This presentation by Olav Jones, Insurance Europe, was made at the OECD-Risklab-APG Workshop on pension fund regulation and long-term investment held in Amsterdam on 7 April 2014. Discussions focused on: long-term pension investment strategies under risk-based regulation; riskiness and procyclicality in pension asset allocation; and, regulatory challenges for long-term illiquid assets. For more information, please visit: http://www.oecd.org/daf/fin/private-pensions/OECD-APG-workshop-pension-fund-regulation-LTI.htm

1. Lessons to learn from Solvency II
Olav Jones
7 April 2014
OECD/APG Workshop

2. Good regulation is important for a healthy industry
The insurance industry supports the original aims of Solvency II:
Policyholder protection
Transparency and high standards of risk management
Harmonise regulations
Support a strong and efficient European insurance industry
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In its final form Solvency II will not be perfect. It can, however,
achieve its goals but it will also have some unintended
consequences on long-term products and investments

3. Solvency II realised late into development how
big an impact long-term liabilities can have
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Because of long-term liabilities:
1. Insurance companies can reduce or eliminate their exposure
to actual losses due to temporary falls in asset prices
2. Even if a change (eg shift to low interest rates) may be
permanent, insurance companies usually have many years to
address the issue

4. Why this matters?
Allowing insurers to continue with long-term approach is vital
Policyholders
Get access to products that protect them from market volatility
Get additional yield available from long-term and illiquid assets
For the wider economy
Largest institutional investor (€8.4trn), with a long-term, patient
investor perspective
Stable funding for economic growth
Stability and counter-cyclical role during crisis
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5. Why long-term investment can change the nature of
risk
For long-term investors very different from traders
NOT exposed to interim changes in market value of the bonds
ARE exposed to actual bond defaults
These are very different: eg for portfolio of 20yr AA bonds:
Value loss from 2007 to 2008 > 30%
Actual defaults only < 0.4%
This affects Solvency measurement in two ways:
1. Solvency Capital Requirement (SCR) set unnecessarily high
2. Available Capital will be very volatile due to market movements to
which the company is not exposed – this will force companies to hold
unnecessary and very large capital buffers
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6. Balance Sheet volatility if Solvency II had no long-
term measures
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Simplified insurance company – with 5, 10 & 15 year portfolios (liabilities and “AA” rated assets,
perfectly cash-flow matched). We assume no change in the asset/liability profile over time

7. Solvency II uses spreads as the basis for calibrating credit risk and so
long duration bonds have a very high SCR
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Long-term investment is especially impacted (1)

8. Care needs to be taken when comparing business models
It’s nevertheless interesting to compare how credit risk is assessed in
other regimes
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Long-term investment is especially impacted (2)

9. 9
Long-term and immediate solvency problems are not
the same (1)
Solvency problems:
can be due to current market conditions => might only be
temporary
the long-term nature of the business means that there may be
many years to allow for solving
There is a difference between:
Immediate shortfalls (eg €200m due to a windstorm)
Future shortfalls (eg €200m due to current low interest rates)

10. 10
Long-term and immediate solvency problems are not
the same (2)
In this example the problem will only arise in 20 years time
If interest rates rise before then the problem can reduce or
disappear

11. Solutions used for SII avoid the worst unintended
consequences but still penalise long-term business
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Adjustment What it is meant to achieve
Matching Adjustment Recognise that in certain cases insurers can eliminate
exposure to asset price volatility (but is exposed to risk of
actual default)
Volatility Adjustment Recognise that even where conditions for Matching
Adjustment are not met, companies are not fully exposed
to asset volatility
Extrapolation Recognise that risk free curve needs to be extended
because liabilities can be longer than available market data
Transitional measures Recognise that long-term nature of business means that
insurance companies both need and have time to adapt
from previous regime, products and market situations to
new one
Extension of recovery
period
Give more time to deal with exceptional situations, such as
falls in financial markets

12. Key lessons from SII
Take care with theoretical approaches – financial theory was
designed for traders and has not yet been extended to take into
account long-term investors – it is the outcome that matters
Do not let the measures create volatility
Recognise the real impact long-term liabilities have on market
risk
Recognise the difference between exposure to changes in credit
spreads and changes in level of defaults is fundamental
Be very concerned about unintended consequences
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