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Capital rule revisions may fail to drive greater investment by European insurers

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Capital rule revisions may fail to drive greater investment by European insurers

The European Commission's proposed changes to capital requirements contained some positive surprises for insurance companies, although they may not be enough to achieve the regulator's goal of driving additional investments.

The technical recommendations of the European Insurance and Occupational Pensions Authority, or EIOPA, to the commission on revising the capital rules regime, known as Solvency II, signaled smaller hits to insurers' capital positions than the industry expected when released in December 2020. The commission's more recent proposals appear to improve on this, envisaging solvency ratio cuts of 2% or 3%, compared with reductions of 13% or 22% under EIOPA's recommendations. Where EIOPA had estimated an €18 billion reduction in surplus own funds, the commission sees a €30 billion increase based on its concept.

The commission plans to phase in certain changes that would negatively impact capital over a five-year period, which it says should mean the industrywide surplus is €90 billion in the short term. The goal is that insurers will invest that surplus in post-pandemic economic recovery efforts, climate commitments and the European Union's capital markets union.

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The proposals could be a "very good starting point," said Olav Jones, deputy director general of pan-European insurance trade body Insurance Europe, but as they stand now, they will not have the impact that the commission would want to see.

The bulk of the expected benefit comes from proposed changes to the risk margin, a capital buffer insurers have to hold above the best estimate of their liabilities. The commission plans to eliminate EIOPA's proposed limit on how much reviews can reduce the risk margin, and cuts the risk margin's cost-of-capital charge to 5% from 6%. The cost of capital charge reduction is "a welcome surprise on the upside," said James Maher, insurance sector leader at EY Financial Services in Ireland.

A further key proposal was simplifying the conditions under which equity investments would be considered long term and thus be eligible for a lower 22% capital charge. Insurance Europe had previously complained that the eligibility criteria meant the benefit of the lower charge would be zero.

The risk margin and equity capital charge changes "appeared more aggressive" than initially expected, said Willem Loots, a senior director in Fitch Ratings' Europe, the Middle East and Africa insurance group.

But the temporary nature of the €90 billion, and the fact that all proposals on the table would reduce solvency ratios, "is not the outcome we need" to address barriers to long-term investment, Jones said. Insurers cannot be expected to make major asset mix, products and strategy changes because of a short-term capital change, he said.

Give and take

The negative effects being phased in by the commission include a change to how insurers calculate the discount rate curves they use to determine how much to set aside for long-term liabilities. For insurers that use the standard model, rather than regulator-approved bespoke ones, the capital requirement for interest rate risk will now include the potential for negative interest rates.

Once those changes are in effect, the end result is not that much different for insurers than what EIOPA recommended, EY's Maher said. The €30 billion net benefit is a "rounding error" compared with the European insurance industry's €10.4 trillion of AUM, Maher said. Insurance companies might spend that sum in implementing the other changes over the phase-in period, he added.

Changing the eligibility requirements for the 22% capital charge for long-term equities, shows the commission has "good intentions," said Jones, but the question is whether it will work out as forecast, given prior failed attempts to bolster investments.

Insurers do want to invest more in equities because of the low interest rate environment and reducing the capital charge for some equities "clearly creates more incentives," said Benjamin Serra, a senior vice president at Moody's. However, if companies increase the duration gap between their assets and liabilities by investing more in stocks, that could lead to additional capital charges for interest rate risk.

The proposed treatment of long-term equities and changes to the volatility adjustment, a mechanism that protects insurers' solvency positions from volatility caused by short term moves in asset prices, stand to help insurers hold assets through volatile periods, Maher said. However, there are restrictions elsewhere in the proposals that may limit what insurers can invest in, he added.

The commission's proposals to revise the Solvency II regime are expected to be implemented in 2024 at the earliest. They now move on to be discussed by the Council of the European Union and the European Parliament.