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Better outcome for customers with sensible reassessment of Solvency II Fundamental Spread says ABI

Changes made today to the calculation of the Solvency II Fundamental Spread by EIOPA (European Insurance and Occupation Pensions Authority) should help ensure annuity prices remain steady for customers, the Association of British Insurers said.

The ABI, which has been working closely with EIOPA to secure this outcome, estimates that this prevents a potential £2.5 billion increase in the value of annuity liabilities across the industry. This will improve firms’ solvency positions and encourage long term investments, including infrastructure. It will also avoid a potential reduction in annuity incomes paid to new customers as insurers will not need to hold an excess of capital for each customer.

The Fundamental Spread is set by EIOPA as part of the Solvency II regime, a new EU wide regime which starts next year, and specifies how much capital insurers and reinsurers need to hold. The Fundamental Spread is used by firms as a part of their Matching Adjustment calculation and represents the expected cost of default and downgrade of assets which back providers’ annuity business and that firms are therefore exposed to. Today’s changes to the fundamental spread calculation are essential to ensure firms’ Matching Adjustments work as intended under the new Solvency II regime, and that the Matching Adjustment benefit is not undermined‎.

The Matching Adjustment is a crucial concept of Solvency II for the UK pensions market, secured during negotiations, recognising that insurers selling annuities are not exposed to short-term market fluctuation. This is intended to prevent significantly higher annuity premiums for pensioners, by reducing the capital that insurers need to hold to ensure they pay pensioners in the future.

Hugh Savill, ABI Director of Regulation, said:

"This sensible change in the calculation of the Fundamental Spread is a result of the close work between the ABI and EIOPA on this issue. This decision will benefit customers, and prevent them being offered higher annuity prices as a result of insurers needing to hold more capital. The Matching Adjustment is a key part of Solvency II for UK pension providers, and this necessary change will ensure it works as intended following lengthy negotiations on Solvency II.

"With just weeks until the start of Solvency II, firms will reflect this vital change as the industry works towards the smooth and successful implementation of the regime."

Notes for Editors

The Matching Adjustment (MA):

  • An adjustment (addition) to the discount rate used to calculate the present value of future liabilities. A higher discount rate means a lower value for the liabilities, increasing a firm’s available capital.
  • It is used by UK insurers when calculating the liabilities associated with their annuity business.
  • This is to reflect that when an insurer invests in assets using a “buy and hold” strategy, they are less exposed to short term market volatility
  • In the short term, an insurance firm faces the risk that the market value of its bond assets may fall and so could only be sold for less than expected. However in the long run, an insurer with long-term liabilities holds these assets to maturity for the purpose of fulfilling its obligations to policyholders — irrespective of any short-term asset price volatility
  • The matching adjustment (MA) looks to address the balance sheet volatility that some insurers would otherwise experience in the short term when using the market-consistent approach of Solvency II

Fundamental spread:

  • A component of the matching adjustment calculation used by firms
  • Whilst the matching adjustment calculation is specific to each firm, the fundamental spread that all firms must use is specified by EIOPA
  • It is a reduction to the MA to reflect the expect cost of default and downgrade of backing assets (typically government or corporate bonds). That is, the risk that a government or company does not make a payment which it has promised (i.e. it defaults), or the risk that a government’s or company’s credit rating gets downgrading.
  • Using a buy-to-hold strategy means that insurers are not exposed to the short-term fluctuations in the market value of those assets. However, they are still exposed to the risk that the asset defaults or has its credit rating downgraded.

Last updated 01/07/2016