BoE creates volatility adjustment ‘stepping stone’ for insurers

A proposed change to the way the Bank of England implements the European Union’s Solvency II regime for insurers should boost the use of the volatility adjustment, according to experts. They say the regulator’s acceptance of a dynamic approach to the VA could result in the rule being used as a waiting room for the matching adjustment, which is a more attractive tool but involves a more difficult approval process.

“I think what you may see is [that] where firms struggled to get certain liabilities or assets into the MA, the dynamic VA could be used as a stepping stone into the MA,” says Andrew Kenyon, insurance origination and solutions actuary at NatWest Markets. “The ultimate aim is probably still to try to restructure liabilities to get MA approval, but putting them first into a dynamic VA portfolio might help facilitate that transition.”

On April 11, the Bank of England’s Prudential Regulatory Authority (PRA) published a consultation paper that announced it would allow insurers to apply to use a dynamic form of VA in the UK for the first time.

The VA allows firms to alter the rate used to discount liabilities, based on the spreads of a reference portfolio of assets that reflects average holdings across the industry. This shields them from market volatility in the price of assets that are backing long-term insurance liabilities, such as life insurance policies.

The MA is similar to the VA, but is not based on an industry reference portfolio. Instead, it allows firms to model their own adjustment to the Solvency II discount curve, based on their own assets and liabilities, as long as cashflow can be proven to be matching and fixed.

In the UK, the MA provides a significantly higher uplift to the discount rate compared with the VA, partly because the VA is capped at 65% of the risk-adjusted spread on the reference portfolio.

“You could imagine the dynamic VA being used for policies that don’t quite qualify for MA,” says Paul Fulcher, managing director of ALM structuring at Nomura. Deferred annuities are an obvious example, he says, because a less certain timetable of cashflow makes it difficult to show they are matched correctly to a particular asset portfolio for supervisory approval of MA.

A dynamic VA allows insurers to anticipate during stable periods the benefit of the adjustment in volatile periods and model the expected impact, ultimately reducing the amount of capital they are required to hold against VA portfolios. 

If a firm already has MA approval in place, they could leverage a lot of that work for a dynamic VA application

Andrew Kenyon, NatWest Markets

The UK regulator had previously argued the reference portfolio used to calculate the VA is dependent on the actions of the industry and therefore difficult to model reliably. In a stress scenario where insurers could become forced sellers, changes in the reference portfolio could distort a recalculated VA.

The PRA’s U-turn followed pressure from the European Insurance and Occupational Pensions Authority (Eiopa), which published an opinion in favour of dynamic VA in December, as well as the UK’s own Treasury Select Committee. Both highlighted a dynamic VA is permitted across the rest of the EU, but not in the UK.

One insurance executive at a large UK life insurer says using the dynamic VA would now make sense for medium-sized internal-model insurers that may find it difficult to gain MA approval for business lines such as bulk annuities on corporate pension schemes, especially if they are taking on such a portfolio for the first time.

Kenyon points to examples of bulk annuity deals between insurers where the transfer has included covenants linked to factors such as the solvency ratio of the firm providing the bulk annuities, rather than just the underlying value of the assets. This has made the liabilities ineligible for the MA, even if the firm already has MA approval for other business.

“If a firm already has MA approval in place, they could leverage a lot of that work for a dynamic VA application. MA approval requires a line-by-line analysis of the portfolio that the dynamic VA doesn’t appear to require to the same extent. The uplift on the discount rate is less than the MA, but it’s better than nothing,” he says.

The dynamic VA could also increase appetite for illiquid credit assets, such as infrastructure, by broadening the range of liabilities against which the assets could be held, Kenyon says. For example, assets with prepayment risk would be ineligible for the MA, but could gain approval for inclusion in a dynamic VA portfolio. 

Low uptake

Regulation experts say the PRA’s original position on dynamic VA may partly explain its relatively low uptake in the UK, compared with the rest of the EU.

Eiopa data shows that as of January 1, 2016, the UK had 24 insurers approved to use the VA, compared with 92 in Italy, 80 in Germany and 217 in France.

Some EU countries, including France and Italy, allow firms to use a dynamic VA automatically, with no prior approval from the regulator. The UK has moved closer to the policy of regulators in Germany and the Netherlands, which allow dynamic VA, but only after they have approved an internal model change.

Whether a firm will apply to use the VA for the first time, or update its existing VA approval to a dynamic VA, is likely to depend on the size and resources of individual firms.

Fulcher at Nomura says the PRA’s paper on dynamic VA suggests the barrier to entry for VA approval may be higher than before, which could stymie the flow of applications to use the newly dynamic VA. Smaller and less sophisticated internal model firms were already put off, or failed to gain VA approval in its original form because of the onerous approval process, he adds.

“The bar was always set quite high for VA. Some clients have been put off applying for it because of that, or have failed to get it. As the PRA consultation makes clear, getting dynamic VA would require a major model change and so involve firms resubmitting internal-model approval-process applications, and it’s not clear every insurer will be willing to go through this,” says Fulcher.