EIOPA Financial Stability Report July 2020

The unexpected COVID-19 virus outbreak led European countries to shut down major part of their economies aiming at containing the outbreak. Financial markets experienced huge losses and flight-to-quality investment behaviour. Governments and central banks committed to the provision of significant emergency packages to support the economy, as the economic shock, caused by demand and supply disruptions accompanied by its reflection to the financial markets, is expected to challenge economic growth, labour market and the consumer sentiment across Europe for an uncertain period of time.

Amid an unprecedented downward shift of interest rate curves during March, reflecting the flight-to-quality behaviour, credit spreads of corporates and sovereigns increased for riskier assets, leading effectively to a double-hit scenario. Equity markets dramatically dropped showing extreme levels of volatility responding to the uncertainties on virus effects and on the status of government and central banks support programs and their effectiveness. Despite the stressed market environment, there were signs of improvement following the announcements of the support packages and during the course of the initiatives of gradually reopening the economies. The virus outbreak also led to extraordinary working conditions, with part of the services sector working from home, which rises the potential of those conditions being preserved after the virus outbreak, which could decrease demand and market value for commercial real estate investments.

Within this challenging environment, insurers are exposed in terms of solvency risk, profitability risk and reinvestment risk. The sudden reassessment of risk premia and the increase of default risk could trigger large-scale rating downgrades and result in decreased investments’ value for insurers and IORPs, especially for exposures to highly indebted corporates and sovereigns. On the other hand, the risk of ultra-low interest rates for long has further increased. Factoring in the knock on effects of the weakening macro economy, future own funds position of the insurers could be further challenged, due to potential lower levels of profitable new business written accompanied by increased volume of profitable in-force policies being surrendered or lapsed.

Finally, liquidity risk has resurfaced, due to the potential of mass lapse type of events and higher than expected virus and litigation related claims accompanied by the decreased inflows of premiums.

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For the European occupational pension sector, the negative impact of COVID-19 on the asset side is mainly driven by deteriorating equity market prices, as, in a number of Member States, IORPs allocate significant proportions of the asset portfolio (up to nearly 60%) in equity investments. However, the investment allocation is highly divergent amongst Member States, so that IORPs in other Member States hold up to 70% of their investments in bonds, mostly sovereign bonds, where the widening of credit spreads impair their market value. The liability side is already pressured due to low interest rates and, where market-consistent valuation is applied, due to low discount rates. The funding and solvency ratios of IORPs are determined by national law and, as could be seen in the 2019 IORP stress test results, have been under pressure and are certainly negatively impacted by this crisis. The current situation may lead to benefit cuts for members and may require sponsoring undertakings to finance funding gaps, which may lead to additional pressure on the real economy and on entities sponsoring an IORP.

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Climate risks remain one of the focal points for the insurance and pension industry, with Environmental, Social and Governance (ESG) factors increasingly shaping investment decisions of insurers and pension funds but also affecting their underwriting. In response to climate related risks, the EU presented in mid-December the European Green Deal, a roadmap for making the EU climate neutral by 2050, providing actions meant to boost the efficient use of resources by

  • moving to a clean, circular economy and stop climate change,
  • revert biodiversity loss
  • and cut pollution.

At the same time, natural catastrophe related losses were milder than previous year, but asymmetrically shifted towards poorer countries lacking relevant insurance coverages.

Cyber risks have become increasingly relevant across the financial system in particular during the virus outbreak due to the new working conditions that the confinement measures imposed. Amid the extraordinary en masse remote working arrangements an increased number of cyber-attacks has been reported on both individuals and healthcare systems. With increasing attention for cyber risks both at national and European level, EIOPA contributed to building a strong, reliable, cyber insurance market by publishing its strategy for cyber underwriting and has also been actively involved in promoting cyber resilience in the insurance and pensions sectors.

Click here to access EIOPA’s detailed Financial Stability Report July 2020

Stress Testing 2.0: Better Informed Decisions Through Expanded Scenario-Based Risk Management

Turning a Regulatory Requirement Into Competitive Advantage

Mandated enterprise stress testing – the primary macro-prudential tool that emerged from the 2008 financial crisis – helps regulators address concerns about the state of the banking industry and its impact on the local and global financial system. These regulatory stress tests typically focus on the largest banking institutions and involve a limited set of prescribed downturn scenarios.

Regulatory stress testing requires a significant investment by financial institutions – in technology, skilled people and time. And the stress testing process continues to become even more complex as programs mature and regulatory expectations keep growing.

The question is, what’s the best way to go about stress testing, and what other benefits can banks realize from this investment? Equally important, should you view stress testing primarily as a regulatory compliance tool? Or can banks harness it as a management tool that links corporate planning and risk appetite – and democratizes scenariobased analysis across the institution for faster, better business decisions?

These are important questions for every bank executive and risk officer to answer because justifying large financial investments in people and technology solely to comply with periodic regulatory requirements can be difficult. Not that noncompliance is ever an option; failure can result in severe damage to reputation and investor confidence.

