- Extrapolation of the long-term rate beyond 20 years: convergence periods of ten and 40 years were tested as underlying assumptions.
- The counter-cyclical premium: a measure applied by EIOPA during volatile market conditions.
On comparison of spread risk calibrations of QIS5 and LTGA, and once we conducted an analysis of rating-maturity ratios, we observed that for the majority of these pairings, there was a reduction in the SCR spread under LTGA – in some cases a reduction of up to 50% when compared to QIS5. We thus showed that, under LTGA, the solvency capital requirement spread capital requirement is:
- lower for bonds with durations of less than one, regardless of rating
- lower for investment grade bonds and of substantial benefit for A-rated bonds
- lower for average duration non-investment grade bonds
- higher for long duration non-investment grade bonds and BBB-rated bonds with a duration above 25
- the weak concentration of AAA highly-rated bonds with durations above ten, for which the reduction in the solvency capital requirement spread is greatest
- the strong concentration of highly-rated bonds with a durations inferior to nine and which have a less significant reduction in the solvency capital requirement spread
- the weak concentration of weakly-rated bonds with long durations for which the capital requirements rise
- the dilution effect linked to the weight of the solvency capital requirement spread
Last, we conducted an analysis on the efficiency of risk-taking based on the bond return-solvency capital requirement ratio. The results show that maximum efficiency is achieved for low durations (between one and three), which corresponds to risk levels of between 3% and 15%, depending on rating. The changes introduced by LTGA in terms of spread shocks do not affect the results in terms of ratings-based maximum efficiency because the capital requirements for low durations (between one and five) remain unchanged from QIS5. The calibration put forward by LTGA continues to favour short-duration bonds (one to three). To conclude, based on the LTGA impact study, along with QIS5, the solvency capital requirement is, overall, an appropriate measure of risk for fixed-rate debt instruments. However, it can still be improved by taking into account the following:
- incorporating a Dampener mechanism for bonds in order to integrate the effects of economic cycles and possibly and adjustment that factors in the geographical area in which the bonds were issued
- a revamp of the way in which risk is measured for long-maturity investment grade bonds which are subject to ALM, particularly given their heavy penalisation under Solvency II. They could be treated using a similar approach to that used for equity-backed ring-fenced pension liabilities
- reformulating the risk approach of high yield bonds. These bonds, which are picked by insurers to obtain additional performance, are sensitive to risk factors different from other bonds. As their valuation is sensitive to loss estimation in the event of default, a model in which default risk is paramount should be used by the European regulator.