Volatility adjustment
A discount rate add-on switched on when credit spreads widen, designed to stop an insurer selling its bonds at the worst moment.
A life insurer holds its bonds to maturity to back long-dated liabilities. When credit spreads widen, the market value of those assets falls, while the cash flows it will collect stay the same. Booked as is, that spread would collapse its solvency ratio and push it to sell at the worst possible moment, the procyclical behavior regulation is precisely trying to prevent. The volatility adjustment, set out in Article 77d of the Solvency II Directive, therefore adds to the discount curve a fraction of the credit spread observed on a reference portfolio. The rate goes up and liability values come down, mirroring the fall in assets. The device is effective and contested for the same reason: it damps the volatility of the ratio, but it also hides it. And its calibration rests on a reference portfolio that belongs to no single undertaking. Its use is not automatic in every member state and must be disclosed, so strip it out before comparing ratios across insurers.
During the sharp widening of credit spreads in March 2020, the volatility adjustment published for the euro rose steeply, cushioning the fall in solvency ratios reported by European life insurers for the first quarter.
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