But savvy financial institutions are looking for – and realizing – a significant return on investment by reaching beyond simple compliance. They are seeing more effective, consistent analytical processes and the ability to address complex questions from senior management (e.g., the sensitivity of financial performance to changes in macroeconomic factors). Their successes provide a road map for those who are starting to build – or are rethinking their approach to – their stress testing infrastructure.

This article reviews the maturation of regulatory stress test regimes and explores diverse use cases where stress testing (or, more broadly, scenario-based analysis) may provide value beyond regulatory stress testing.

Comprehensive Capital Assessments: A Daunting Exercise

The regulatory stress test framework that emerged following the 2008 financial crisis – that banks perform capital adequacy-oriented stress testing over a multiperiod forecast horizon – is summarized in Figure 1. At each period, a scenario exerts its impact on the net profit or loss based on the

  • as-of-date business,
  • including portfolio balances,
  • exposures,
  • and operational income and costs.

The net profit or loss, after being adjusted by other financial obligations and management actions, will determine the capital that is available for the next period on the scenario path.

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Note that the natural evolution of the portfolio and business under a given scenario leads to a state of the business at the next horizon, which then starts a new evaluation of the available capital. The risk profile of this business evaluation also determines the capital requirement under the same scenario. The capital adequacy assessment can be performed through this dynamic analysis of capital supply and demand.

This comprehensive capital assessment requires cooperation from various groups across business and finance in an institution. But it becomes a daunting exercise on a multiperiod scenario because of the forward-looking and path-dependent nature of the analysis. For this reason, some jurisdictions began the exercise with only one horizon. Over time, these requirements have been revised to cover at least two horizons, which allows banks to build more realistic business dynamics into their analysis.

Maturing and Optimizing Regulatory Stress Testing

Stress testing – now a standard supervisory tool – has greatly improved banking sector resilience. In regions where stress testing capabilities are more mature, banks have built up adequate capital and have performed well in recent years. For example, the board of governors for both the US Federal Reserve System and Bank of England announced good results for their recent stress tests on large banks.

As these programs mature, many jurisdictions are raising their requirements, both quantitively and qualitatively. For example:

  • US CCAR and Bank of England stress tests now require banks to carry out tests on institution-specific scenarios, in addition to prescribed regulatory scenarios.
  • The regions adopting IFRS 9, including the EU, Canada and the UK, are now required to incorporate IFRS 9 estimates into regulatory stress tests. Likewise, banks subject to stress testing in the US will need to incorporate CECL estimates into their capital adequacy tests.
  • Liquidity risk has been incorporated into stress tests – especially as part of resolution and recovery planning – in regions like the US and UK.
  • Jurisdictions in Asia (such as Taiwan) have extended the forecast horizons for their regulatory stress tests.

In addition, stress testing and scenario analysis are now part of Pillar 2 in the Internal Capital Adequacy Assessment Process (ICAAP) published by the Basel Committee on Banking Supervision. Institutions are expected to use stress tests and scenario analyses to improve their understanding of the vulnerabilities that they face under a wide range of adverse conditions. Further uses of regulatory stress testing include the scenariobased analysis for Interest Rate Risk in the Banking Book (IRRBB).

Finally, the goal of regulatory stress testing is increasingly extending beyond completing a simple assessment. Management must prepare a viable mitigation plan should an adverse condition occur. Some regions also require companies to develop “living wills” to ensure the orderly wind-down of institutions and to prevent systemic contagion from an institutional failure.

All of these demands will require the adoption of new technologies and best practices.

Exploring Enhanced Use Cases for Stress Testing Capabilities

As noted by the Basel Committee on Banking Supervision in its 2018 publication Stress Testing Principles, “Stress testing is now a critical element of risk management for banks and a core tool for banking supervisors and macroprudential authorities.” As stress testing capabilities have matured, people are exploring how to use these capabilities for strategic business purposes – for example, to perform “internal stress testing.”

The term “internal stress testing” can seem ambiguous. Some stakeholders don’t understand the various use cases for applying scenario-based analyses beyond regulatory stress testing or doubt the strategic value to internal management and planning. Others think that developing a scenario-based analytics infrastructure that is useful across the enterprise is just too difficult or costly.

But there are, in fact, many high-impact strategic use cases for stress testing across the enterprise, including:

  1. Financial planning.
  2. Risk appetite management.
  3. What-if and sensitivity analysis.
  4. Emerging risk identification.
  5. Reverse stress testing.

Financial Planning

Stress testing is one form of scenario-based analysis. But scenario-based analysis is also useful for forward-looking financial planning exercises on several fronts:

  • The development of business plans and management actions are already required as part of regulatory stress testing, so it’s natural to align these processes with internal planning and strategic management.
  • Scenario-based analyses lay the foundation for assessing and communicating the impacts of changing environmental factors and portfolio shifts on the institution’s financial performance.
  • At a more advanced level, banks can incorporate scenario-based planning with optimization techniques to find an optimal portfolio strategy that performs robustly across a range of scenarios.

Here, banks can leverage the technologies and processes used for regulatory stress testing. However, both the infrastructure and program processes must be developed with flexibility in mind – so that both business-as-usual scenarios and alternatives can be easily managed, and the models and assumptions can be adjusted.

