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Dr Florian Ueltzhöfer

Actuary DAV/IVS

Teoman Kaplan

Actuary DAV

In our earlier instalments, we saw the positive impact of the CoViD market turmoil on the solvency ratio in countries like The Netherlands and Denmark. We have also seen these markets to be highly affected by the Volatility Adjustment (VA). To appreciate why these findings are not a coincidence, it is first important to understand how the VA works.

The VA is calculated based on reference portfolios determined by EIOPA, and updated annually. The EUR-currency portfolio is close to the average asset allocation of the Eurozone insurance market.* Below, on the left, you can see the bucket of investments, and their allocation as it was for most of 2020. Despite 27.9% of the portfolio being non-rate-sensitive, i.e., not contributing to the VA spread at all, we observe below, on the right, that the VA spread has increased from 7 bps as of Dec 2019 to 46 bps by the end of March 2020.

The implementation of the VA was made to counter spread volatility during market turmoil, as many insurers still invest in Fixed Income on a buy-and-maintain basis. When market values drop through spread-widening, the applicable VA increases. Ceteris paribus, the liabilities are calculated with a higher interest rate reducing their market value, and partially compensating the loss on assets. Hence, the volatility of the own funds should be reduced.

Nevertheless, even NL and DK have seen a significant volatility of the own funds, albeit to their benefit. It appears as if the losses and retrievals in the actual investment portfolios were overcompensated by the strong widening and tightening of the VA spread.

To underpin this claim, we would need to thoroughly analyse the balance sheet structure, i.e., the Duration Gap and the asset allocation. On the one hand, the Liability duration is about 14 years** in both markets, whereas the Asset duration is about 5 years (DK) and 9 years (NL) only. On the other hand, French and Italian Govies have a weight of 17% in the representative portfolio, which is quite high compared to the real asset allocation in those two countries. All in all, this principally leads to the massive increase of own funds in Q1 2020. The “overshooting” of the VA applied to the liabilities with a longer spread duration and a greater rate-sensitive balance-sheet ratio decreases the value of the liability relatively stronger than the losses incurred through spread-widening on ratesensitive assets.

This is of course just a very simple deduction. It still might explain most of the effects described. But as always in life there is more than just what is obvious on the surface… 

LOOKING FORWARD TO FUTURE DISCUSSIONS ON THIS CHANNEL!

EUR currency VA reference portfolio (2020/21) and monthly VA (Dec 2018 – Dec 2020)

Source: EIOPA, Risk-free interest rate term structures, Monthly technical information Dec 2018 – Dec 2020; own presentation.
* Denmark is using a separate DKK-currency reference portfolio.
** EIOPA, Report on insurers’ asset and liability management in relation to the illiquidity of their liabilities, Dec 2019.

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