European insurers could handle Covid-redux, but may be leaning too much on loopholes, says regulator

European insurers could handle another pandemic-induced economic crunch without major breakdowns in solvency or liquidity, but resilience in the industry might be overly built on use of regulatory loopholes, some of which are set to be closed within a decade, the European regulatory office EIOPA said in its latest round of stress tests.

Asked how they would fare in a Covid-style shock that sent 28 bps (basis points) into average 10 year sovereign yields, increased sovereign risk spreads, drove the corporate sector to "widespread insolvencies" with spreads up 71 to 269 bps across sectors and took a quick 45 percent out of equity markets, all but a handful of major European insurers could pass the regulatory bar. EIOPA's scenario further added a layer of insurance-specific shocks, including payment lapses, mass surrenders, a rise in mortality and frequency, severity and premium problems across non-life.

Solvency II capital ratios would fall from an opening 218 percent to just under 126 percent with 9 out of 44 study participants falling below the 100 percent regulatory threshold, but no one going negative equity. Insurers applying select rescue actions in the hypothetical stress scenario would add 13.6 percentage points to the aggregate SII ratio and allow 7 of the 9 troubled insurers to stay above the regulatory minimum.

But those measures show an industry over-reliant both on long-term guarantee (LTG) mechanisms designed to dull the solvency impact of market volatility and on the variety of transitional measures designed to ease the industry from Solvency I to Solvency II but which will be removed from the framework by 2032, EIOPA authors noted.

Excluding the impact of the transitional measures alone, regulatory solvency would fall from an estimated 205 percent to 111 percent or 124 percent if allowing managers to make emergency adjustments. The number falling below the regulatory thresholds would rise to 15 of the 44-strong group (10, after adjustments).

The LTG, an accounting means allowing insurers to gloss over market volatility in solvency calculations, is an even greater crutch. Removing both the LTG and transitional measures, an aggregate solvency ratio of 173 percent today falls to 47.2 percent or 55 percent if allowing managers to manage their balance sheets in reaction.

In that scenario, a full 31 out of 44 surveyed entities would fall under the minimum solvency threshold (27 after allowing for the constrained adjustments) and eight slip to outright negative equity (7 after adjustments).

"Overall, the capital component of the exercise confirms that the main vulnerabilities come from the market shocks,” authors wrote. Nonetheless, “the European insurance industry proves (with limited exceptions) that through the enforcement of reactive actions it is able to cope with such an adverse development of the markets.”

Emergency responses to the shock chiefly include profit-retention and de-risking of investment portfolios, but with some imagining they would be able to issue fresh equity or sub-debt, albeit at discount prices. Investment portfolio de-risking "can potentially" have a material impact on the fixed-income market, authors added.

The impact of the shock scenario on liquidity would run some €10 billion beyond the industry's ready cash pile, a shortfall easily covered through sale of liquid assets, authors noted.

"The liquidity component confirmed that the liquidity position is less of a concern than the capital and solvency positions for the European insurance industry, since the large amount of liquid assets held by insurers can be used to cover the extra liquidity outflows generated by adverse circumstances," authors wrote.

Outflows in the stress scenario would include a rise in surrenders from €32.2 billion to €346.7 billion. Claims would be up by some €21.8 billion on the mortality shock, followed by a €13 billion decline in premiums, authors suggested.

The study covered 43 insurance groups and one stand-alone insurer, covering 75 percent of the European Economic Area insurance sector by assets. The liquidity study was run on the 117 component stand-alone units.

Did you get value from this story?  Sign up to our free daily newsletters and get stories like this sent straight to your inbox.