When the Solvency II Framework Directive was adopted on 25 November 2009, the technical provisions calculation seemed straight forward enough: “The value of technical provisions [is] the sum of a best estimate and a risk margin”, where: “The best estimate shall correspond to the probability weighted average of future cash-flows, taking account of the time value of money…using the relevant risk-free interest rate term structure.

Unfortunately, it took almost exactly 4 years for policy makers to agree, and then explain, what they meant when they said best estimate and the relevant risk-free interest rate term structure (the Structure). When the Council of the European Union published the final version of the Omnibus II Directive on 27 November 2013, it finally let us in on the secret – a Russian doll of rules that work like this:

Step 1: Determine the Structure in a way that uses, and is consistent with, “information derived from relevant financial instruments”. Use actual information, if the market for the relevant instruments is deep, liquid and transparent; and extrapolated information, if it isn’t.

Step 2(a): If you have prior regulatory approval, you may “apply a matching adjustment” to the Structure when you calculate the “best estimate” of a portfolio of life obligations; but only if (for example) you assign an appropriate portfolio of assets “to cover the best estimate of the portfolio” of obligations and maintain it over the life of the obligations.  The relevant obligations and assets must also be “identified, organised and managed separately” from the rest of the business, and the assets cannot be used to cover losses on other business.

Warning: If you begin to apply a matching adjustment, you can’t easily stop; and, if you do, you can’t reapply a matching adjustment for at least 2 years.

Warning: If you apply a matching adjustment to a portfolio of obligations, you can’t apply a volatility adjustment as well.

Step 2(b): You may “apply a volatility adjustment” to the Structure when you calculate the “best estimate”, but only if you have prior supervisory approval (if that’s required in your Member State). For each relevant currency, the volatility adjustment must be “based on the spread between the interest rate that could be earned from assets included in a reference portfolio for that currency and the rates of the relevant basic” Structure for that currency. And the “reference portfolio” for each currency must be “representative for the assets which are denominated in that currency and which [firms] are invested in to cover the best estimate for insurance and reinsurance obligations denominated in that currency.” The volatility adjustment can “apply only to the risk-free interest rates of the term structure that are not derived by means of extrapolation”.

Where’s the law, and is it what we were expecting?

We only have 5 sentences of actual European law, at present (see article 77(2) of the Solvency II Framework Directive).  If the European Parliament adopts the final version of the Omnibus II Directive at its plenary session on 25 February 2014 (as expected), we’ll have 4 more articles (articles 77(a) to 77(d)) and 7½ more pages of European law for the European Member States to transpose into their own rules by 31 March 2015.

EIOPA and the Commission may also make implementing technical standards and, if they do, firms will be required to comply with them when they calculate the “best estimate”, “matching adjustment” and “volatility adjustment”. These technical standards (if any) are likely to form part of a European Regulation, made under (what will become) article 77(e) of the Solvency II Framework Directive and (what is already) article 291 of the Treaty on the Functioning of the European Union.

EIOPA will also publish, for each relevant currency, and at least once a quarter: (a) a Structure to calculate the best estimate without any matching adjustment or volatility adjustment; (b) for each relevant duration, credit quality and asset class a fundamental spread for the calculation of the matching adjustment; and (c) for each relevant national insurance market a volatility adjustment to the Structure.

In addition, EIOPA will be required to (a) carry out an annual impact assessment of these arrangements, between 2017 and 2021; and (b) submit an annual opinion to the European Commission. And the Commission will be required, on at least one occasion during that period, to submit a report to the European Parliament and Council with proposals for legislative change (if appropriate).

These arrangements are entirely new, from a Solvency II Framework Directive perspective; and materially different from an Omnibus II perspective, at least when compared with the proposals made by each of the Commission, the Council, and the Parliament during the trilogue negotiations. They also differ significantly from the arrangements most commentators were expecting immediately before the final trilogue negotiations took place. For example, the proposed restriction on the proportion of BBB-rated bonds that a firm could hold in a matching portfolio has been removed; there’s no obligation to sell BBB-rated assets within 3 months of a downgrade; and the floor of the fundamental spread of the matching adjustment has been reduced from 65% of the long-term average spread, to 30% for government bonds and 35% for corporate bonds.

My recent blogs on related issues are here, here and here.