Circular NBB_2025_06 / Circular on the Valuation of Mortgage Loans under Solvency II

NBB_2025_06 – April 15, 2025 Communication – p. 1/7 14 Boulevard de Berlaimont – BE-1000 Brussels tel. +32 2 221 27 31 enterprise number: 0203.201.340 RPM Brussels www.nbb.be

Circular
Public
Brussels, April 15, 2025
Reference: NBB_2025_06
Your contact:
Antoine Nyssen tel. +32 2 221 26 80 antoine.nyssen@nbb.be

Circular on the Valuation of Mortgage Loans under Solvency II

Scope
Belgian insurance or reinsurance undertakings (excluding small Belgian insurance undertakings referred to in Articles 275 and 276 or local undertakings referred to in Article 294 of the Solvency II Law).
Branches established in Belgium of insurance or reinsurance undertakings subject to the law of states that are not members of the European Economic Area.
Entities responsible for a Belgian insurance or reinsurance group within the meaning of Articles 339, 2°, and 343, paragraph 2, 1° and 2° of the Solvency II Law, for which the Bank has been designated as the group supervisor within the meaning of Articles 407 and 408 of the aforementioned Law.
Entities responsible for a Belgian financial conglomerate within the meaning of Article 340, 1° of the Solvency II Law, for which the Bank has been designated as the group supervisor within the meaning of Articles 471 and 472 of the aforementioned Law.

Summary/Objective
This circular aims to explain the parameters and methodology to be taken into account in the context of the valuation of mortgage loan portfolios held by Belgian insurance and reinsurance undertakings.

Dear Sir, Dear Madam,

1. Context
   Mortgage loans represent an increasingly significant investment for Belgian insurance and reinsurance undertakings. A significant proportion of mortgage loans currently originates from abroad, particularly from the Netherlands. This trend is partly explained by the fact that the Netherlands has a more liquid mortgage market, offering attractive investment opportunities for Belgian insurers. Due to their importance, the National Bank of Belgium (hereinafter "the Bank") actively monitors various developments related to mortgage loans held by insurance undertakings. In this regard, two circulars have been issued on this subject:

• Circular NBB 2018-27 - Reporting on mortgage loans for insurance undertakings
  The International Monetary Fund (IMF), as part of the analysis of the Belgian financial system (Financial Sector Assessment Program - FSAP 2018)1, formulated a series of recommendations for the Belgian financial sector, including the insurance sector. One of these recommendations concerns the prudential supervision of the exposure of Belgian insurers to mortgage loans. The Bank was invited to closely monitor the risks associated with mortgage loan portfolios, both from a micro-prudential and macro-prudential perspective. In response to this recommendation and due to limitations in the information available in Solvency II reporting, the Bank implemented additional reporting on mortgage loans, covering both a micro-prudential and macro-prudential perspective, with distinct stakes and scope.
• Circular NBB 2019-27 - Expectations of the Belgian macro-prudential authority regarding the internal implementation of Belgian mortgage credit standards applied by banks and insurance undertakings operating on the Belgian residential real estate market
  This circular clarifies the explicit expectations formulated by the Bank, acting as the macro-prudential authority, regarding the internal management of Belgian mortgage credit standards applied by banks and insurance undertakings operating on the Belgian residential real estate market. Through this initiative, the Bank aims to limit the accumulation of new vulnerabilities in Belgian mortgage loan portfolios. In a context of high volatility in financial markets, the valuation of mortgage loans held by insurance undertakings has a significant impact. Unlike credit institutions that distinguish between a banking book and a trading book, mortgage loans, like other assets held by insurance undertakings, are always valued at market value under Solvency II. This circular aims to clarify the Bank's expectations regarding the valuation of mortgage loan portfolios held by Belgian insurance and reinsurance undertakings.