Risk Appetite Management

A closely related topic to stress testing and capital planning is risk appetite. Risk appetite defines the level of risk an institution is willing to take to achieve its financial objectives. According to Senior Supervisors Group (2008), a clearly articulated risk appetite helps financial institutions properly understand, monitor, and communicate risks internally and externally.

Figure 2 illustrates the dynamic relationship between stress testing, risk appetite and capital planning. Note that:

  • Risk appetite is defined by the institution to reflect its capital strategy, return targets and its tolerance for risk.
  • Capital planning is conducted in alignment with the stated risk appetite and risk policy.
  • Scenario-based analyses are then carried out to ensure the bank can operate within the risk appetite under a range of scenarios (i.e., planning, baseline and stressed).

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Any breach of the stated risk appetite observed in these analyses leads to management action. These actions may include, but are not limited to,

  • enforcement or reallocation of risk limits,
  • revisions to capital planning
  • or adjustments to current risk appetite levels.

What-If and Sensitivity Analysis

Faster, richer what-if analysis is perhaps the most powerful – and demanding – way to extend a bank’s stress testing utility. What-if analyses are often initiated from ad hoc requests made by management seeking timely insight to guide decisions. Narratives for these scenarios may be driven by recent news topics or unfolding economic events.

An anecdotal example illustrates the business value of this type of analysis. Two years ago, a chief risk officer at one of the largest banks in the United States was at a dinner event and heard concerns about Chinese real estate and a potential market crash. He quickly asked his stress testing team to assess the impact on the bank if such an event occurred. His team was able to report back within a week. Fortunately, the result was not bad – news that was a relief to the CRO.

The responsiveness exhibited by this CRO’s stress testing team is impressive. But speed alone is not enough. To really get value from what-if analysis, banks must also conduct it with a reasonable level of detail and sophistication. For this reason, banks must design their stress test infrastructure to balance comprehensiveness and performance. Otherwise, its value will be limited.

Sensitivity analysis usually supplements stress testing. It differs from other scenariobased analyses in that the scenarios typically lack a narrative around them. Instead, they are usually defined parametrically to answer questions about scenario, assumption and model deviations.

Sensitivity analysis can answer questions such as:

  • Which economic factors are the most significant for future portfolio performance?
  • What level of uncertainty results from incremental changes to inputs and assumptions?
  • What portfolio concentrations are most sensitive to model inputs?

For modeling purposes, sensitivity tests can be viewed as an expanded set of scenario analyses. Thus, if banks perform sensitivity tests, they must be able to scale their infrastructure to complete a large number of tests within a reasonable time frame and must be able to easily compare the results.

Emerging Risk Identification

Econometric-based stress testing of portfolio-level credit, market, interest rate and liquidity risks is now a relatively established practice. But measuring the impacts from other risks, such as reputation and strategic risk, is not trivial. Scenario-based analysis provides a viable solution, though it requires proper translation from the scenarios involving these risks into a scenario that can be modeled. This process often opens a rich dialogue across the institution, leading to a beneficial consideration of potential business impacts.

Reverse Stress Testing

To enhance the relevance of the scenarios applied in stress testing analyses, many regulators have required banks to conduct reverse stress tests. For reverse stress tests, institutions must determine the risk factors that have a high impact on their business and determine scenarios that result in the breaching thresholds of specific output metrics (e.g., total capital ratio).

There are multiple approaches to reverse stress testing. Skoglund and Chen proposed a method leveraging risk information measures to decompose the risk factor impact from simulations and apply the results for stress testing. Chen and Skoglund also explained how stress testing and simulation can leverage each other for risk analyses.

Assessing the Impacts of COVID-19

The worldwide spread of COVID-19 in 2020 has presented a sudden shock to the financial plans of lending institutions. Both the spread of the virus and the global response to it are highly dynamic. Bank leaders, seeking a timely understanding of the potential financial impacts, have increasingly turned to scenario analysis. But, to be meaningful, the process must:

  • Scale to an increasing array of input scenarios as the situation continues to develop.
  • Provide a controlled process to perform and summarize numerous iterations of analysis.
  • Provide understandable and explainable results in a timely fashion.
  • Provide process transparency and control for qualitative and quantitative assumptions.
  • Maintain detailed data to support ad hoc reporting and concentration analysis.

Banks able to conduct rapid ad hoc analysis can respond more confidently and provide a data-driven basis for the actions they take as the crisis unfolds.

Conclusion

Regulatory stress testing has become a primary tool for bank supervision, and financial institutions have dedicated significant time and resources to comply with their regional mandates. However, the benefits of scenario-based analysis reach beyond such rote compliance.

Leading banks are finding they can expand the utility of their stress test programs to

  • enhance their understanding of portfolio dynamics,
  • improve their planning processes
  • and better prepare for future crises.

Through increased automation, institutions can

  • explore a greater range of scenarios,
  • reduce processing time and effort,
  • and support the increased flexibility required for strategic scenario-based analysis.

Armed with these capabilities, institutions can improve their financial performance and successfully weather downturns by making better, data-driven decisions.

