The Solvency II Review and its measures for Long-Term-Guarantees (LTG) comprise significant changes to the in-force Interest Rate (IR) extrapolation and Volatility Adjustment (VA) methods. With the 2027 go-live of Solvency II Review approaching, insurance companies must adapt processes now to ensure both operational efficiency and regulatory compliance of their LTG measures.
Interest Rate Extrapolation: A shift towards market sensitivity
Under Solvency II, risk-free discount rates are derived from market prices of financial instruments. Due to limited depth, liquidity and transparency (DLT) at longer maturities, EIOPA employs the Smith-Wilson method to extrapolate risk-free rates beyond the Last Liquid Point (LLP) towards an Ultimate Forward Rate (UFR). This approach, based solely on the liquid market data before the LLP, has been criticized for ignoring post-LLP market data and failing to appropriately reflect changing market conditions for longer tenors.
New Extrapolation Method:
To address these limitations, an alternative extrapolation method will be introduced. A key feature is the inclusion of the Last Liquid Forward Rate (LLFR), which is calculated as a weighted average of forward rates based on liquid tenors after the first smoothing point (FSP). Blending the LLFR and UFR ensures that all available market data is considered for the construction of the risk-free interest rate curve, while also leading to a smoother convergence from observed market rates to the UFR.
Key methodological changes include:
- Smoother transition to the UFR, replacing the Smith-Wilson method’s direct and exponential convergence of the forward rates
- The convergence parameter α set to 11% for most currencies, resulting in reduced anchoring to the UFR compared to the Smith-Wilson extrapolation in low-interest-rate regimes
- Improved adaptability to market dynamics after the FSP via the LLFR
Volatility Adjustment: Tailored to undertaking-specific characteristics
The Volatility Adjustment under the current framework is built from two components: a currency and a country specific component, which are both based on a centrally defined EIOPA reference portfolio. Amongst others, the approach has been criticized for insufficiently accounting for insurers' risk profiles and for applying a risk correction that is mostly insensitive to credit spread movements.
Changes to the VA Framework:
To address these limitations, the Solvency II Review proposes several modifications to the VA framework:
- Introduction of a credit-spread sensitivity ratio to better reflect each insurer’s actual risk exposure
- Introduction of a risk correction method based solely on credit spread data
- Replacement of the country component with a macro-VA that is based on Euro-area spreads and that allows to smooth sudden VA changes
- Introduction of an enhanced prudency principle for internal model applications to avoid overcompensation for credit spread movements
How d-fine can support you
The key updates to the IR extrapolation and VA frameworks under the Solvency II Review require a careful adaption of existing processes to stay compliant and operationally efficient.
d-fine offers extensive expertise in the field of Solvency II risk management and the LTG measures. We have implemented many Solvency II-compliant (dynamic) VA models and extrapolation approaches and are helping (re-)insurance companies in adapting their internal models to align with the updated LTG measures. Our in-depth knowledge of the insurance landscape, peer practices, and regulator expectations makes us your ideal partner to achieve targeted and effective solutions.
For more information on the Solvency II Review and how we can support you, please do not hesitate to contact us!
