Fitch: Dutch, German Life Insurers Most Exposed to UFR Reduction
The UFR, which is currently set at 4.2%, is used to extrapolate the forward curve for valuing liabilities that have a long duration (over 20 years for euro business, over 50 years for sterling). The European Insurance and Occupational Pensions Authority (EIOPA), which has been reviewing the UFR, on Wednesday proposed a new methodology that would cut the rate to 3.7%, potentially over several years. Cutting the rate effectively increases the amount of capital that firms need to hold against these long-term liabilities and would therefore reduce insurers' solvency ratios under the new Solvency II (S2) regime.
If the UFR is cut, Dutch firms would probably face the biggest drop in solvency ratios because of their relatively high exposure to long-term guaranteed products and because the Dutch regulator has not implemented transitional measures to gradually phase in the impact of S2.
Delta Lloyd in particular could see a significant drop in its S2 solvency ratio due to its large annuity business. The insurer said in February that its 4Q15 solvency (including an equity raising) was 156%, but would have been 123% if the UFR was reduced by 1pp. The relationship will not be exactly linear, so the proposed 50bp reduction in the UFR might reduce the solvency ratio by less than half of the impact of a 1pp cut. Other Dutch insurers with less annuity business would probably see a smaller impact than Delta Lloyd, but the drop could still be significant.
German life insurers generally have portfolios even more skewed to long-term guaranteed products. But the impact on existing business would probably be substantially mitigated by the transitional measures that most German life insurers are using, which mean it will take 16 years for S2 to fully take effect. Notable German insurers not using these are Allianz and Munich Re, but their business profiles make their capital relatively insensitive to UFR changes.
However, a cut in the UFR would have an immediate impact on German life insurers' new business because transitional measures do not apply. This would make long-term guaranteed products more expensive and would add to the trend towards products with shorter or no guarantees, which is already well under way as a consequence of low interest rates.
UK life insurers also have large annuity portfolios, but the UFR only applies to sterling liabilities over 50 years, so the impact on UK firms would be negligible.
The 4.2% rate was based on judgement rather than a specific methodology, so EIOPA's plan to set out a precise way of calculating the UFR would increase transparency around S2 rules and would make it easier for insurers to predict and prepare for future changes in the rate. It could even enable insurers to hedge their S2 capital positions against UFR changes, although it is unclear whether this would be feasible or affordable.
Any changes to solvency ratios from a change to the UFR will not directly affect ratings, as we will continue to assess insurers' capital primarily using our Prism Factor-Based Capital Model. This model differentiates between insurers based on their exposure to long-term low interest rates, and we believe it offers better comparability between firms than S2 metrics.