Click here to access SAS’ latest Whitepaper

EIOPA : Sound Regulation in an Evolving Landscape

Regulation is only effective for as long as it remains relevant. While EIOPA is evolving into a supervisory-focused organisation, it pays close attention to how regulation is applied and how effective it remains, with a view to reinforcing cross-sectoral consistency and improving fairness and transparency and with a focus on better and smart regulation.

INSURANCE

  • SOLVENCY II REVIEW

Since the successful implementation of Solvency II Directive in 2016, EIOPA played an important role in monitoring its consistent implementation and during 2018 was able to provide valuable input into preparations for its review.

EIOPA provided advice to the European Commission on the review of the Solvency Capital Requirement based on an in-depth analysis of 29 different elements of the Standard Formula. The advice focused on increasing proportionality, removing unjustified constraints to financing the economy and removing technical inconsistencies.

EIOPA proposed further simplifications and reduced the burden to insurers by:

  • Further simplifying calculations for a number of sub-modules of the Solvency Capital Requirement (SCR) such as natural, man-made and health catastrophes, in particular fire risk and mass accident;
  • Simplifying the use of external credit ratings in the calculation of the SCR (an issue especially relevant for small insurers);
  • Reducing the burden of the treatment of lookthrough to underlying investments;
  • Developing simplifications in the assessment of lapse and counterparty default risks;
  • Recommending the use of undertaking specific parameters for reinsurance stop-loss treaties.

Furthermore, one of the major technical inconsistencies found related to the calculation of interest rate risk, which did not capture very low or even negative interest rates. EIOPA recommended to adjust the methodology using a method already adopted by internal model users and, given the material impact on capital requirements, suggested to implement it gradually over three years.

EIOPA also carried out an analysis of the loss-absorbing capacity of deferred taxes practices. In face of the evidence of wide diversity, especially concerning the projection of future profits, EIOPA proposed a set of key principles that will ensure greater convergence and level playing field, while maintaining a certain degree of flexibility.

Finally, EIOPA analysed the treatment and the evidence available on unrated debt and unlisted equity and proposed criteria for a more granular treatment, namely with the use of financial ratios.

In some areas, the analysis of recent developments did not provide for sufficient reasons to change. This is, for example, the case of mortality and longevity risks and the cost of capital in the calculation of the risk margin. The evolution of financial markets does not justify a change in the cost of capital: the decrease in interest rates has not lead to a decrease in the cost of raising equity.

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  • REPORTING ON THE IMPLEMENTATION OF SOLVENCY II

In 2018, EIOPA published a number of reports related to different aspects of Solvency II.

  • Report on group supervision and capital management

In response to a European Commission’s request for information, EIOPA submitted its Report on Group Supervision and Capital Management of (Re)Insurance Undertakings and specific topics related to Freedom to Provide Services (FoS) and Freedom of Establishment (FoE) under the Solvency II Directive. The report concluded that overall the Solvency II Group supervision regime was operating satisfactorily. The tools developed by EIOPA to further strengthen group supervision and supervision of cross-border issues contributed to further convergence of practices of NCAs’ supervisory practices.

The report also highlighted a number of gaps in the regulatory framework, including issues related to the application of Solvency II requirements for determining scope of insurance groups subject to Solvency II group supervision, the application of certain of these provisions governing the calculation of group solvency in particular where several methods are used, the definition and supervision of intra-group transactions, or the application of governance requirements at group level.

Further, EIOPA’s report emphasised that effective supervision of insurance groups will benefit from a harmonised approach on a number of areas, for example, early intervention, recovery and resolution and the assessment of group own funds.

  • Second annual report on the use of capital addons under Solvency II

In December 2018, EIOPA published its second annual report on the use of capital add-ons by NCAs according to Article 52 of Solvency II. The objective was to contribute to a higher degree of supervisory convergence in the use of capital add-ons between supervisory authorities and to highlight any concerns regarding the capital add-ons framework. In general, the capital add-on appears to be a good and positive measure to adjust the Solvency Capital Requirement to the risks of the undertaking, when the application of other measures, for example the development of an internal model, is not adequate.

  • Third annual report on the use of limitations and exemptions from reporting under Solvency II

This report, published in December 2018, addresses the proportionality principle on the reporting requirements, from which the limitations and exemptions on reporting – as foreseen in Article 35 of the Solvency II Directive – are just one of the existing proportionality tools. Reporting requirements also reflect a natural embedded proportionality and in addition, risk-based thresholds were included in the reporting Implementing Technical Standard (ITS).

  • Third annual report on the use and impact of long-term guarantee measures and measures on equity risk

This is a regular report published in accordance with Article 77f(1) of the Solvency II Directive. This year’s report also included an analysis on risk management aspects in view of the specific requirements for LTG measures set out in Article 44 and 45 of the Directive as well as an analysis of detailed features and types of guarantees of products with long-term guarantees.

This report shows that – as in previous years – most of the measures, in particular the volatility adjustment and the transitional measures on technical provisions are widely used. The average Solvency Capital Requirement (SCR) ratio of undertakings using the voluntary measures is 231 % and would drop to 172 % if the measures were not applied. This confirms the importance of the measures for the financial position of (re)insurance undertakings.

