Contrary to initial expectations, the recent update of the EU's Solvency II regulatory framework is set to ease insurers' capital requirements, rather than tighten them. In 2020, the European Insurance and Occupational Pensions Authority (EIOPA) estimated that Solvency II ratios could drop by about 20 percentage points (ppts) after implementation of the review; after the update, S&P Global Ratings now expects the insurance sector to benefit by up to 25 ppts on an aggregate basis. Our base-case estimate is that the industry could see total capital relief of up to €80 billion over 2026-2027, once EU member states implement the update.

Rising interest rates underpin this positive outcome. The Solvency II update includes several measures to ease capital requirements but the gap between the initial estimates and the final result is largely due to the sensitivity of Solvency II ratios to very low interest rates. Should interest rates repeat the "lower for longer" pattern seen between 2015 and 2021, much of the potential capital relief could dissipate.

EIOPA initially proposed the easing measures in 2020, to offset the tightening of rules that would have had a very negative impact on life insurance. The measures were proposed as part of the Solvency II review (see "EIOPA's Proposals Increase The Economic Sensitivity Of Solvency II, At A Cost To Some Life Insurers" published April 22, 2021). European policymakers subsequently expanded the easing measures to give insurers an incentive to make more long-term equity investments in the economy. Their aim was to support GDP growth prospects and to attract new sources of funding for energy transition infrastructure projects.

The two measures that tighten capital requirements are the removal of a floor at 0% on calibrating interest rate risk charges and a partial recalculation of the long-term discount rate. The impact of these measures has been blunted by the sharp rise in interest rates since 2020. Therefore, we no longer expect them to have a material impact on European insurers' solvency ratios.

Capital Relief Will Be Welcome, But Not A Game Changer

EIOPA's data shows that, at the end of 2022, aggregate available regulatory capital across the European insurance industry exceeded €1 trillion. This figure excludes the U.K. and Swiss insurance industries, which operate under different regulatory frameworks. On this scale, the estimated capital relief of up to €80 billion on an aggregate basis is considerable, but not critical. Nevertheless, insurers with long-tail lines, especially life insurers, could receive the lion's share of the benefits from the easing measures.

In deriving our estimate of the total benefit, we incorporated several high-level assumptions regarding the effect of each of the easing measures (see table 1). These assumptions will apply to all insurers that either use the standard Solvency II formula or combine a partial internal model with the standard formula. The impact of the Solvency II review on insurers that use a full internal model will be very limited because only the risk margin calculation will affect them.

Table 1

Risk margin reduction

We estimate that reducing the risk margin would bring total capital relief of €43 billion, or a 30% reduction in the risk margin.

The risk margin is an additional buffer added to the best estimates of technical reserves to ensure that insurers can meet their obligations. It is based on the assumed cost of capital for risks that cannot be hedged and is currently fixed at 6%. The update reduces the risk margin to 4.75% plus a "lambda" discounting factor of 97.5% per year.

EIOPA had initially proposed maintaining the 6% cost of capital and a using a higher lambda discounting factor. By contrast, the U.K. regulator, the Prudential Regulation Authority (PRA), cut the cost of capital to 4% and also allowed for a higher discounting factor. The change, implemented at the end of 2023, reduced the risk margin for many U.K. insurers by over 50% (see "Solvency U.K. Reforms: Not A Revolution For Insurers," published on May 7, 2024).

Increased application ratio on the volatility adjustment (VA)

This measure is expected to provide about €16 billion in capital relief to insurers which use the volatility adjustment, chiefly life insurers and composite insurers.

The VA is applied to the basic risk-free interest rate to mitigate the impact of short-term fluctuations in bond spreads on insurers' solvency. To prevent insurers from gaining excessive benefits by using the VA, an application ratio is used to reduce the benefit available. The final review increases the application ratio to 85% from the current 65%.

Reduced correlation between spread risk and interest rate risk

Our estimate of the capital relief from this measure is based on EIOPA's 2020 estimate that it would improve the solvency ratio by 3 percentage points.

The update reduces the correlation between spread and interest rate risk to 25% from 50%, which increases diversification benefit.

Extending the 22% risk charge to long-term equities

The Solvency II update widens the scope of long-term equity investments (LTEI) that would be eligible for the more-favorable 22% regulatory risk charge. Although we estimate that this measure could bring €15 billion in capital relief, we see the relief as more hypothetical than the other measures. An insurer will not automatically benefit from capital relief on its equity holdings; the capital relief only applies to LTEI that the insurer identifies to regulators as an investment that it has committed to holding for more than five years.

In calculating our estimate of the benefit, we assume that European insurers will move 80% of their €100 billion unlisted equity portfolio (Source: EIOPA) to long-term equity investments (LTEI) that qualify for the capital requirement of 22%. Unlisted equities have a capital requirement of 49%, net of the assumed regulatory diversification benefit of 30%.

The measure is, however, much more lenient than the current rules for LTEI eligibility, which requires that:

• LTEI are ring-fenced and matched with an identified pool of technical reserves; and
• Insurers demonstrate that they would be able to hold the LTEI for at least 10 years, under stressed conditions.

Increased Sensitivity To Interest Rates Adds An Element Of Uncertainty

The update includes two measures that EIOPA forecast in 2020 would tighten capital requirements:

• The removal of the 0% floor for calibrating interest rate risk charges; and
• The partial recalculation of the long-term discount rate beyond 20 years, to the ultimate forward rate (UFR).

