Because strategically allocating assets and managing investments are key to an insurer’s business, valuing assets and liabilities is an important area of focus.

In this episode of “The Standard Formula,” host Rob Chaplin, head of Skadden’s Financial Institutions Group in Europe, is joined by associate Olivier Peeters for a conversation about Solvency II’s requirements for asset and liability valuation. Rob and Oliver cover the general principles and specific rules for some balance sheet items and explore recent trends regarding investments into illiquid, or alternative, assets.

💡 Meet Your Host 💡

Name: Robert Chaplin

Title: Partner, Insurance at Skadden

Specialty: Rob primarily focuses on transactional and advisory work in the insurance sector. He advises on mergers and acquisitions, disposals, joint ventures and strategic reinsurances. He also counsels on regulatory issues, with an emphasis on Solvency II. 

Connect: LinkedIn  

💡 Featured Guest 💡

Name: Olivier Peeters

What he does: Olivier advises insurers, brokers and private equity sponsors on mergers and acquisitions, disposals, investments, reorganizations, alternative transaction structures, multijurisdictional disputes and regulatory matters. 

Organization: Skadden

Words of wisdom: “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 assets, it may also be necessary to establish and document evaluation framework and relevant valuation procedures. This is particularly the case in a matching adjustment context.”

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The Standard Formula is a podcast by Skadden, Arps, Slate, Meagher & Flom LLP, and Affiliates. This podcast is provided for educational and informational purposes only and is not intended and should not be construed as legal advice. This podcast is considered advertising under applicable state laws.

From Skadden, The Standard Formula is a Solvency II podcast for UK and European insurance professionals. Join us as Skadden partner, Robert Chaplin, leads conversations with industry practitioners and explores Solvency II developments that matter to you.

Welcome back to The Standard Formula podcast. I'm Rob Chaplin. In today's episode, we're going to discuss an important topic, namely 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 in of long-term assets under management, or 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.

Today, I'm joined by my colleague, Olivier Peeters. Together, we'll cover 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. We'll also cover recent trends regarding investments into illiquid or alternative assets. Olivier, can you start by giving us a brief introduction to the valuation of assets and liabilities under Solvency II?

Hi, Rob. Great to be here. 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.

This approach has a number of upsides. It's 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. Obviously, this interacts with the regulatory objectives of ensuring appropriate capitalization of insurance undertakings, and ultimately, policyholder protection and stability in the financial system.

Thanks, Olivier. Let's now explore how insurers apply this approach in practice, especially when not all assets and liabilities have readily observable market prices or data, particularly given the trend towards greater investment into illiquids or alternatives, such as private credit and real estate.

That's a good point, Rob. Solvency II recognizes that the available level of market data varies between asset classes, and is frequently driven by factors including the existence or not of a public market and the trading volume and liquidity in the market concerned.

The Solvency II regime 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. Rob, why don't you walk us through these?

With pleasure, Olivier. The first level of the valuation hierarchy is the default valuation method. This uses quoted market prices in active markets for the same assets. This is regarded as the most reliable and objective way to value assets, since it reflects actual transactions and the expectations of market participants. Where this is not possible, the second level of the valuation hierarchy comes in. This uses quoted market prices in active markets for similar assets.

It then 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, and the volume or level of activity in the markets within which the inputs are observed. Olivier, please take us through the next level.

Thanks, Rob. The third level of the valuation hierarchy 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, and 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, and 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 before, such as the condition, location, comparability and traded volume of the assets.

Thanks, Olivier. Whether are no observable inputs available, the fourth and final level of the valuation hierarchy applies, and alternative valuation techniques may be used. This allows the use of unobservable inputs that reflect the assumptions that market participants would use when pricing the assets and liabilities concerned. This includes 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 the 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. First, the market approach, which uses prices and other relevant information generated by market transactions involving identical or similar assets, liabilities, or group of assets and liabilities.

Second, the income approach, which 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 about those future amounts. Valuation techniques consistent with the income approach include present value techniques, option pricing models, and the multi-period excess earnings method.

And third, the cost approach, or current replacement cost approach, which 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. Olivier, why don't you run us through some of the valuation methods that Solvency II says insurers should not use?

Thanks, Rob. Solvency II prohibits the use of valuation methods that are not consistent with the market approach, such as valuing financial assets at cost or amortized cost, using the lower of the carrying amount and fair value less costs to sell, or valuing property, investment property, planned and equipment at cost, less depreciation and impairment. There are also specific rules for certain items such as contingent liabilities, goodwill and intangibles, holdings and related undertakings, and deferred tax assets. Rob, let's explain how these items are valued under Solvency II.

