See all chapters of A Guide to Solvency II.
This chapter discusses the valuation of assets and liabilities under Solvency II. Given that strategic asset allocation and investment management are key aspects of an insurer’s business, especially for life insurers, this is an important area of focus across the industry.
In addition, given the opportunities for the deployment of sophisticated asset management techniques, and for the gathering of long-term assets under management (AUM), insurers have become a significant area of focus for alternative asset managers. Indeed, some alternative asset managers have, in large part, effectively become insurance businesses.
The chapter covers the general principles applicable to valuation, the so-called “valuation hierarchy,” the specific rules for some balance sheet items and the interaction with certain accounting standards. Recent trends regarding investments into illiquid or alternative assets are also examined.
Valuation principles applicable to technical provisions are not covered in this chapter. Instead, please consult Chapter 7: Technical Provisions.
1. An Introduction to the Solvency II Valuation Concepts
The valuation of assets and liabilities under Solvency II is based on market value. This means that assets and liabilities should be valued at the amount for which they could be traded in an arm's length transaction.330
This approach has a number of upsides. It is based on objective, and in many cases readily ascertainable, data points, and is also intended to reflect the realistic proceeds, which could be achieved on sale. Consequentially, this approach interacts with the regulatory objectives of ensuring appropriate capitalisation of insurance undertakings, and ultimately policyholder protection and stability in the financial system.
At the same time, this approach is not without its critics — who particularly point out that (putting the matching adjustment regime and credit risk on one side) a market valuation ignores a basic premise of asset/liability matching, which states that assets in some cases simply will never be immediately required, so the day-to-day market value of an asset that has a certain maturity value is less relevant.
The basic framework is supplemented by the general principle that assets and liabilities shall be recognised and valued in according with International Financial Reporting Standards (IFRS) provided that they are consistent with the Solvency II approach.331 If the IFRS approach is inconsistent, then valuation methods that are consistent must be used.
2. Application of the Market Valuation Concept in Practice
Application of the market value concept is not always straightforward. It is important to understand how insurers apply this approach in practice, especially when not all assets and liabilities have readily observable market prices or pricing data, particularly given the trend toward greater investment into illiquids or alternatives, such as private credit and real estate.
Solvency II recognises that the available level of market data varies between asset classes, and is frequently driven by factors including the existence (or nonexistence) of a public market and the trading volume and liquidity in the market concerned.
3. The Valuation Hierarchy
The Solvency II regime332 provides a valuation hierarchy that insurers must follow when valuing their assets and liabilities. The valuation hierarchy consists of four levels, reflecting the degree of reliance on market inputs and permitting the use of alternative valuation methods where necessary.
Level 1 – Quoted Market Prices for the Same Assets
The first level of the valuation hierarchy is the default valuation method and uses quoted market prices in active markets for the same assets. This is regarded as the most reliable and objective method to value assets, since it reflects actual transactions and the expectations of market participants.
Level 2 – Quoted Market Prices for Similar Assets With Adjustment
Where the level one valuation is not possible, the second level of the valuation hierarchy is next considered. This uses quoted market prices in active markets for similar assets, and applies an adjustment to reflect the differences between the assets being valued and the ones for which market prices are available.
The adjustments in the second level should take into account factors such as:
- The condition and location of the asset.
- The extent to which the inputs relate to items that are comparable to the asset or liability.
- The volume or level of activity in the markets within which the inputs are observed.
Level 3 – Use of Market Inputs to Greatest Extent Possible
If the first and second levels are not applicable, assessment moves to the third level of the valuation hierarchy, which applies where there are no market prices available for similar assets in active markets. In these circumstances, Solvency II requires that relevant market inputs should be used to the greatest extent possible. Inputs which are specific to the insurer should be relied upon as little as possible.
Relevant market inputs include:
- Quoted prices for identical or similar assets in inactive markets.
- Inputs other than quoted prices that are observable, including interest rates and yield curves, implied volatilities and credit spreads.
- Market corroborated inputs, which may not be directly observable but are based on observable market data.
These market inputs should be adjusted for the factors that we mentioned prior, such as the condition, location, comparability and traded volume of the assets.
Level 4 – Use of Alternative Valuation Techniques
Where no observable inputs are available, the fourth and final level of the valuation hierarchy applies — and alternative valuation techniques may be used. This allows use of unobservable inputs that reflect the assumptions that market participants would use when pricing the assets and liabilities concerned, including risk assumptions.
Undertaking-specific data may be used, but where there is reasonable available information indicating that other market participants would use different data or there is something particular to the undertaking that is not available to other market participants, the data should be appropriately adjusted.
Solvency II then provides that alternative valuation techniques should be consistent with one or more of the following approaches:
- Market approach: uses prices and other relevant information generated by market transactions involving identical or similar assets, liabilities or group of assets and liabilities.
- Income approach: converts future amounts, such as cash flows or income or expenses, to a single current amount. The fair value is to reflect current market expectations for those future amounts. Valuation techniques consistent with the income approach include present value techniques, option pricing models and the multi-period excess earnings method.