  • INVESTIGATING ILLIQUID LIABILITIES

The treatment of long-term insurance business remains a hotly debated issue. In particular, it has been discussed whether the risks of long-term insurance business and the associated investments backing those long-term insurance business are adequately reflected. The illiquidity characteristics of liabilities may contribute to the ability of insurers to mitigate short-term volatility by holding assets throughout the duration of the commitments, even in times of market stress.

To explore any new evidence on the features of liabilities, especially concerning their illiquidity characteristics, a dedicated EIOPA Project Group on illiquid liabilities was set up with the following main goals:

  1. To identify criteria of liquidity characteristics for the liabilities and measures for insurers’ ability to invest over the long term;
  2. To explore the link between the characteristics of liabilities and the management of insurers’ assets;
  3. To analyse whether the current treatment in the regulatory regime appropriately addresses the risks associated with the long-term nature of the insurance business.

Following a request for information from the European Commission on asset and liability management, EIOPA launched a request for feedback on illiquid liabilities in autumn and held a roundtable with interested stakeholders in December to discuss the submitted responses on illiquidity measurements and asset liability management practices.

  • ANALYSIS OF THE INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS) 17 INSURANCE CONTRACTS

Following the publication of International Financial Reporting Standards (IFRS) 17 Insurance Contracts by the International Accounting Standards Board (IASB), EIOPA assessed its potential effects on financial stability and the European public good, on product design, supply and demand of insurance contracts, and the practical implementation in light of the applicable inputs and processes for Solvency II.

EIOPA concluded that the introduction of IFRS 17 can be described as positive paradigm shift compared to its predecessor IFRS 4 Insurance Contracts, bringing increased transparency, comparability and additional insights on insures’ business models. EIOPA, however, noted a few reservations regarding concepts that may affect comparability and relevance of IFRS 17 financial statements.

PENSIONS

EIOPA promotes greater transparency in the European pensions sector. In support of this aim, EIOPA is working to enhance the information available to consumers and supporting pension providers by making clear the expectations, justifications and decisions linked with the information they provide, in particular to prospective members, members and beneficiaries as laid out in Articles 38 – 44 of the EU Directive on the activities and supervision of institutions for occupational retirement provision (IORP II).

  • REPORT ON THE PENSION BENEFIT STATEMENT: GUIDANCE AND PRINCIPLESBASED PRACTICES IMPLEMENTING IORP II

The report presents the outcomes of NCA exchanges of views and assessments of current practices for the implementation of the IORP II Pensions Benefit Statement (PBS) requirement. Based on this investigation, several principles have been identified that will facilitate clear understanding and comparability of statements.

Two proposals are now in further development: a basic PBS and an advanced PBS (containing more detailed information) to meet the PBS goals. These proposals will, as far as possible, take account of the behavioral approach principle be subject to further consumer testing.

  • DECISION ON THE CROSS-BORDER COLLABORATION OF NCAS WITH RESPECT TO IORP II DIRECTIVE

This Decision, published in November 2018, replaces the former Budapest Protocol which had to be revised as a result of the new IORP II Directive. The Decision introduces new rules to improve the way occupational pension funds are governed, to enhance information transparency to pension savers and to clarify the procedures for carrying out cross-border transfers and activities.

The Decision also describes different situations and possibilities for NCAs to exchange information about cross-border activities in relation to the ‘fit and proper’ assessment and the outsourcing of key functions, both new provisions of the IORP II Directive in addition to the cross-border transfer.

PRESERVING FINANCIAL STABILITY

As part of EIOPA’s mandate to safeguard financial stability, EIOPA works to identify trends, potential risks and vulnerabilities that could have a negative effect on the pension and insurance sectors across Europe.

  • 2018 INSURANCE STRESS TEST

EIOPA published the results of its stress test of the European insurance sector in December 2018. This exercise assessed the participating insurers’ resilience to the three severe but plausible scenarios: a yield curve up shock combined with lapse and provisions deficiency shocks; a yield curve down shock combined with longevity stress; and a series of natural catastrophes.

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In total, 42 European (re)insurance groups participated representing a market coverage of around 75 % based on total consolidate assets. EIOPA published for the first time the post-stress estimation of the capital position (Solvency Capital Requirement ratio) of major EU (re)insurance groups.

Overall, the stress test confirmed the significant sensitivity to market shocks combined with specific shocks relevant for the European insurance sector. On aggregate, the sector is adequately capitalised to absorb the prescribed shocks. Participating groups demonstrated a high resilience to the series of natural catastrophes tested, showing the importance of the risk transfer mechanisms, namely reinsurance, in place.

An additional objective of this exercise, stemming from recommendations from the European Court of Auditors, was to increase transparency in order to reinforce market discipline by requesting the voluntary disclosure of a list of individual stress test indicators by the participating groups. Since EIOPA does not have the power to impose the disclosure of individual results, participating groups were asked for their voluntary consent to the publication of a list of individual stress test indicators. Only four of the 42 participating groups provided such consent.