In our view, the negative impact of the two tightening measures has disappeared because of the current interest-rate environment. Nevertheless, if risk-free interest rates were to drop sharply to the level seen in 2020, European insurers' solvency ratios would still take a hit.

The Solvency II update increases the sensitivity of solvency ratios to low interest rates. In June 2020, the removal of the 0% floor when applying the stressed interest curve to determine the corresponding risk charge would have resulted in an interest rate shock, with negative rates up to 28 years maturity (see chart 1). EIOPA therefore estimated a 12-ppt negative impact on solvency ratios. However, given the current interest rate, the 0% floor no longer has any impact on risk charges.

Chart 1

To calculate the long-term discount rate after year 20, insurers currently use a linear extrapolation between the risk-free interest rate curve and the UFR. After the Solvency II update, they will use the weighted average of market rate and that same linear extrapolation. In June 2020, EIOPA estimated that this recalculation would have depressed solvency ratios by 36 ppts. However, since then, the euro risk-free discount rate has risen sharply, while the UFR has declined to 3.3% (see chart 2). As the two rates converge, the impact of the update decreases. Based on current figures, the change will no longer have a material impact on solvency ratios.

Chart 2

New Requirement To Model Climate Risks Is Welcome

Insurers are now required to conduct long-term climate scenario analysis as part of their ongoing own risk and solvency assessment. The analysis should be run at least every three years. This new requirement was introduced following the Solvency II update and is already in place. Although we recognize the modeling and data challenges that insurers face in developing reliable scenarios analysis, we welcome the development of climate risk modeling. In our view, structural risk trends associated with climate change will be one of the industry's biggest obstacles in the coming years.

The new regulation will require insurers to run a minimum of two long-term climate change scenarios, such as:

• A scenario where temperatures rise by no more than 2C above pre-industrial levels (the goal of the Paris Agreement); and
• A scenario where temperatures rise much higher.

Solvency II Ratios Could Diverge From Our Measure Of Capital Adequacy

A change to the Solvency II regulatory framework for calibrating risk charges does not alter how we measure capital adequacy using the S&P Global Ratings risk-adjusted capital model. Making aggressive use of the capital relief available under the Solvency II update could therefore create a diverging trend, whereby Solvency II ratios rise while our view of capital adequacy remains stable or even declines. In our opinion, the key question is how insurers intend to make use of the capital released through the easing measures:

• Divergence will remain limited for insurers that use the buffer to gradually accelerate revenue growth and make incremental shifts to long-term equities. We therefore see little potential rating impact.
• Capital adequacy would be undermined, in our view, if insurers were to use the capital relief to significantly increase investments in long-term equities or make large shareholder payouts. This could depress our ratings on an insurer if it has thin capital adequacy buffers relative to its capital and earnings assessment.

In particular, the update creates a gulf between the treatment of Type 2 unlisted equities that are eligible for the 22% risk charge on LTEI under Solvency II versus our capital model. The risk charge would be 60% lower under Solvency II (see chart 3).

Chart 3

Although LTEI qualification was introduced in 2018, the restrictions were so strict that it was very difficult to implement. The update significantly eases treatment of LTEI under Solvency II, making them a potentially attractive way of reducing the risk charge. This could increase the share of private equity (especially related to the energy transition) in investment portfolios. Insurers will also be able to apply LTEI to private equity funds that are classified as "low risk" under Solvency II; the definition of low risk will be further clarified in the Solvency II technical documentation (referred to as delegated acts), as well as in member states' legal interpretation of the Solvency II update.

Therefore, we restricted our estimate of the impact of the LTEI risk charge to the existing amount of unlisted equity investments. Insurers have invested about €100 billion in unlisted equity, in aggregate. We estimate that the bulk of this could be shifted to LTEI-eligible holdings. We have insufficient information to accurately forecast the potential shift in insurers' aggregate investment mix toward private equity funds and unlisted infrastructure equity funds.

European insurers have considerable flexibility to increase their equity investments. EIOPA reported that the industry held over €5.6 trillion in investments, excluding unit-linked assets, at end-2022. Of this, 4% was in listed and unlisted equities and 22% was in funds, including some in private equity and infrastructure funds.

Implementation Will Take At Least Two Years

In our opinion, insurers' solvency ratios are unlikely to be affected until 2026. The EU's member states will incorporate the revised Solvency II directive into their national regulations over the next two years.

Our estimate that insurers could see €80 billion in capital relief by 2026-2027 is our base case. In the long term, however, this capital relief is uncertain--structurally low growth prospects in most European countries could create a downward trend in long-term interest rates. This had occurred before the pandemic.

The current interest-rate volatility could provide European insurers with a further incentive to increase their exposure to long-term equities. Given the huge cost of financing energy transition infrastructure, European governments have publicly announced their intention of harnessing the investment capacity of the insurance industry. As such, European insurers may feel that the regulatory benefits of contributing to the financing of the green transition amount to a moral obligation.

Related Research

• Solvency U.K. Reforms: Not A Revolution For Insurers, May 7, 2024
• European Commission Proposes New Tools For Insurance Regulators, Oct. 26, 2021
• EIOPA’s Proposals Increase The Economic Sensitivity Of Solvency II, At A Cost To Some Life Insurers, April 22, 2021
• European Insurers: Capitalization Appears Resilient Under Solvency II, Somewhat Less Under Our Capital Model, May 28, 2020