- Cost approach or current replacement cost approach: reflects the amount that would be required currently to replace the service capacity of an asset. From the perspective of a market participant seller, the price that would be received for the asset is based on the cost to a market participant buyer to acquire or construct a substitute asset of comparable quality adjusted for obsolescence.
4. Prohibited Valuation Methods
Solvency II prohibits the use of valuation methods that are not consistent with the market approach, such as:
- Valuing financial assets or liabilities at cost or amortised cost.
- Using models based on the lower of the carrying amount and fair value less costs to sell.
- Valuing property, investment property, plant and equipment at cost less depreciation and impairment.333
5. Specific Rules for Certain Items
There are also specific valuation rules for certain items, such as contingent liabilities, goodwill and intangibles, holdings in related undertakings and deferred tax assets.
Contingent Liabilities
Contingent liabilities are liabilities that may arise from uncertain future events or existing conditions that are not yet confirmed. Solvency II requires the recognition of material contingent liabilities, based on the risk free discounted present value of future cash flows required to settle the contingent liability concerned.334
Contingent liabilities will be material if they could influence the decision-making of the recipient of the disclosure, for example, the regulator. Note that the Solvency II approach is stricter than that of the International Accounting Standard (IAS), where contingent liabilities are disclosed and continuously assessed, rather than recognised.335 Under the IAS rules, contingent liabilities are provided for if there is a present obligation, where payment is more likely than not and the amount can be estimated reliably.
Goodwill and Intangibles
For goodwill and intangibles, which are assets that arise from investment, business combinations or non-physical and non-financial transactions, Solvency II requires a valuation of zero, unless the assets can be sold separately and a valuation can be derived from a quoted market price in an active market for the same or a similar intangible asset.336 An example of this would be an asset related to software development, which would be capable of being realised by separate sale.
Again, it is important to note that this approach is different from, and stricter than, the approach under IFRS. IFRS allows recognition of goodwill, for example following an M&A transaction, where the consideration paid by the purchaser exceeds the fair value of the assets acquired.337
With the effluxion of time and developments in technology, this has perhaps become one of the more controversial areas of the Solvency II regime. By preventing insurers from recognising most investments in technology as an asset and forcing them to expense such investment as an annual cost through their profit and loss statement, this approach arguably stifles innovation — controversially, as insurance is one of the areas that could most obviously benefit from developments in artificial intelligence.
Holdings in Related Undertakings
A holding in a related undertaking refers to an insurer that holds a participation in another company with which it has a special relationship, such as a subsidiary, although a range of scenarios can potentially be relevant.
Solvency II has a specific valuation hierarchy for holdings in related undertakings:338
- The first level of this hierarchy is to use quoted market prices in active markets for the same assets, which is the same as in the general hierarchy.
- The second level of this hierarchy is to use an adjusted equity method, which is to value the holding based on the share of the excess of assets over liabilities of the related undertaking, as valued by Solvency II.
- Where the first and second levels are not possible, and where the undertaking is not a subsidiary undertaking, the third level will apply. This level uses market prices for similar assets, adjusted for relevant differences. In certain circumstances, specific alternative valuation methods may also be used, which permit an IFRS-like approach but deduct items like goodwill and other intangible assets.339
It is important to note that if the related undertaking is excluded from group supervision, or deducted from the own funds eligible for group solvency, in most cases a valuation of zero must be applied.
Consequently, it is important to remember the treatment of participations in the calculation of own funds. In summary, and save when an exception applies,340 participations may have to be (to a greater or lesser extent, depending on the circumstances) be deducted from the value of group own funds where they involve the holding of interests in financial or credit institutions or investment firms (on a solo basis a capital charge is instead applied in the equity risk sub-module).341
An entity may be excluded by the group supervisor if it is (i) in a third country and there are legal impediments regarding obtaining the required information, (ii) negligible in the context of the objectives of group supervision, or (iii) such that its inclusion would be inappropriate or misleading given the objectives of group supervision.342
Deferred Taxes
Solvency II requires insurers to recognise and value deferred taxes if they relate to an asset or liability that is recognised for solvency or tax purposes under Solvency II. Generally, therefore, the position under IAS 12 (Income Taxes) is followed.343
There are some modifications to the IAS 12 rules. Other than in respect of deferred tax assets deriving from the carry-forward of unused tax credits or unused tax losses, deferred tax assets are valued as the difference between the tax basis and the Solvency II valuation — not the IFRS valuation.344
In addition, a deferred tax asset can only have a positive value if it is probable (more likely than not) that the asset can actually be used against future taxable profit. This requires consideration of any legal or regulatory constraints on the time limits relating to the carry forward of unused tax losses or the carry forward of unused tax credits.345
Finance Leases
For finance leases, Solvency II generally requires insurers to apply a fair value method. This is slightly different from IFRS, which measures finance leases as an asset and liability using the lower of fair value and present value of the minimum lease payment in some circumstances.346
Property, Plant and Equipment
For property, plant and equipment, Solvency II also requires a fair value method. It does not permit valuations based on cost or cost less depreciation and impairment.347
6. Illiquid or Alternative Assets
This subject is of particular interest to many private equity sponsors, other alternative asset managers and insurers, namely the recent trend toward insurers making investments in illiquid or alternative assets.
