The Committee of European Insurance and Occupational Pensions Supervisors (Ceiops) has proposed allowing the use of an illiquidity premium for assessing capital levels for annuity providers’ existing business, in its latest round of Solvency II implementation advice, published in November. As Life & Pensions reported at the end of October, grandfathering is being considered as a potential solution to the impasse between Ceiops, which insists a risk-free rate should be applied to long-dated liabilities, and the UK industry, which feels this would result in onerous capital requirements. Thaddeus Nyahasha, director of group solvency at Aviva, which holds a substantial portion of the UK’s annual £7 billion worth of annuity business, welcomed Ceiops’ move to opt for grandfathering as a “significant shift” for the insurance industry. Nyahasha cited the recent decision by the Chief Financial Officers’ Forum to recognise the liquidity premium as part of its market-consistent embedded value (Life & Pensions, October 2009) as an example of the industry’s unified view on the issue. However, he went on to state that by opting for grandfathering, Ceiops was still not accepting the industry’s view. “The industry still has some way to go before it has completely got its point across. Ceiops’ move seems to be only a reluctant acceptance. The industry does not want transitional relief, rather it wants the new solvency standards to be economically based,” he said. “The decision-making process will be conducted by the European Commission, with Ceiops as a key adviser, and we are cautiously optimistic it will take a pragmatic economic approach to this issue.” Ceiops’ reluctance to back the liquidity premium was evident in its advice, where it reiterated that “the vast majority of Ceiops’ members believes the relevant risk-free interest rate term structure should not include the referred addition to discount the cashflows of certain insurance obligations”. In other words, the risk-free rate should apply to all types of business, irrespective of duration. However, according to Ceiops, the “minority that do not share this view [that the liquidity premium should not be included]” have not taken into account the two major problems with using an illiquidity premium. In Ceiops’ view, the increase in size of the liquidity premium in times of crisis ran contrary to the need for greater policyholder protection at the time. Ceiops might not yet accept the existence of the liquidity premium, but apparently the market does. According to figures within the UK’s insurance sector, the expectation that Solvency II would only use a triple-A government discount rate across the board means banks are already marketing products that would trade the liquidity premium as a form of regulatory arbitrage. Ceiops’ concession was welcomed by Lord Myners, the UK’s Financial Services Secretary. In a speech to the Association of British Insurers in London on November 12, Myners described Ceiops’ move as “a fundamental step forward”, but said more needs to be done. “We need to make sure we do not overvalue the risks associated with annuity liabilities, thus requiring overly prudent levels of capital,” he said. “Capital must be sufficient to provide security and assurance, but setting capital at an excessively conservative level will have very real consequences in terms of dis-incentivising retirement provision and adversely impacting pensioner income. “For all the talk of discount rates and technical provisions, we must be crystal clear that the risk here is increased costs for pension businesses and, ultimately, pensioners. We absolutely cannot allow this to happen.” London-based Legal & General has been a vocal opponent of Ceiops’ decision to not allow for the addition of a liquidity premium to a triple-A government bond rate to discount annuity liabilities. A spokesman said it was “very encouraged” by recent moves by Myners and the UK Treasury’s commitment to “achieving the right outcome on Solvency II”. He acknowledged Ceiops’ concession over the grandfathering of existing capital requirements meant “the direction of travel now appears more positive on the liquidity premium issue, particularly for the back book of existing business”, but said discussions over Solvency II were far from complete. Legal & General had previously warned of the negative impact on the value of pension pots if Solvency II was implemented without a liquidity premium. This stance was backed by Nyahasha, who argued this situation would “eliminate a product [annuities] by price. And we do not see this as a UK-only issue. If you look at the demographic transition taking place on the continent, it is likely there will be an increase in private pension provision – a trend that would suffer, unless some form of liquidity premium is permitted for this type of business”. ...
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