Risks of the Matching AdjustmentThe Matching Adjustment creates a protected environment for liabilities that are matched by assets. Short term volatility risk is offset by a premium on the discount rate with which future liabilities are valued. The concept of earning a liquidity premium on long dated assets which are held to maturity is not new. If you accept this concept, then the Matching Adjustment makes sense in general, but only if applied under strict conditions i.e. close matching of assets and liabilities, no lapse risk, separately managed illiquid assets and full transparency. There are however two main risks associated with the Matching Adjustment. First, it creates concentration risk. If Solvency II puts in place protection for certain assets it creates an incentive to acquire such assets. That is, their current market value can be disregarded because the value of the ‘matched’ liabilities will be adjusted accordingly. This will drive investors to these assets. In fact, this is exactly one of the goals of the Matching Adjustment: creating an incentive for insurers to invest in long-term, matching assets. Although this goal is commendable, the trade-off with the risk of concentration of assets should be born in mind. Second, and more fundamentally, there is a concern that the Matching Adjustment, together with the transitional measures related to the discount rate, is being used to support the struggling long-term guarantee business. This line of business is struggling not because of Solvency II but because the market conditions for these products have deteriorated with current low interest rates and high volatility. Products that were offered in better economic times are now no longer profitable. The Matching Adjustment may effectively become a subsidy for the insurance industry, which will have to be paid for at some point down the line.
The Counter-Cyclical PremiumThe broader application of the principle of adjusting liabilities to short-term volatility of asset prices is the Counter-Cyclical Premium. Upon announcement of a crisis situation, insurers may increase the discount rate used for all their liabilities (except those covered by the Matching Adjustment) in order to alleviate stress on the balance sheet. From a macro-prudential perspective there are a number of problems applying this principle. For a start the CCP is not a symmetric mechanism and therefore cannot be considered to be counter-cyclical. Because the CCP will only apply in times of distress it makes no provision for reserve accumulation when asset prices are inflated. This creates an incentive towards risky behaviour because of the implicit downside guarantee which it provides. In an interconnected global financial market in which everything tends to go wrong at the same time, the CCP gives regulatory relief to insurers but investors may discover that insurers in fact will not have the capital to cover possible losses. Treating what is essentially a problem on the asset side of the balance sheet by adjusting liabilities is problematic. In economic terms we really don’t know what the technique or mechanism should be to properly correct the risk-free interest rates without unjustified manipulation of balance sheets. Years of experience will be needed to study how this mechanism should work. It is as if you started doing monetary policy in a world where it had never existed before. There is simply not enough empirical evidence. Moreover, it is impossible to find one single adjustment size for all companies (in one currency unit, or one country) that, when applied to the discounting of liabilities, will result in an appropriate correction of asset side distortions. We should bear in mind that small adjustments to the risk free rate cause large shifts in life insurer’s balance sheets.
Difficulties in applying the CCPPerhaps the most problematic aspect of the CCP is the question when to apply it. A supervisory authority with inside information making an official public announcement that markets are in distressed conditions is likely to prove controversial. Even today, when markets are still in considerable turmoil and global economic conditions are poor, nobody wants to officially declare that there is financial distress. The pressure on EIOPA or national supervisors to make that call would be strong and its effect on markets could be counter-productive. One possibility is that market participants will dismiss the announcement as ill-informed and ignore it altogether. However, it is more likely to cause a panic, since market participants are aware that insurance supervisors are in contact with central banks; any move to protect a certain class of assets or the assets of a certain country will raise suspicion that there is a deeper underlying problem, leading to a fire sale of those assets. To address this issue, and add more certainty to how the CCP will be used, there is a proposal to introduce the CCP using a set of indicators that will act as a semi-automatic activation trigger. This is also quite problematic because indicators are mostly backward looking and offer little judgment on current and future conditions, as we have recently witnessed with the Spanish ‘dynamic provisioning’ mechanism for bank regulation. Because this instrument was drawing on past data, it resulted in buffers being insufficient.
Way forward and alternative approachesThe current Solvency II framework already contains two counter-cyclical elements. The equity dampener smoothes the capital charge on equities over the economic cycle. This is a symmetrical mechanism which changes the capital requirement on the asset side. It is therefore easier to implement and calculate instead of trying to compensate on the liability side. The other, is an extension to the recovery periods in the case of a significant drop in asset prices. The latter must have strong conditionality attached to it. Recovery periods that are too long raise concerns about systemic undercapitalisation. They also raise concerns about accountability, given that most board members and senior management seldom remain in position for such durations. These two instruments already create a useful hierarchy of instruments whereby each is introduced only after the previous one is exhausted, which is preferable to concurrent introduction of a number of instruments. But given the small amount of capital requirements to the entire balance sheet stipulated by Solvency II, industry and politicians believe the above mentioned measures are not sufficient to reduce the volatility insurers are facing for long-term guarantee products. So what should be the solution to the remaining volatility of Solvency II? The proposed impact assessment called for by the trilogue parties should reveal the pros and cons of both the Matching Adjustment and the CCP, from both a quantitative and qualitative perspective. If the concerns outlined above prove to be a reality, alternative measures which decrease volatility should be sought. While recognising the legislative primacy of the trilogue parties, and without anticipating the outcome of the impact assessment, one can think of the following three alternative approaches:
- Decrease volatility on the asset side by creating a separate portfolio of assets which are not valued at market prices, on the basis that they are held to maturity (similar to the banking book in banking regulation).
- Decrease volatility of own funds by creating a revaluation reserve, which may not be used during high growth periods, and which is added to the own funds in distressed periods.
- Make the calculation of the SCR more counter-cyclical by expanding the current equity dampener to other market risk modules, such as the spread module or by adding a macro-prudential SCR module to the standard formula (similar to the counter-cyclical buffer in banking regulation).