Q&A

Question

We would like to seek for clarification with regard to the Q&A response no. 1678:

“The capital requirement for mass lapse risk in accordance with Article 142(6) of Commission Delegated Regulation (EU) 2015/35 should reflect the adjustments after the mass lapse event that the insurer would have to make to the expense component of the cash flow projection in the best estimate calculation. Whether and by how much future expenses can be reduced due to the lower number of policies depends on company specifics like the proportion of fixed and variable costs. Using the assumption of constant per policy expense for determining the capital requirement for mass lapse risk may in many cases be too optimistic with respect to the possibility to reduce costs.”

We agree with the principle highlighted that not all company expenses are variable and if the mass lapse event occurs in practice, the level of reduction in expenses is likely to be less than the reduction in policy counts, causing a rise in the future per-policy expenses.  

However, we don’t think Solvency II standard formula requires firms to review the per-policy expense assumption under mass lapse stress. If we review the expense assumption, wouldn't it result in contradiction / inconsistency with the market consistent construct of the Pillar 1 requirement as implied by Article 76 of the Level 1 Directive?

Background of the question

Our interpretation of the Solvency II level 1 Directive and level 2 Delegated Regulation is that we don’t think Solvency II standard formula requires firms to review the per-policy expense assumption under mass lapse stress for the following reasons: 1.    The response would contradict Article 76 of the Solvency II Level 1 Directive that “the value of technical provisions shall correspond to the current amount insurance and reinsurance undertakings would have to pay if they were to transfer their insurance and reinsurance obligations immediately to another insurance or reinsurance undertaking.  The calculation of technical provisions shall make use of and be consistent with information provided by the financial markets and generally available data on underwriting risks (market consistency).” In other words, firms should use market consistent expense assumptions for technical provisions calculation.  Market consistent expenses could be understood as a weighted average per-policy cost over all providers across the entire industry.  As firms don’t have access to the industry expense data, they often use their own per-policy expense experiences as proxy measures to market consistent expenses.  This is accepted as a general market practice. This can be understood as when insurance liabilities are up for sale (corresponding to the Level 1 requirement of market valuation), it would be the buyers’ expense experience that drives the market valuation of liabilities as opposed to the sellers’ expense experience. Hence the relevance of the firm’s own expense base is as an estimate for the market consistent value but this would not be a reliable estimate in the mass lapse event if expenses are handled as proposed. After a company experiences a mass lapse event, its own future per-policy expense may vary.  But the market consistent expense assumption isn’t likely to be materially affected.  Hence the market valuation of the liabilities should only reflect the reduction in the size of the book arising from mass lapse rather than allowing for the second order impact from the loss of expense economy. 2.    The response would also contradict a previous advice paper on Solvency II standard formula correlations which suggests that the correlation factor between expense risk and the lapse risk reflects the potential loss of economies as a result of the mass lapse event. Any additional increase in per-policy expenses under the mass lapse stress would therefore amount to double counting of losses.

EIOPA answer

This question has been rejected because the matter it refers to has been answered in Q&A 1678 , which remains valid. Article 75 requires market consistent valuation for assets and liabilities, and assumptions on best estimate valuation, including expenses, to be consistent with the characteristics of the portfolio of insurance and reinsurance obligations. However, market data may not be available or not properly reflect the characteristic of the portfolio. For this reason, undertaking should use undertaking specific data where the calculation of technical provisions in a prudent, reliable and objective manner without that information is not possible. As the stress scenario includes situations where many undertakings would be affected by a deterioration in their economies of scale, market consistency is not contradicted.