Thanks, Olivier. Let's start with contingent liabilities, which 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.

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 under IFRS, where contingent liabilities are disclosed and continuously assessed rather than recognized.

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. An example of this would be an asset related to software development, which would be capable of being realized by separate sale.

Again, it's important to note that this approach is different from and much stricter than under IFRS. As a reminder, 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. Olivier, why don't you walk us through the treatment of holdings in related undertakings?

Thanks, Rob. A holding and a related undertaking refers to an insurer which 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 and related undertakings. 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 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. It's 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.

In addition, it's also important to remember the treatment of participations in the calculation of own funds. We've covered this before separately, but in summary, participations may have to be, to a greater or lesser extent, depending on the circumstances, be deducted from the value of own funds where they involve the holding of interests in financial or credit institutions or investment firms. Rob, please explain the rules applicable to deferred taxes.

Thanks, Olivier. Generally, Solvency II requires insurers to recognize and value deferred taxes if they relate to an asset which is recognized for solvency or tax purposes under IFRS. However, Solvency II applies some modifications to these rules. For example, certain deferred tax assets are valued as the difference between the tax basis and the Solvency II valuation, not the IFRS valuation.

In addition, a deferred tax asset can only have positive value if it is probable that the asset can actually be used against future taxable profit. This requires consideration of any legal or regulatory requirements on the time limits relating to the carry-forward of unused tax losses or the carry-forward of unused tax credits. Olivier, please walk us through the valuation methods applicable to finance leases in property, plant and equipment.

Thanks, Rob. For finance leases, Solvency II generally requires insurers to apply a fair value method. This is slightly different from IFRS, which for example, permits leases to use the present value of the minimum lease payment in some circumstances. As 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.

Thanks, Olivier. It's also interesting to note that in the EU, Solvency II generally requires valuation of assets in accordance with EU-endorsed IFRS. In the UK, not all companies report under EU-endorsed IFRS. Although there is the possibility of a derogation in practice, this has limited effects in the UK.

Let's move on to discussing a topic which will be of interest to many private equity sponsors, other alternative asset managers, and insurers, namely the recent trend towards insurers making investments in illiquid or alternative assets. Olivier, please introduce the topic.

Thanks, Rob. Illiquid assets are broadly defined as assets which are more difficult to trade than conventional publicly traded bonds and equities. Because they have less liquidity, it can also be more difficult to price these assets accurately, as there aren't as many obvious precedent transactions available. Illiquid assets include types of credit, commercial real estate, and infrastructure.

Insurers are increasingly seeking to invest into assets that offer improved returns. Oftentimes, their involvement 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 alternative assets.

Illiquid assets can offer an investment profile which is similar to traditional assets, for example, regarding maturity and the level of risk while promising higher returns, often driven by a liquidity premium or sourcing premium. That is, they return more, as they are difficult to 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. Because of this, the regulator has articulated considerations for insurers and their asset managers concerning illiquid assets. Rob, please walk us through these.

Thanks, Olivier. Three key considerations are relevant here. 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 assets. This may include, considering at a high-level, what types of illiquid 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 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 defensively invest into illiquid 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 that they are suitably skilled to handle the investments being contemplated. This is also important when the insurer chooses to outsource their investment activities. In that case, this assessment needs to extend to the investment manager. Olivier, please walk us through some of the valuation considerations relating to illiquid assets.

Thanks, Rob. As discussed, the Solvency II preferred valuation approach relies heavily on publicly available and objectively verifiable market data. Now, by definition, this may be harder to come by for illiquid assets. This can take a number of forms. There may simply be less data available, or 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 which are comparable, as well as valuation based on the cash flows which will be generated by the asset. A process which 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 assets, it may also be necessary to establish and document evaluation framework and relevant valuation procedures. This is particularly the case in a matching adjustment context.

That's an excellent note to end on, Olivier. Thank you to our listeners for joining us. We hope you'll continue to tune in for future episodes. If you have any questions or comments on any of the topics we spoke about today, or Solvency II in general, do please feel free to contact us. Thank you, and we hope you'll join us next time.

Thank you for joining us on The Standard Formula. If you enjoyed this conversation, be sure to subscribe in your favorite app so you don't miss any future episodes. Additional information about Skadden can be found at skadden.com.

The Standard Formula is a podcast by Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates. Skadden is recognized for its deep experience in representing insurance and reinsurance companies and their advisors on a wide variety of transactional and regulatory matters.

This podcast is provided for educational and informational purposes only, and is not intended and should not be construed as legal advice. This podcast is considered advertising under applicable state laws.