Volatility adjustment under the loop
A Risk Management approach for the Volatility Adjustment
Each month EIOPA publishes the VA which is calculated based on a pre-defined reference investment portfolio, representing an average European insurer.
Under a Solvency II balance sheet, the liabilities are valued at Market Value.The Best Estimate of the Liabilities are calculated by discounting future cash-flows using the risk-free rate (RfR). On top of this risk-free rate, EIOPA allows under specific circumstances to add a “volatility adjustment” for long-term guarantees insurance products. This Volatility Adjustment (VA) aims to dampen irrational market developments that would result in unjustified credit spreads. More concretely, the purpose is to moderate the effect of deteriorating bond prices as a result of low market liquidity or as a result of an exceptional (non-credit related) widening of bond spreads.
While the use of a generic representative asset portfolio and the resulting adjustment on the liability discounting curve are desirable ensuring convergence in the calculation of the Solvency II ratio under pillar 1 quantitative requirements, it would be possible to tailor the approach as part of pillar 2 system of governance to make it fully up-to-date and insurer specific resulting in an “Own VA assessment”:
- We observe that, throughout Europe, the composition of insurer’s asset portfolios can differ quite significantly. From a risk management perspective, it would be more appropriate to start from an individual insurer’s asset portfolio and extract the non-default related fluctuations in market value of assets;
- If the VA is added towards the liabilities’ discounting curve, it is necessary to link assets and liabilities by taking into account the duration gap and the level at which liabilities are covered by the fixed income portfolio.
We introduce an alternative approach for determining the Volatility Adjustment which aims to meet the above objectives while respecting the VA purpose and the developments performed so far at EIOPA level.