Circular NBB_2016_16 / Circular on guidelines for the treatment of market and counterparty risk exposures in the standard formula

NBB_2016_16 – 25 April 2016 Circular – Page 1/5 boulevard de Berlaimont 14 – BE-1000 Brussels tel. +32 2 221 38 12 – fax +32 2 221 31 04 company number: 0203.201.340 RPM Brussels www.bnb.be

Circular Brussels, 25 April 2016 Reference: NBB_2016_16 your contact: Kajal Vandenput tel. +32 2 221 51 77 – fax +32 2 221 31 04 Kajal.vandenput@nbb.be

Circular on guidelines for the treatment of market risk and counterparty risk exposures in the standard formula

Scope Belgian insurance or reinsurance undertakings. Insurance or reinsurance undertakings that are part of a Belgian group within the meaning of Article 339, 2°, of the Law of 13 March 2016 on the status and supervision of insurance or reinsurance undertakings. Belgian undertakings that are part of a Belgian financial conglomerate within the meaning of Article 340, 1°, of the aforementioned Law of 13 March 2016. Branches of undertakings from third countries carrying on insurance [or reinsurance] activities in Belgium. This circular applies to mutual insurance companies as defined in Article 15, 79° of the aforementioned Law of 13 March 2016. For these undertakings, "the Bank" should be replaced by "the Office for the Supervision of Mutualities and National Unions of Mutualities" as defined in Article 15, 84° of the same Law. This circular does not apply to insurance undertakings referred to in Articles 275, 276 or 294 of the aforementioned Law of 13 March 2016.

Subject This circular aims to explain the Bank's guidelines regarding the treatment of market risk and counterparty risk exposures in the calculation of the solvency capital requirement under the standard formula.

Legal References The Law: The Law of 13 March 2016 on the status and supervision of insurance or reinsurance undertakings. Regulation 2015/35: Delegated Regulation (EU) 2015/35 of the Commission of 10 October 2014 supplementing Directive 2009/138/EC of the European Parliament and of the Council on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II).

Circular – Page 2/5 NBB_2016_16 – 25 April 2016 Structure I. Objectives II. Definitions III. Additional Information IV. Entry into Force V. Guidelines on the treatment of market risk and counterparty risk exposures in the standard formula

Madam, Sir,

I. Objectives This circular relates to Articles 154 to 160 of the Law, as well as Articles 164 to 202 of Regulation 2015/35. It aims to provide additional specifications on the treatment of market risk and counterparty risk exposures in the standard formula.

II. Definitions For the purposes of this circular, the following definition has been developed:

• "short equity position": a short position relating to equities resulting from a short sale within the meaning of Article 2(1)(b) of Regulation 236/2012. In the absence of a definition in this circular, terms have the meaning defined in the legislative and regulatory acts referred to therein.

III. Additional Information This circular is part of the harmonised implementation of the principles of Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II), as determined by the guidelines of the European Insurance and Occupational Pensions Authority. Undertakings may consult these guidelines for information at the following address: https://eiopa.europa.eu/publications/eiopa-guidelines.

IV. Entry into Force This circular applies from 23 March 2016.

NBB_2016_16 – 25 April 2016 Circular – Page 3/5 V. Guidelines on the treatment of market risk and counterparty risk exposures in the standard formula

Guideline 1 – Extra-legal benefits to employees If liabilities for extra-legal benefits to employees are accounted for in accordance with Chapter II of Regulation 2015/35, undertakings should take them into account in the calculation of capital requirements for the "counterparty risk" and "market risk" modules. For this purpose, undertakings should take into account the nature of the benefits and, where applicable, the entirety of contractual agreements with a professional pension institution, as defined in Directive 2003/41/EC, or another insurance or reinsurance undertaking providing these benefits. If the management of assets representing liabilities for extra-legal benefits to employees is outsourced, undertakings acting as sponsors should take this into account when calculating the capital requirement for the "market risk" and "counterparty risk" modules, insofar as they are responsible for any loss in the value of these assets.

Guideline 2 - Influence of redemption options on duration When determining the duration of bonds and loans with redemption options, undertakings should take into account the possibility that they will not be redeemed by the borrower if their credit quality deteriorates, if credit spreads widen, or if interest rates increase.

Guideline 3 – Average duration of the "equity risk" sub-module based on duration Undertakings should interpret the average duration referred to in Article 162 § 1, second paragraph, point c) of the Law as the duration of the aggregated cash flows of the liabilities.