  • RISK DASHBOARD

EIOPA publishes a risk dashboard on a quarterly basis and a financial stability report twice a year. In the December 2018 report, EIOPA concluded:

  1. the persistent low yield environment remains challenging for insurers and pension funds;
  2. the risk of a sudden reassessment of risk premia has become more pronounced over recent months amid rising political and policy uncertainty;
  3. interconnectedness with banks and domestic sovereigns remains high for European insurers, making them susceptible to potential spillovers;
  4. some European insurers are significantly exposed in their investment portfolios to climate-related risks and real estate.
  • FINANCIAL STABILITY REPORT

EIOPA published two reports on the financial stability of the insurance and occupational pensions sector in 2018.

In general the persistent low yield environment remains challenging for both the insurance and pension fund sector, which continues to put pressure on profitability and solvency. However, towards the end of the year, as noted in the December report, the risk of a sudden reassessment of risk premia became more pronounced. This is largely due to rising political uncertainty and trade tensions, concerns over debt sustainability and the gradual normalisation of monetary policy. In the short run a sudden increase in yields driven by rising risk premia could significantly affect the financial and solvency position of insurers and pension funds as the investment portfolios could suffer large losses only partly offset by lower liabilities. In this regard, the high degree of interconnectedness with banks and domestic sovereigns of insurers could lead to potential spillovers in case a sudden reassessment of risk premia materialise.

While overall the insurance sector remains adequately capitalised, profitability is under increased pressure in the current low yield environment. The Solvency Capital Requirement ratio for the median company is 225 % for life and 206 % for non-life insurance sector, although significant disparities remain across undertakings and countries.

In the European occupational pension fund sector, total assets increased for the euro area and cover ratios slightly improved. However, the current macroeconomic environment and ongoing low interest rates continue to pose significant challenges to the sector, with the weighted return on assets considerably down in 2017.

  • ENHANCED INFORMATION AND STATISTICS

EIOPA continuously works to improve the availability and quality of available information and statistics on insurance and pensions.

  • Solvency II information

For the insurance sector, EIOPA publishes high-quality insurance statistics at both solo and group level. The statistics are based on Solvency II information from regulatory reporting and their regular publication demonstrates EIOPA’s commitment to transparency. Over the past year, through the increased availability of Solvency II data EIOPA has been able to increase the coverage of its statistics. In June 2018, for the first time, the Authority published further insight into the assets of solo (re)insurance undertakings at country level.

  • Decision on EIOPA’s regular information requests towards NCAs regarding provision of occupational pensions information

In April 2018, the Authority published its decision regarding the submission of occupational pension information. The decision defined a single framework for the reporting of occupational pension information that facilitates reporting processes. As a result, EIOPA will receive the information required to carry out appropriate monitoring and assessment of market developments, as well as in-depth economic analyses of the occupational pension market. The requirements were developed in close cooperation with the European Central Bank in order to minimise the burden on the industry and will apply as of 2019.

  • Pensions information taxonomy

In November 2018, EIOPA published the eXtensible Business Reporting Language (XBRL) Taxonomy applicable for reporting of information on IORPs. It provides NCAs with the technical means for the submission to EIOPA of harmonised information of all pension funds in the European Economic Area. Developed in close collaboration with the European Central Bank (ECB), it allows for integrated technical templates and means to report via a single submission both the information required by EIOPA and the ECB.

CRISIS PREVENTION

In addition to regular financial stability tools, EIOPA undertooka number of additional activities in 2018 related to crisis prevention.

  • Development of a macroprudential framework for insurance

With the aim of contributing to the overall debate on systemic risk and macroprudential policy, over the last year, EIOPA has published a series of reports that extend the debate to the insurance sector and, more specifically, the characteristics of that sector. These reports cover the following:

  1. Systemic risk and macroprudential policy in insurance;
  2. Solvency II tools with macroprudential impact; and
  3. Other potential macroprudential tools and measures to enhance the current framework.

As a next step, EIOPA will consult on concrete proposals to include macroprudential elements in the upcoming review of Solvency II.

  • Analysis of the causes and early identification of failures and near misses in insurance

In July 2018, EIOPA published ‘Failures and near misses in insurance: Overview of the causes and early identification’ as the first in a series aimed at enhancing supervisory knowledge of the prevention and management of insurance failures. The report’s findings are based on information contained in EIOPA’s database of failures and near misses, covering the period from 1999 to 2016, including sample data of 180 affected insurance undertakings in 31 European countries.

The report focuses on an examination of the causes of failure in insurance, as well as the assessment of the reported early identification signals. It also examines the underlying concepts ‘failure’ and ‘near miss’ as well as providing further information on EIOPA’s database, established in 2014.

Click here to access EIOPA’s 2018 Annual Report

EIOPA’s Insurance Stress Test 2018 Recommendations

Introduction

During the course of 2018, EIOPA carried out a European-wide stress test (ST) in accordance with Articles 21(2)(b) and 32 of Regulation (EU) 1094/2010 of 24 November 2010 of the European Parliament and of the Council (hereafter the ‘Regulation’).

The Recommendations contained in this document are issued in accordance with Article 21(2)(b) of the Regulation in order to address issues identified in the stress test.

EIOPA will support National Competent Authorities (NCAs) and undertakings through guidance and other measures if needed.