Background
Illiquid/alternative assets are broadly defined as assets that are more difficult to trade than conventional publicly traded bonds and equities. Since they have less liquidity, it can also be more difficult to price these assets accurately as there are not as many obvious precedent transactions available. Illiquid/alternative assets include types of private credit, commercial real estate and infrastructure.
Insurers are increasingly seeking to invest into assets that offer improved returns. Often, their association with a private equity sponsor, or other alternative asset manager, also brings with it increased sophistication, especially where the incoming manager is familiar with a broader range of illiquid/alternative assets. Illiquid/alternative assets can offer an investment profile that is similar to traditional assets — for example regarding maturity and the level of risk — while promising higher returns, often driven by illiquidity premium or sourcing premium (i.e., they return more as they are difficult to sell and/or source).
In this area, regulators are looking to strike a balance between two competing considerations. On the one hand, they want to ensure that insurers have fully assessed and understood the risks attached to the acquisition, holding, performance and disposal of these assets. On the other hand, they do not want to deter insurers from investing into these assets, given they often have positive macroeconomic consequences and there is a political tailwind associated with some of them (e.g., investment in public infrastructure).
Regulators are becoming increasingly sceptical about cross-border asset-intensive reinsurance (funded reinsurance) transactions that facilitate great use of illiquids/alternatives than would be permitted in the home jurisdiction. They are also likely to exercise particular scrutiny over insurers that appear to be used simply as asset gathering vehicles.
Because of this, the Prudential Regulation Authority (the PRA) has articulated considerations for insurers and their asset managers concerning illiquid/alternative assets.
Regulatory Concerns
Three key considerations are relevant regarding regulatory concerns:
- First, insurers must consider the application of the prudent person principle. They must ensure they have an appropriate governance framework in place for investing into and holding illiquid/ alternative assets. This may include considering at a high level what types of illiquid/alternative assets are appropriate for the insurer to invest in. The insurer should only invest into assets for which it has the relevant knowledge, and where it has thoroughly assessed the risks and rewards.
- Second, any investment into illiquid/alternative assets should only be as part of a well-diversified portfolio. Liquidity risk must be appropriately managed. Insurers will need to assess what percentage of their portfolio they can defensibly invest into illiquid/alternative assets. This needs to involve stress-testing the portfolio and identifying cross-contagion risks between assets in stressed scenarios.
- Third, the insurer needs to consider the staff it employs to ensure they are suitably skilled to handle the investments being contemplated. This is also important when the insurer chooses to outsource their investment activities — in which case the assessment needs to extend to the investment manager.
Valuation Considerations
The Solvency II preferred valuation approach relies heavily on publicly available and objectively verifiable market data. By definition, this may be harder to come by for illiquid/alternative assets. This can take a number of forms: there may simply be less data available, the data may be less recent or it may be more difficult to establish pricing for comparable assets.
Where market pricing is not available, Solvency II mandates the use of alternative valuation approaches. This can include valuation based on pricing or other information from transactions in assets that are comparable, as well as valuation based on the cash flows that will be generated by the asset — a process alternative asset managers are usually comfortable with and experienced in.
Either way, where quoted market prices are not readily available, insurers should be prepared to justify their valuation approach to the regulator. For insurers that routinely invest in illiquid/alternative assets, it may also be necessary to establish and document a valuation framework and relevant valuation procedures. This is particularly the case in a matching adjustment context.
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330 Recital 45 Solvency II; Article 75 Solvency II.
331 Article 9 Delegated Regulation.
332 Article 10 Delegated Regulation.
333 Article 16 Delegated Regulation.
334 Articles 11 and 14 Delegated Regulation.
335 IAS 37 (Provisions, Contingent Liabilities and Contingent Assets).
336 Article 12 Delegated Regulation.
337 IFRS 3 (Business Combinations) and IAS 38 (Intangible Assets).
338 The definition of related undertaking is complex. It includes a subsidiary undertaking (a broader concept than a subsidiary relationship), an undertaking in which a participation is held, or an undertaking linked with another undertaking by a relationship per Article 12(1) Directive 83/349/EEC (unified undertakings).
339 Article 13 Delegated Regulation.
340 There is an exception for strategic participations, which are included in the group solvency calculation using the accounting consolidation method.
341 See paragraph 12 in Chapter 1: Own Funds.
342 Article 214(2)(a) Solvency II as referenced by Article 13(2) Delegated Regulation.
343 Article 15(1) Delegated Regulation.
344 Article 15(2) Delegated Regulation.
345 Article 15(3) Delegated Regulation; PRA Supervisory Statement 38/15.
346 IAS 17 (Leases).
347 Article 16 Delegated Regulation, cf. the differing approach under IAS 16 (Property, Plant and Equipment), which requires an initial valuation at cost and then subsequent revaluations at cost less depreciation and impairment, or fair value less subsequent depreciation/impairment (where fair value may be reliably measured).
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