PRA Reviews Solvency II Effective Value Test Parameters
PRA published a statement on the review of Solvency II Effective Value Test (EVT) parameters applicable from September 30, 2020. PRA has set the minimum deferment rate used in the EVT at 0.5% per annum while the volatility parameter to be used in the EVT remains at 13% per annum. Firms that have elected to use a minimum deferment rate of 0% to conduct the EVT prior to December 31, 2021 may continue to do so, notwithstanding the minimum deferment rate published in the statement. However, when conducting the EVT, all firms should use the published volatility parameter mentioned in the statement, regardless of the minimum deferment rate they are using.
PRA has set out the EVT in the supervisory statement (SS3/17) on illiquid unrated assets under Solvency II. PRA expects that firms will use the EVT as a diagnostic tool to monitor compliance with Solvency II requirements related to the calculation of the matching adjustment benefit where liabilities are matched by restructured equity release mortgages, recognizing the risks arising from the no negative equity guarantee feature. The minimum deferment rate parameter is an annual discount rate that applies to the current value of a property to give a price that would be agreed and settled today to take ownership of the property at some point in the future.
The minimum deferment rate in the policy statement (PS31/18) on equity release mortgages, as of December 2018, was 1% per annum, which was reduced to 0.5% per annum in September 2019 following a review of movements in long-term real interest rates. For the review in September 2020, PRA has again examined long-term real interest rates, measured using a range of swaps-based data sources, at a range of long-term tenors from 10 to 30 years. The PRA’s judgment, informed by this analysis, is to retain the minimum deferment rate used in the EVT at 0.5% per annum. PRA will keep the minimum deferment rate under review.
The volatility parameter is used in modeling the extent to which property prices could vary in the future. PRA has analyzed house price indices from Nationwide and the Office for National Statistics up to first quarter of 2020. A time series model was fitted to quarterly log-returns from each of these indices to derive values for long-term index volatility. These values were then adjusted to incorporate the effect of idiosyncratic behavior of individual properties (using data from the Land Registry). As a result of this analysis, PRA has decided to retain a value for the volatility parameter to be used in the EVT at 13%.
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Keywords: Europe, UK, Insurance, Solvency II, Effective Value Test, Minimum Deferment Rate, Volatility Parameter, Equity Release Mortgage, Matching Adjustment, PRA
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