The 2018 Stress Test results showed that on aggregate the insurance sector is sufficiently capitalised to absorb the combination of shocks prescribed in the three scenarios. However, it also confirms the significant sensitivity to market shocks for the European insurance sector with Groups being vulnerable

  • not only to low yields and longevity risk,
  • but also to a sudden and abrupt reversal of risk premia, combined with an instantaneous shock to lapse rates and claims inflation.

The exercise further reveals potential transmission channels of the tested shocks to insurers’ balance sheets. For instance, in the YCU scenario the assumed claim inflation shock leads to a net increase in the liabilities of those Groups more exposed to non-life business through claims inflation. Finally, both the YCD and YCU scenario have similar negative impact on post-stress SCR ratios.

As outlined in the Executive Summary of the 2018 Insurance Stress Test Report, further analyses of the results are required by EIOPA and the NCAs to obtain a deeper understanding of the risks and vulnerabilities of the sector.

In order to follow-up on the main vulnerabilities, EIOPA is issuing the present Recommendations related to the 2018 stress test exercise.

Recommendation 1
NCAs should strengthen the supervision of the Groups identified as facing greater exposure to Yield Curve Up and/or Yield Curve Down scenarios. This affects, in particular, those Groups where transitional measures have a greater impact.

Recommendation 2
NCAs should carefully review and, where necessary, challenge the capital and risk management strategies of the affected Groups. In particular:

  • NCAs should require Groups to clarify the impact of the stress test in terms of capital and risk management.
  • For the affected Groups, stress test scenarios similar to YCU and YCD should be properly considered in the risk management framework, including the ORSAs.
  • Review the risk appetite framework for the affected Groups.

Recommendation 3
NCAs should evaluate the potential management actions to be implemented by the affected Groups. In particular:

  • NCAs should require Groups to indicate the range of actions based on the results of the stress testing.
  • NCAs should assess if the actions identified are realistic in such stress scenarios.
  • NCAs should consider any eventual second-round effects.

Recommendation 4
NCAs should further contribute to enhance the stress test process.

Recommendation 5
NCAs should enhance cooperation and information exchange with other relevant Authorities, such as the ECB/SSM or other national authorities, concerning the stress test results of the affected insurers which form part of a financial conglomerate.

EIOPA ST

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2018 EIOPA Insurance Stress Test report

