The fault lines in Europe's Solvency II compromise

Row over calculation of discount rates exposes political differences


A developing row over how discount rates are set has reminded European insurers that Solvency II relies on a political deal – and that political deals can be broken.

To make the directive possible, European policy-makers negotiated a compromise to soften the effect of a market-based regime on certain pockets of the industry – taking the form of the matching adjustment, volatility adjustment and transitional measures.

Few would suggest reversing any of those, but the European Insurance and Occupational Pensions Authority (Eiopa) is proposing changes to how the directive's ultimate forward rate (UFR) is calculated – an idea that is proving highly controversial.

Insurers use the UFR to formulate the liability discount curve beyond the point where markets are liquid. At its current 4.2% level, many in the industry see the UFR as unjustifiably high. But others see it as part of the political bargain struck to bring the directive into being.

Eiopa's proposals to recalculate the UFR in future – the proposals would reduce the rate to 3.7% if applied today – have prompted strong opposition from German insurers and policy-makers in particular.

They argue the rate reflects assumptions about long-term inflation and growth in the EU and that Eiopa is wrong to compare it against long-term spot rates. An additional argument is that cutting the UFR would force insurers to buy more long-dated assets, forcing down rates at the long end and setting in motion a pro-cyclical feedback loop of lowering rates and lowering UFR resets.

On the other side of the debate, regulators such as Jan Parner, deputy director-general at Denmark's Finanstilsynet, say an artificially high discount rate is unfair on future generations that might have to absorb the cost of any error that becomes apparent in years to come.

Eiopa is unmoved by the spat it has triggered, and says the UFR is a technical matter and beyond the reach of politicians. That might not be wholly true, though.

The European Parliament, Commission and Council will review Solvency II in 2018 and 2020, and some politicians – such as Member of the European Parliament Burkhard Balz – are hinting at reprisals if Eiopa goes ahead unchecked. The message is pretty clear: if the UK wants to secure changes to the risk margin, for example, it should oppose amendments to the UFR (see UFR change would 'threaten' Solvency II political compromise).

Eiopa will decide on the outcome of its review in September. Until then, the industry must wait to see whether the political deal struck to get Solvency II on the statute book is starting to weaken in places.

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