Recent amendments to Solvency II spread risk module

Regulatory capital for (re)insurance undertakings

As with credit and financial institutions, (re)insurance undertakings must also hold regulatory capital (solvency capital requirement, SCR). For European (re)insurers, the SCR is determined primarily by the Directive 2009/138/EC ("Solvency II") and the relevant level 2 (Commission Delegated Regulation (EU) 2015/35, "DelReg (EU) 2015/35", most recently amended by the Commission Delegated Regulation (EU) 2019/981 ("Amending Regulation")) and level 3 (EIOPA Guidelines on Solvency II relating to Pillar I etc.) legislative and regulatory provisions.

Solvency capital requirement

The SCR is the amount of funds that (re)insurance companies are required to hold under Solvency II in order to have 99.5% confidence they can survive over the course of a year. In assessing this, companies can generally choose between a standard formula and an internal model approach.

One of the most relevant risk drivers for the SCR is market risk. This in turn consists of various risk components, of which spread risk (default and credit risk) is the most relevant, i.e. the sensitivity of the values of assets, liabilities and financial instruments to changes in the level, or the volatility, of credit spreads over the risk-free interest rate term structure.

New spread risk provisions

The recently adopted Amending Regulation, which concerns the existing level 2 regulation (DelReg (EU) 2015/35), includes new spread risk provisions, especially for debt positions (bonds and loans). The current Article 176 DelReg (EU) 2015/35 makes a blanket distinction between rated and unrated debt positions, the latter with and without eligible collateral. This approach is at times not very risk-sensitive.

In a little more detail:

1. bonds or loans for which a credit assessment by a nominated ECAI is available (Article 176(3) DelReg (EU) 2015/35);
2. bonds and loans for which a credit assessment by a nominated ECAI is not available and for which debtors have not posted collateral that meets the criteria set out in Article 214 DelReg (EU) 2015/35 (Art. 176(4) DelReg (EU) 2015/35);
3. bonds and loans for which a credit assessment by a nominated ECAI is not available and for which debtors have posted collateral that meets the criteria set out in Article 214 DelReg (EU) 2015/35 (Art. 176(5) DelReg (EU) 2015/35).

The second point above (i.e. exposure that must generally be allocated to and stressed by Article 176(4) DelReg (EU) 2015/35) is amended by Article 176a of the Amending Regulation. With regard to the order of applicability, the new Article takes precedence over Article 176(4) DelReg (EU) 2015/35, provided that its requirements are fulfilled (cf. new Article 176(4a) of the amended DelReg (EU) 2015/35). The relevant requirements are contained in the first two paragraphs of Article 176a of the amended DelReg (EU) 2015/35, which read as follows:

"1. A bond or loan for which a credit assessment by a nominated ECAI is not available and for which debtors have not posted collateral that meets the criteria set out in Article 214 may be assigned to credit quality step 2 if all of the criteria set out in paragraphs 3 and 4 are met with respect to the bond or loan.

2. A bond or loan for which a credit assessment by a nominated ECAI is not available and for which debtors have not posted collateral that meets the criteria set out in Article 214, other than a bond or loan assigned to credit quality step 2 under paragraph 1, may be assigned to credit quality step 3 if all of the criteria set out in paragraphs 3 and 5 are met with respect to the bond or loan."

This means that, for any of these, the criteria of Article 176a(3) of the amended DelReg (EU) 2015/35 must be met and, if so, it becomes determinative whether also Article 176a(4) or (5) of the amended DelReg (EU) 2015/35 is fulfilled. If that is not the case, the default would be a fallback to Article 176(4) DelReg (EU) 2015/35. Some of these new criteria to be fulfilled relate to the internal credit assessments and procedures of the (re)insurance company, which are specified in more detail in Article 176b of the amended DelReg (EU) 2015/35.

Making use of Article 176a of the amended DelReg (EU) 2015/35 requires, for example, that no claims on the issuing company of the bond or loan rank senior to the bond or loan, and that the bond or loan provides a fixed redemption payment on or before the date of maturity, in addition to regular fixed or floating rate interest payments. Besides, the bond or loan must be issued by a company that, for example, has its head office in a country which is a member of the EEA and that has operated without any credit event over at least the previous ten years. Furthermore, there are many other (strict) requirements, such as the contractual terms of the bond or loan (cf. para. 3 of Article 176a).

Impact

(Re)insurance companies as well as asset managers aiming at a Solvency II-optimised investment should familiarise themselves in detail with the new provisions and implement the necessary processes at an early stage, as their application would result in a significant reduction in the stressing required, as the following example shows (for the standard formula):

For example (the two different duri used hereafter illustrate the significance of this variable in terms of capital adequacy and are used as examples only; they cannot replace a case-by-case assessment):

• an unrated, unsecured loan for which the criteria of Article 176a(1) in connection with (3) and (4) of the amended DelReg (EU) 2015/35 are met and which is allocated a modified duration "duri" of 1.5 years respectively 7.5 years would receive the following stressing (credit quality step 2):

• an unrated, unsecured loan for which the criteria of Article 176a(2) in connection with (3) and (5) of the amended DelReg (EU) 2015/35 are met and which is allocated a modified duration "duri" of 1.5 years respectively 7.5 years would receive the following stressing (credit quality step 3):

• If the (current) Article 176(4) DelReg (EU) 2015/35 would apply to the same unrated and unsecured loan, stressing would be calculated as follows:

This shows that meeting the criteria of Article 176a of the amended DelReg (EU) 2015/35 provides for a substantial decrease in stressing. Lastly, the amendments are not limited to the standard formula; Article 176c of the amended DelReg (EU) 2015/35 deals with these issues under the internal model regime.

The above could also be used to optimise investment vehicles such as funds. Their managers should carefully examine the underlying fund assets and try to fulfil the above criteria to improve the competitiveness of the fund structure from a regulatory capital perspective. This can also be done during the term of an existing fund.

Conclusion

The new provisions on spread risk for bonds and loans are extensive in some cases, but allow a much more risk-sensitive assessment of the individual debt positions compared with the previous provisions. Accordingly, a detailed examination of the new provisions is likely to be worthwhile for (re)insurers and investment fund providers.