2. Entry into Force
   This circular will apply no later than from June 30, 2025.
   1 Cf. https://www.imf.org/external/np/fsap/fsap.aspx Communication - p. 2/7 NBB_2025_06 - April 15, 2025

3. Legal Basis - Regulation

• The Law: the Law of March 13, 2016 on the status and supervision of insurance or reinsurance undertakings.
• Regulation 2015/35: the Delegated Regulation (EU) 2015/35 of the Commission of October 10, 2014 supplementing Directive 2009/138/EC of the European Parliament and of the Council on the access to and exercise of the activities of insurance and reinsurance (Solvency II).
  Article 75 of Directive 2009/138/EC of the European Parliament and of the Council of November 25, 2009 on the access to and exercise of the activities of insurance and reinsurance, transposed into Article 123 of the Solvency II Law, stipulates that for insurance undertakings, assets are valued at the amount for which they could be exchanged in a transaction concluded under normal competitive conditions between informed and willing parties.
  Article 9 of Delegated Regulation 2015/35 sets out the general principles of valuation methods for liabilities and assets. Asset valuation must comply with international accounting standards adopted by the Commission under Regulation (EC) No 1606/2002 of the European Parliament and of the Council of July 19, 2002 on the application of international accounting standards, provided that these standards prevail over valuation methods consistent with the valuation method provided for in Article 75 of Directive 2009/138/EC.
  Article 10 of Delegated Regulation 2015/35 establishes the hierarchy of valuation methods. Mortgage loans, due to their nature, are generally valued based on alternative valuation methods. In accordance with IFRS 13.3, insurance and reinsurance undertakings rely as little as possible on entity-specific data when using alternative valuation methods. To the extent possible, companies use relevant market data to value their mortgage loans.
  Article 10, paragraph 7 of Delegated Regulation 2015/35 stipulates that when using alternative valuation methods for mortgage loans, companies must adopt techniques consistent with one or more of the following approaches:
  a) market approach; b) income approach - Cash flows; c) cost approach or current replacement cost approach.

4. Main Observed Mortgage Loan Valuation Methods
   Since mortgage loans are not traded on liquid markets, their valuation relies on the discounting of cash flows. In practice, two predominant methodologies are generally observed to determine this discount rate: the "top-down" method and the "bottom-up" method. Both approaches, when correctly applied, are valid and compatible, their choice often being dictated by the type of product and geographic origin. Hybrid methods between "top-down" and "bottom-up" are also conceivable and observed. These hybrid approaches generally involve calculating a valuation by taking an average of the estimates obtained from the two methods.

4.1. "Top-down" Methodology
With the "top-down" method, for a given loan at time t, the discount rate will correspond to the commercial interest rate currently offered for an equivalent loan, i.e., for a loan presenting similar characteristics (LTV, DSTI, etc.) and a maturity corresponding to the residual maturity of the loan in question. In this calculation, the interest rates of the initial loan are replaced by the average market rates at time t. In other words, instead of using the specific interest rates of the loan to calculate the discount rate, the top-down method takes into account the average rates offered on the market at that precise moment. This approach aims to reflect current market conditions and ensure that the discount rate is in line with rates practiced on the market. To use this method, it is necessary to have detailed information on the rates currently offered on the market. This is possible, for example, on a transparent market such as that of the Netherlands. In fact, for (almost) all mortgage loans marketed in the Netherlands, the top-down method is used. In this case, the interest rate is determined based on public pricing grids.

4.2. "Bottom-up" Methodology
The discount rate in the "bottom-up" methodology is composed of the risk-free rate plus a "spread". The risk-free interest rate is directly observable on financial markets. However, the "spread" is not directly observable, and it is generally composed of various sub-elements. Although not all insurance undertakings using the "bottom-up" method use the same elements or terminology, we can distinguish several parameters to obtain the discount rate. Other elements may also be included in the valuation, but the following elements must at least be covered. Of course, provided that all risks are taken into account, these elements can be aggregated together or subdivided into sub-categories.

Bottom-up method (BE)
Risk free rate
+
Default Risk
Liquidity Premium
Capital Cost premium
Service Cost
Prepayment risk*

Risk-free rate: Insurance undertakings will use a discount curve based on market swap rates which will serve as the basis for determining the discount interest rate of the mortgage loan portfolio for its valuation.
Default risk: This component aims to compensate for expected losses due to credit risks in the mortgage loan portfolio. In other words, it takes into account the probability that some borrowers may not be able to (fully) repay their loan, resulting in losses for the insurance company. The impact of defaults will take into account the impairment of the collateral, its realization delay, and the recovery probability. Liquidity Premium: The liquidity component aims to compensate for the lack of liquidity of the mortgage loan portfolio. Capital cost premium: This component represents compensation for the holding of regulatory capital required due to mortgage loans. This premium compensates for the costs associated with mobilizing this capital under regulation. Communication - p. 4/7 NBB 2025 06 - April 15, 2025

