premium were to be allowed at all (which itself seemed doubtful), it should only be applied as a transitional measure in relation to certain annuity business in force as at 31 October 2012. In response, the European Commission asked CEIOPS to form and lead a task force to consider the issue further. The findings of that task force (outlined below) were released in early March 2010. The task force broadly supports the adoption of an illiquidity premium on a permanent (rather than a transitional) basis. However, many points of detail are outstanding and the ultimate question of whether an illiquidity will in fact apply within Solvency II remains with the European Commission.
What is an illiquidity premium?
The illiquidity premium in question represents an increase in the discount rate applied in the calculation of the present value of future payments under certain long-term insurance contracts. That is, the illiquidity premium is designed to reduce the value of certain insurance liabilities (most obviously, annuities).
This reduction in liability valuation is justified by reference to similar reductions in the value of the assets backing these liabilities. The underlying insurance liabilities tend to be funded by investments in correspondingly illiquid fixed-interest assets (usually, corporate bonds). Since an increase in a bond’s yield implies a decrease in its market value (i.e., the relative value of a fixed coupon can only be “increased” by trading the bond for less than its face value), the asset side of an insurer’s balance sheet is subject to reductions to accommodate any increases in yield demanded by fixed-interest investors.
Insurers have sought to off-set such reductions on the asset side with corresponding reductions on the liability side, by increasing the discount rate (and therefore decreasing the liability valuation) of the long-term insurance liabilities to which the illiquid assets relate. In this way, a potential mismatch between asset and liability valuations is avoided.
The task force’s advice
Those hoping for a decisive resolution to this issue will be disappointed by the task force’s paper. The paper does not contain a recommendation that an illiquidity premium be allowed in any particular form. Instead, it sets out the majority view that an illiquidity premium should be permitted in the valuation of long-term (re)insurance liabilities and that the value of this premium should be determined by reference to illiquidity premia on corresponding assets. It is clear from the paper that CEIOPS remains sceptical about the appropriateness of translating illiquidity premia on the asset side to liability valuations.
There is also a suggestion in the paper that the concept of an illiquidity premium may be inconsistent with the text of the Directive, which expressly refers in Article 77(2) to the “relevant risk-free interest rate term structure” (to which the illiquidity premium is arguably an addition) in defining the best estimate. However, the paper reports that a representative of the European Commission confirmed that the concept can be accommodated within the Directive as it stands. Thus, the paper ultimately does support the concept of an illiquidity premium for liability valuations. Moreover, the paper supports a permanent application of this premium (i.e., to new and in-force business, rather than only to in-force business as at 31 October 2012).
The task force noted that illiquidity operates on a sliding scale such that there are degrees of illiquidity between different insurance products. On this basis, it was argued that there ought to be corresponding degrees to which the illiquidity premium is applied (rather than it being applied on a binary/all-or-nothing basis). This was apparently a controversial issue within the task force, however a majority ultimately appears to favour an approach that divides the spectrum of illiquidity into a series of “buckets” and then scales the illiquidity premium to each bucket based on its degree of illiquidity. Even on this approach, there appears to be a point below which the illiquidity premium should not be applied at all. This cut-off point applies if there are no “objective and reliable methods” by which illiquidity can be measured in relation to given liabilities.
The task force has set out nine principles that should be used in applying an illiquidity premium to liability valuations (assuming that the illiquidity premium concept is accepted by the European Commission at all). One of the more interesting principles is that the illiquidity premium should be set by a central European Union body, rather than being determined by individual (re)insurers. This is based on the fact that there is no observable illiquidity premium per se and the means usually employed to estimate it have produced varied results in the past.
The task force has also recommended that the SCR standard formula be recalibrated to ensure that it remains set at a 99.5% value-at-risk target level. The concern here is that an insurer’s basic own funds will be increased by the application of an illiquidity premium (by off-setting asset devaluations with liability devaluations). The task force recommends that this risk be reflected in the SCR spread-risk module. Finally, the task force has identified a need for further work in relation to the risk margin (which, together with the best estimate, forms the value of technical provisions for non-hedgable insurance liabilities) in order to ensure that it is not inadvertently affected by any illiquidity premium that the European Commission may adopt which would affect the best estimate component.
For further information, please contact:
Victoria Sander (victoria.sander@linklaters.com, (+44) 20 7456 3395).
