Covid-19 and Solvency II – No time to lose

01 June 2020

by Lieve Lowet

This is the last part of a series of three articles about my investigation into Covid-19 and Solvency II. We have already published two interesting blogs, which can be found in the related items section. The first part was about buying time and data and the second part was about the Covid-19 pandemic risk. In the light of the Solvency II review, one question is whether pandemic risk is adequately dealt with in the solvency capital requirements. Are the calibrations and parameters in the life and health underwriting risk submodules for catastrophic risk still in line with the (new) insights and observations of a worldwide pandemic, such as COVID-19? And if not, is an adaptation necessary? Are additional parameters required?  

The next question is automatically whether pandemic risk is properly captured in the non-life underwriting risk module, and whether it matters for each line of business.

  • In case pandemic risk is currently part of the framework, are there new insights which suggest further fine tuning of the existing underwriting risk framework for certain LOBs?
  • Should pandemic risk be included in underwriting risk beyond the current LOBs?
  • And if yes, where? Should there be a limit? Should that limit be defined EU wide?

But above all, the impact hitherto stretches beyond the risk categories that were considered relevant for a pandemic situation when Solvency II was developed more than 10 years ago. From what we observe today, a pandemic, such as COVID-19, has the potential to impact more than only underwriting and operational risks. This has come as a surprise. The pandemic has impacted financial markets and its consequences stretch beyond underwriting and operational risks into market risk, credit risk, and liquidity risk. Should the standard formula risk modules be adapted for the new insights obtained from this stressed environment?

  • Regarding market risk, EIOPA observed that the market impact of the ongoing COVID19 crisis could lead to a situation where a large share of corporate and government bonds could be downgraded. If bonds currently rated BBB would be downgraded to non-investment grade this would lead to losses of about 1,6% of total EEA (including UK) investments. What would be the impact of pro-cyclical credit downgrades on the solvency position of the sector? In addition, volatility has increased in several equity markets.
  • Regarding credit risk, there are heightened and /or perceived risks of downgrades and defaults. There is talk about ballooning credit spreads. What will this do to recoverables? What is the impact of loans and mortgage payment moratoria? Will state guarantees on credits and credit lines have an impact?
  • Regarding liquidity risk, excess mortality claims but also premium payment holidays combined with increased lapses and withdrawals especially in the area of life savings and pension insurance due to lack of income may be observed. Combined with potential lower new business volumes in the light of deteriorating financial conditions, and reductions in the liquidity of an insurer’s portfolio’s asset classes, liquidity risk might be impacted.

The key question in all the above is if and how far policymakers can reasonably extend the capital and risk management requirements of the insurance and reinsurance sector and stretch its capacity? Should pandemic risk coverage more broadly be included in the SII framework? The current storm around business interruption (BI) insurance, especially non-damage BI and event cancellation insurance definitely puts this pressing question on the table. The insurance industry (in some countries) is knocking on the door of governments and public authorities requesting a public private solution for the future in the broader area of catastrophe risk.

Stephen Davies, head of Education at the Institute of Economic Affairs, London, wrote a month ago in a Briefing Paper “Going Viral: the history and economics of pandemics”: “Historical comparisons tell us a number of things about pandemics, which are also true in this case: they break out after prolonged periods of increasing economic integration; the initial foci are connected cities that are centres of trade and/or governance; the pattern is usually one of a series of waves, with the second one historically the most damaging…. We should be aware that, on historical precedent, the pandemic will last for about 18 months (so to summer 2021); that there will be another pandemic at some point and for structural reasons this is more likely than was the case a number of decades ago.” Without waiting for the next pandemic, our reflection on incorporating into Solvency II our new insights should start. Remembering Davies’ words, there is no time to lose.

The author, Lieve Lowet is an EU Affairs consultant and lobbyist since 2003, focuses on European dossiers relevant for the insurance and pension sector. From 2003 to 2008, she was Secretary-General for the international mutual insurance association AISAM (now AMICE), which accounted for 15% of the European and 6% of the world insurance market. Prior, she worked for McKinsey as a European banking and insurance expert. 

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