Executive Summary

  1. The 2018 insurance stress test is the fourth European-wide exercise initiated and coordinated by EIOPA. As in previous exercises, the main objective is to assess the resilience of the European insurance sector to specific adverse scenarios with potential negative implications for the stability of the European financial markets and the real economy. Hence, it cannot be considered as a pass-or-fail or capital exercise for the participating groups. In total 42 (re)insurance groups, representing a market coverage of around 75% based on total consolidated assets, participated. As this exercise is based on group level information, no country results are provided in the report.
  2. The exercise tests the impact of a prolonged low yield environment (Yield Curve Down – YCD – scenario) as well as of a sudden reversal of risk premia (Yield Curve Up – YCU – scenario), which are currently identified as key risks across financial sectors. In the YCD scenario, market shocks are complemented by a longevity shock. In the YCU scenario, market shocks are combined with an instantaneous shock to lapse rates and claims inflation. The market shocks prescribed in the YCD and YCU scenarios are severe but plausible and were developed in cooperation with the ESRB, based on past market observations. Additionally, a natural catastrophe (NC) scenario tests the resilience of insurers to a potential materialisation of a set of catastrophe losses over Europe.
  3. Groups were requested to calculate their post-stress financial position by applying the same models used for their regular Solvency II reporting. The use of LTG and transitional measures was taken into account and the impact of these measures had to be reported separately. Restrictions were prescribed in order to accommodate for the instantaneous nature of the shocks and the static balance sheet approach. In particular, the impact of the transitional measure on technical provisions was held constant in the post-stress situation and potential management actions to mitigate the impact of the scenarios were not allowed.
  4. The novelty of this year’s exercise is the assessment of the post-stress capital position of the participants, with an estimate of the post-stress Solvency Capital Requirement (SCR). Given the operational and methodological challenges related to the recalculation of the group SCR, participating groups were allowed to use approximations and simplifications as long as a fair reflection of the direction and magnitude of the impact was warranted.
  5. In the pre-stress (baseline) situation, participating groups have an aggregate assets over liabilities (AoL) ratio of 109.5% (the ratio ranges from 103.0% to 139.5% for participating groups). Overall, the participating groups are adequately capitalised with an aggregate baseline SCR ratio of 202.4%, indicating that they hold approximately twice as much capital than what is required by regulation.
  6. In the YCU scenario, the aggregate AoL ratio drops from 109.5% to 107.6%, corresponding to a drop of 32.2% in the excess of assets over liabilities (eAoL). Without the use of LTG and transitional measures the impact would be more severe, corresponding to a drop in AoL ratio to 105.1% (53.1% in the eAoL) with 3 groups reporting an AoL ratio below 100% (accounting for approximately 10% of total assets in the sample). The impact of the YCU scenario is driven by a significant drop in the value of assets (-12.8% for government bonds, -13.0% for corporate bonds and -38.5 % for equity holdings). Overall, the losses on the asset side outweigh the gains on the liability side. Technical Provisions (TP) decrease by 17.0%, attributed mainly to a decrease in life TP (-14.5%) due to the reduced portfolio (instantaneous lapse shock) and the increased discounting curve (upwards shock to the swap curves). However, an increase in TP was observed for those groups focusing mainly on non-life business. In this case, the impact of the claims inflation shock on the non-life portfolio leads to an increase in the TP, outweighing the beneficial effect of the increased discounting curve due to shorter-term liabilities.
  7. The capital position is materially affected in the YCU scenario, but the poststress aggregate SCR ratio remains at satisfactory levels of 145.2% corresponding to a drop of 57.2 percentage points. However, 6 groups report a post-stress SCR ratio below 100%. This is mainly driven by a significant decrease (-29.9%) in eligible own funds (EOF) following the shocks to the asset portfolio that are not fully compensated by the reduction of the TP, while the SCR decreases only slightly (-2.3%). LTG and transitional measures play a significant role in the post-stress capital position. Without the application of the transitional measures the aggregate SCR ratio drops by an additional 14.3 percentage points to 130.9%, while in case both LTG and transitional measures are removed, the SCR ratio drops to 86.6%, with 21 groups reporting a ratio below 100%. This finding confirms the importance of the aforementioned measures for limiting the impact of short-term market movements on the financial position of insurers, as expected by their design.
  8. In the YCD scenario, the aggregate AoL ratio decreases from 109.5% to 106.7%, corresponding to a drop in eAoL of 27.6%. Again, the impact is more severe without the use of LTG and transitional measures. The aggregate AoL ratio would drop to 104.8% in that case, corresponding to a decrease of 47.7% in eAoL, with 3 groups reporting an AoL ratio below 100% (accounting for approximately 10% of total assets in the sample). The impact of the YCD scenario can be mainly attributed to an increase in the TP on the liability side (+2.1%), driven by the increase of the life TP (+6.1%) due to the reduction of the discounting curve and the longevity shock. Total assets show a decrease (-0.8%) due to the drop in value of assets held for unit-linked contracts and equity holdings (-14.7%) which is partly offset by the increase in value of the fixed income assets (+3.1% government bonds and +2.3% corporate bonds). This scenario confirms that the European insurance industry is vulnerable to a prolonged low yield environment, also at group level.
  9. The aggregate SCR ratio in the YCD scenario drops by 64.9 percentage points, but remains at 137.4% after shock, although 7 participating groups report a ratio below 100%. The decrease in SCR ratio is driven by a material decrease in EOF (-23.5%) and a significant increase in SCR (+12.7%), both mainly due to higher technical provisions. The LTG and transitional measures partly absorb the negative impact of the prescribed shocks. Without the application of the transitional measures the SCR ratio drops to 124.1%, while excluding both LTG and transitional measures leads to an aggregate SCR ratio of 85.4%, with 20 participating groups reporting a ratio below 100%.
  10. In the NC scenario, participating groups report a drop of only 0.3 percentage points in the aggregate AoL ratio. The limited impact of the NC scenario on the participating groups is mainly due to the reinsurance treaties in place, with 55% of the losses transferred to reinsurers. The most affected participants are therefore reinsurers and those direct insurers largely involved in reinsurance activities. Furthermore, it should be noted that the losses are ceded to a limited number of counterparties, highlighting a potential concentration of risk. The high resilience of the groups to the series of natural catastrophes is confirmed by the limited decrease in aggregate eAoL (-2.7%). Without the LTG and transitional measures, the eAoL would decrease by 15.1% compared to the baseline.
  11. Overall, the stress test exercise confirms the significant sensitivity to market shocks for the European insurance sector. The groups seem to be vulnerable to not only low yields and longevity risk, but also to a sudden and abrupt reversal of risk premia combined with an instantaneous shock to lapse rates and claims inflation. The exercise further reveals potential transmission channels of the tested shocks to insurers’ balance sheets. For instance, in the YCU scenario the assumed inflation shock leads to a net increase in the liabilities of those groups more exposed to non-life business through claims inflation. Finally, both the YCD and YCU scenario have similar negative impact on post-stress SCR ratios.
  12. Further analysis of the results will be undertaken by EIOPA and by the National Competent Authorities (NCAs) to obtain a deeper understanding of the risks and vulnerabilities of the sector. Subsequently, EIOPA will issue recommendations on relevant aspects where appropriate. The responses received on the cyber risk questionnaire that are not part of this report, will be evaluated and discussed in future EIOPA publications.
  13. This exercise marks an important step in the reassessment of capital requirements under adverse scenarios and provides a valuable basis for continuous dialogue between group supervisors and the participating groups on the identified vulnerabilities. EIOPA is planning to further work on refining its stress test methodology in order to fully capture the complexity of the reassessment of capital requirements under adverse scenarios. EIOPA expects that participants use the acquired experience to foster their abilities to produce high quality data and to enhance their corresponding risk management capabilities. NCAs are expected to oversee and promote these improvements.

AoL without LTG Transition

SCR With and without LTC Transition

NC Reinsurance

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