Guideline 4 – "Interest rate risk" sub-module Undertakings should include all assets and liabilities sensitive to interest rates in the calculation of the capital requirement for the "interest rate risk" sub-module. The technical provision should be recalculated according to scenarios using the risk-free interest rate curve after the shock, determined by stress-testing the base risk-free interest rate curve and adding the equalisation adjustment, volatility adjustment, or transitional measure on risk-free rates, where applicable. The value of assets should be recalculated according to scenarios by applying stress tests only to the base risk-free interest rate curve, and any margins relative to the base risk-free interest rate curve should remain unchanged. This may involve the use of a model-based valuation to determine the value of assets subject to stress tests. Insurance and reinsurance undertakings should ensure that asset values before stress tests obtained using model-based valuation are consistent with the prices of relevant assets on active markets.

Guideline 5 - Investments with characteristics of equities and debt securities If assets exhibit characteristics of both debt securities and equities, undertakings should take both traits into account when determining the applicable sub-module of the standard formula. When determining the applicable sub-modules of the standard formula, undertakings should take into account the economic substance of the asset. If the asset can be considered as comprising distinct components, undertakings should, where applicable, apply the relevant stress tests to each of these components separately. If it is not possible to consider the asset as comprising distinct components, undertakings should determine the applicable sub-modules of the standard formula based on the predominance of debt or equity characteristics in an economic sense.

Circular – Page 4/5 NBB_2016_16 – 25 April 2016 Guideline 6 - Short equity positions If undertakings hold short equity positions, these should only be used to offset long equity positions in the calculation of the capital requirement for equity risk, if the conditions set out in Articles 208 to 215 of Regulation 2015/35 are met. Undertakings should not take into account any other short equity positions (residual short equity positions) in the calculation of the capital requirement for equity risk. The value of residual short equity positions should not be considered as increasing due to the application of equity stress tests. This guideline also applies to short bond positions used to offset long bond positions in the calculation of the capital requirement for spread risk, if the conditions set out in Articles 208 to 215 of Regulation 2015/35 are met.

Guideline 7 – "Market risk concentration" sub-module Without prejudice to Article 187(3), second paragraph, of Regulation 2015/35, undertakings should not assign a risk factor of 0% to investments in entities belonging to the entities listed in Article 187(3) of Regulation 2015/35.

Guideline 8 – Securities lending transactions and similar agreements When determining capital requirements for securities lending or borrowing transactions and repo agreements including liquidity swaps, undertakings should follow the accounting treatment of the elements exchanged in the Solvency II balance sheet. They should also take into account the contractual terms and risks arising from the transaction or agreement. If the lent asset remains on the balance sheet and the received asset is not accounted for, undertakings should: a) apply the relevant "market risk" sub-modules to the lent asset; b) include the lent asset in the calculation of the capital requirement for counterparty risk on Type 1 exposures, taking into account the risk mitigation provided by the received asset if it is accounted for as collateral in accordance with the requirements set out in Article 214 of Regulation 2015/35. If the received asset is accounted for and the lent asset does not remain on the balance sheet, undertakings should: a) apply the relevant "market risk" sub-modules to the received asset; b) take into account the lent asset in the calculation of the capital requirement for counterparty risk on Type 1 exposures based on the book value of the lent asset at the time of the exchange, if the contractual terms and legal provisions in the event of the borrower's insolvency create the risk that the lent asset will not be returned even though the received asset has been returned. If both the lent asset and the received asset are accounted for in the Solvency II balance sheet, undertakings should: a) apply the relevant "market risk" sub-modules to the lent asset and the borrowed asset; b) include the lent asset in the calculation of the capital requirement for counterparty risk on Type 1 exposures, taking into account the risk mitigation provided by the received asset if it is accounted for as collateral in accordance with the requirements referred to in Article 214 of Regulation 2015/35; c) take into account liabilities on its balance sheet resulting from the lending agreement in the calculation of the capital requirement for the "interest rate risk" sub-module.

Guideline 9 – Commitments likely to give rise to payment obligations In accordance with Article 189(2)(e) of Regulation 2015/35, the capital requirement for Type 1 exposures in the "counterparty risk" module should be applied to legally binding commitments that the undertaking has issued or agreed to.

NBB_2016_16 – 25 April 2016 Circular – Page 5/5 When no nominal value is explicitly indicated in the commitment agreement, undertakings should determine the corresponding loss given default as provided for in Article 192(5) of Regulation 2015/35 based on an estimated nominal amount. The estimated nominal amount is the maximum amount that could be paid in the event of a credit event concerning the counterparty. A copy of this circular is sent to the auditor(s) and statutory auditor(s) of your undertaking. We ask you to accept, Madam, Sir, the expression of our distinguished sentiments.

Jan Smets Governor