Fitch Ratings has said it expects investors to adopt the headline Solvency II (S2) ratio as their first measure of insurers’ capital strength, despite its flaws.

To draw valid conclusions on capital strength, the ratings agency said it will be essential to analyse not only the ratio itself, but also its calculation basis and sensitivities.

Fitch explained S2 has increased the focus on German life insurers’ exposure to low interest rates, which was largely hidden under Solvency I.

It expects the fuller S2 disclosure required in 2017 – including metrics without the benefits of transitional measures – to shed more light on this issue.

Many German life insurers are allowed to use 16-year transitional measures that shield their S2 ratios from the effects of low rates, according to Fitch.

But Dutch insurers facing low rates are not granted this option. To understand how the two markets’ S2 positions compare, Fitch Ratings said it would consider the ratios without transitional benefits, i.e. on a "fully loaded" S2 basis.
Even without transitional benefits, Fitch said S2 ratios may not be comparable.

For example, it said Aegon, Allianz, AXA and Prudential have large US operations, for which they feed US-based regulatory capital metrics into their group S2 ratios.

Fitch Ratings’ report Solvency II ratios move into the spotlight, said: "This reflects the provisional S2 equivalence granted to the US by the EC, which avoided the potentially awkward imposition of S2 on US businesses. However, US regulatory capital calculations differ significantly from S2, and group S2 ratios based on a blend of US and S2 numbers may be far removed from "true" S2."

Given this background, Fitch expects sovereign charges to be introduced for standard formula users, which would weaken S2 ratios for Italian insurers in particular.

Its report commented: "The 4.2% ultimate forward rate to extrapolate the forward curve for valuing long-term liabilities looks set to be reduced; this would weaken S2 ratios for several Dutch life insurers and accelerate the decline in German guaranteed savings business. We also expect an easing of the risk margin arising from longevity business – important for UK annuity providers."

Fitch said it will continue to assess insurers’ capital based primarily on its Prism Factor-Based Capital Model, as it believe Prism scores are more comparable than S2 metrics.