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Dutch insurers 1st to feel sting as European regulator cuts discount rate

With their heavy exposure to the life business and their relatively slim capital ratios, Dutch insurers will be among those that suffer the most from a European regulator's decision to change the way liabilities are accounted for.

Life insurers pledge to make payouts that may not come due until decades into the future, but still need to ensure that the funds will be there to meet those commitments. They are able to "discount" the value of those liabilities by an amount equivalent to the "risk-free" return they would receive by putting the funds in ultrasafe government bonds, but there are no reliable rate benchmarks for the longest-dated liabilities.

To value these, insurers use an artificial rate, known in Europe as the Ultimate Forward Rate. This had been set at 4.20% by the European Insurance and Occupational Pensions Authority, although many argued that today's ultralow interest rate environment justified a lower rate.

Setting out a framework for calculating the rate, EIOPA said April 5 that a more realistic figure is 3.65% — calculated by adding the ECB's 2% inflation target and its expectation of real long-term interest rates. To allow insurers time to adjust, however, EIOPA also said that the UFR will be cut by no more than 15 basis points per year. At the beginning of 2018, therefore, it will be set at 4.05%.

Dutch insurers will be the first to be hit by the UFR, said Albert Ploegh, an analyst with ING Group. Not only do they have a large number of long-dated liabilities, but their relatively weak solvency ratios also already worry investors, he said in an interview.

What's more, the Dutch regulator doesn't allow transitional regimes such as those that soften the blow of Solvency II rules in countries such as Germany, where insurers also have significant long-dated life liabilities.

Research by Rabobank showed that in the Netherlands, Solvency II ratios lag the European Economic Area average by 42 percentage points, coming in at 161%. The ratio measures an insurer's capital holdings as a proportion of the amount it would need to withstand a scenario forecast to occur only once in a 200-year period.

ASR Nederland NV reported at the end of 2016 that a cut of 50 basis points in the UFR would reduce its Solvency II ratio by 11 percentage points, while Delta Lloyd NV's would be cut by 13 points. For Ageas SA/NV (which is headquartered in neighboring Belgium), that figure was 2 percentage points, for Achmea BV 6 points, and for AEGON NV, it came to 4 points.

Ploegh said investors should be primarily concerned about those Dutch insurers with Solvency II ratios that are already on the low side, such as AEGON, which reported a ratio of 157% at the end of 2016.

"The issue is that the market wants to establish what a good headline [Solvency II] ratio is," Ploegh said. "Is it 150%? Is it 200%? [The UFR cut] is relevant if you're at the lower end of the range."

For many insurers, though, the impact will be limited, said Matthias de Wit, an analyst with KBC Securities. The way the UFR is designed means that the immediate reduction in insurers' capital strength will gradually be offset as extra capital is generated in the future, meaning that only those insurers with particularly low Solvency II ratios at the moment are likely to provide cause for concern, he said in an interview.

"This methodology strikes the right balance between a stable UFR and the need to adjust it in case of changes in long-term expectations about interest rates and inflation," EIOPA Chairman Gabriel Bernardino said in a statement. "[It] ensures that the UFR moves gradually and in a predictable manner, allowing insurers to adjust to changes in the interest rate environment and ensuring policyholder protection."

A reduction of 20 basis points, Bernardino had said in a March 14 letter, would trim European insurers' Solvency II ratio on average by only 2 percentage points, to 201% from 203%.

Insurance Europe, an industry lobby group, urged EIOPA not to make "rushed changes" to the UFR, pointing out that the Solvency II regime already forces insurers to build capital reserves on the assumption that the present low-rate environment continues for another two decades.

"The UFR is part of the valuation system of Solvency II," wrote Olav Jones, the group's deputy director general. "There are already concerns that this valuation system does not correctly reflect insurers' long-term business and will have a detrimental impact on insurers' ability to invest long-term."

Jones said any change to the UFR should only be finalized as part of the European Commission's wide-ranging review, scheduled for 2020, into the effectiveness of Solvency II as a regulatory framework.