Solvency
Solvency: 3 technical terms explained – definition, synonyms and legal basis.
Interest Rate Risk
Synonyms: Zinsrisiko
Interest rate risk is the risk that an insurance company fails to earn, from its investments, the discount rate assumed in premium calculation.
Drivers
The extent of interest rate risk is determined by the gap between the current capital market rate and the discount rate assumed in premium calculation, the allocation of investments across asset classes, and the maturity structure of fixed-income holdings. It is particularly pronounced in traditional life insurance with long-term interest guarantees.
Assessment
Quantification is done through stochastic simulation: for a large number of possible capital market paths, the insurance portfolio and investments are projected until run-off and the present values of possible shortfalls are calculated. Under Solvency II, this present value may exceed the available own funds in only a very small share of scenarios (0.5 percent).
Management
To limit interest rate risk, insurers adjust investment and maturity structures and reduce guarantees in new business. However, the limited availability of long-dated fixed-income securities makes this difficult given the extremely long durations of many life insurance products.
Legal basis: EU: Solvency II
Yield Curve (Term Structure of Interest Rates)
Synonyms: Term structure of interest rates, Interest rate curve
The yield curve shows how the yields of comparable bonds depend on their remaining maturity at a given point in time, and it forms the basis for the market-consistent valuation of insurers' future payment obligations.
Concept
The term structure describes how the yield of comparable bonds (for example government bonds, covered bonds) depends on remaining maturity. Plotted graphically, this produces the yield curve. It enables present-value comparison of different cash flows with comparable default risk through market-consistent discounting.
Relevance for insurers
For Solvency II purposes, the swap term structure is often used as a proxy for a risk-free term structure, with European supervisors requiring a deduction (the “credit risk adjustment”) to correct for the risk premium embedded in swap rates. The resulting risk-free yield curve underpins the valuation of technical provisions.
Practical relevance
Movements in the yield curve directly affect the solvency ratio of life insurers, since they influence both the asset and liability sides of the balance sheet. Transitional measures such as the interest rate transitional measure soften this effect for legacy business.
Legal basis: EU: Solvency II
Interest Rate Transitional Measure
Synonyms: Zinstransitional
The interest rate transitional measure is a Solvency II transitional provision that allows insurers to temporarily approximate the risk-free yield curve used to value their obligations to an earlier Solvency I interest rate.
How it works
The adjustment is calculated as the difference between the interest rate applicable under Solvency I on 31 December 2015 and the market-consistent effective annual rate used since then under Solvency II. Since 2016 the size of the adjustment has decreased linearly from 100 percent of the calculated amount to zero percent on 1 January 2032.
Conditions
The transitional measure may only be applied to obligations concluded before 1 January 2016 for which no matching adjustment is used. It also requires supervisory approval, for example under section 351 of the German Insurance Supervision Act (VAG).
Practical relevance
The interest rate transitional measure eases the move from Solvency I to Solvency II for life insurers with large legacy portfolios by cushioning abrupt jumps in the valuation of obligations. It also prevents unwanted distortions in policyholders’ surplus participation during the transition period.
Legal basis: EU: Solvency II