Following pressure from UK insurers (largely through the Association of British Insurers (ABI)), an external review of European Insurance and Occupational Pensions Authority (EIOPA)’s fundamental spreads was conducted during November 2015. The results have led to a revised calculation model with a knock-on impact to the size of fundamental spreads.
"The first bit of good news is that nearly all fundamental spreads have reduced, albeit by varying degrees."
Those insurers with matching adjustment (MA) approval under Solvency II use the fundamental spreads in the calculation of their discount rate for technical provisions as a deduction from the expected asset yields to allow for defaults. The lower the fundamental spread, the higher the discount rate and the lower the technical provision.
The fundamental spread makes allowance for the cost of both asset defaults and downgrades. This review centred on a double-counting of the probability of default in the cost of downgrade calculation, which has been revised.
The first bit of good news is that nearly all fundamental spreads have reduced, albeit by varying degrees. The largest differences are seen in the non-financial sector data.
The table below shows reductions in the (full) fundamental spread between end October and end November for non-financials:
The most significant falls (highlighted in red) occur in the sub-investment grade asset classes, as can been seen in the credit quality step (CQS) columns 5 (corresponding to a B rating) and 6 (CCC and below). However, these assets are used sparingly due to their higher capital charges and the rules capping the MA benefit at BBB levels.
"Any firms who conducted a cost benefit analysis of the MA earlier in the year and decided against applying may want to revisit their conclusions."
We expect the real impact to be felt around the longer dated A and BBB (CQS 2 and 3) rated stocks. Differences of up to 35 basis points are still quite a significant shift. Previously, financials had been more attractive than non-financials in this range and that discrepancy has now largely disappeared.
If we consider the benefit of these new fundamental spreads across an entire typical MA portfolio, we expect an overall benefit of between 5 and 10 basis points, although the quantum is heavily dependent on the portfolio constituents. Not to be sniffed at, but also not quite the level of significance some commentators are reporting.
The fundamental spread calculations have changed numerous times since they started being produced in February 2015, resulting in lower figures. Any firms who conducted a cost benefit analysis of the MA earlier in the year and decided against applying may want to revisit their conclusions.