12 April 2017

Changes to UFR may impact ability to pay dividends

The European Insurance and Occupational Pensions Authority (EIOPA) has published changes to insurers’ ultimate forward rate (UFR) under the Solvency II framework, to be applied for the first time at the beginning of 2018. The consequences will vary across insurance products, but the main impact will be felt by life insurers because of their long-term liabilities.  As a result, insurers might find it more difficult to obtain approval from the Dutch Central Bank before distributing dividends.

Insurers’ liabilities can have maturities of several decades, making it difficult to determine their value. The market for long-term liabilities is less liquid, making market information less reliable. For this reason, the Solvency II’s ultimate forward rate is applied to convert the yield curve used to calculate the present value of long-term liabilities (with maturities exceeding 20 years) into a fixed level. As a result, the solvency calculation is also more stable.

However, in the current low interest environment, the application of the UFR (currently 4.2%) has the effect of increasing rates with maturities exceeding 20 years. A lower UFR intends to correct for the lower interest rates.

The Solvency II framework did not contain the methodology for calculating the UFR. After launching a consultation in 2016, EIOPA published the methodology on 5 April 2017. The methodology will be applied for the first time at the beginning of 2018. According to the methodology, the UFR for the euro is 3.65%. As annual changes will not be higher than 0.15% and the current UFR is 4.2%, there will be a phasing-in period. In January 2018, the UFR will be 4.05%.

In general, the change in UFR will impact Dutch life insurers, which have many long-term liabilities. A consequence might be that they may find it more difficult to obtain Dutch Central Bank approval for dividend distributions. The Dutch Association of Insurers has released a press release urging the European Commission not to implement the UFR change in the short term. In line with earlier statements by the European Parliament and the Commission, the association suggests not reviewing the UFR in isolation, but waiting until a full review of Solvency II can take place.