Service cost: The service cost component aims to compensate for the ongoing costs related to the management and administration of mortgage loans. These costs include loan monitoring, payment processing, document management, and other operational fees. For insurance undertakings, the consideration of mortgage loan management costs must be allocated between expenses related to the 'best estimate' and those related to the valuation of mortgage loans. The requirement is to avoid any double counting and to ensure that amounts are fully reflected, without any omission. This is essential to maintain accuracy and transparency in the evaluation of the mortgage loan portfolio. The allocation between the 2 elements must be justified and comply with Solvency II principles. Costs related to the product and departments for the management of mortgage loans must be fully taken into account. However, one-off underwriting fees are not taken into consideration, as a market actor acquiring the portfolio would not be required to bear these costs. Prepayment risk: This component encompasses the impact of early repayments of mortgage loans, including both the early repayments themselves and the uncertainties related to prepayments resulting from interest rate fluctuations. It will thus be calculated using a stochastic model that will take into account unexpected early repayments as well as the sensitivity of these prepayments to the evolution of the economic environment.

5. Recommendations Related to the Valuation of Mortgage Loans
   Recommendation 1 - Choice of valuation methodology: For insurance undertakings that have decided to use one or the other of the two methods described above ("top-down" or "bottom-up"), the Bank may require these companies to proceed with a re-evaluation of a sample of the portfolio using the other method, following the principle of proportionality described below. The re-evaluation of a sample of the portfolio using the other method will be carried out for portfolios meeting the "PHL micro" reporting criteria set out in Circular NBB_2018_27, namely insurers whose exposure to national and international residential mortgage loans exceeds:

• 5% of their entire investment portfolio, excluding investments held as part of branch 23 products;
• or 650 million euros.
  For the insurance undertakings concerned, the Bank will require auditors to perform a number of agreed procedures and to draw up a special report on this subject (cf. Article 334 of the Law). A first special report will be prepared based on the valuation at December 31, 2025. For subsequent years, depending on the results and the evolution of risks, the Bank will determine the frequency and scope of companies for which this special report will be requested. The Bank will communicate the precise terms of this mission to the auditors and the concerned companies in a separate letter.

Recommendation 2 - Day-1 valuation: Upon the origination of a mortgage loan, it is generally expected that its initial valuation, or "day-1", is close to its nominal value. Although a slight profit margin may be included, the profit arising from a mortgage loan, excluding market fluctuations, is generally spread over the life of the loan. If the Day-1 valuation is higher than the nominal value of the loan, it is recommended that insurance undertakings demonstrate that this is due to marketing at an interest rate higher than the market rate. This practice should allow the company to justify cases where the initial valuation is slightly higher than the nominal value of the mortgage loan. NBB_2025_06 - April 15, 2025 Communication - p. 5/7

Recommendation 3 - Pre-payments: Insurance undertakings must calibrate their pre-payment model based on the sensitivity of their mortgage loan portfolio. This calibration may depend on several parameters, such as the mortgage loan interest rate, market rates, rate review, and remaining loan term. Insurance undertakings should aim to use the most appropriate model for their mortgage loan portfolio. The previously cited parameters may vary depending on the origin of the loans and their characteristics.

Recommendation 4 - Non-performing loans: A widely accepted classification to identify non-performing exposures, also known as "non-performing loans", can be based on Article 202 of European Regulation 2015/35. This classification includes, in a non-exhaustive manner, defaulted loans, loans in arrears for more than 90 days, etc.
Their valuation must be carried out separately from other mortgage loans and using particularly prudent assumptions regarding default probability and collateral resale to account for the uncertain repayments of these loans.

Recommendation 5 - Reference rates in the "top-down" methodology: Companies will ensure that the rates selected based on the "top-down" methodology are sufficiently representative. Some interest rates, although displayed, may sometimes be used only for a very specific type of loan and thus rarely marketed. For the Dutch market, information is available (for a fee) on the volume of loans issued by term and by rate by a mortgage loan issuer. It will be verified that the selected interest rate has been sufficiently marketed and can therefore serve as a reference to be used as a discount rate. In cases where marketed volumes are too low, these will be removed from the analysis.

Recommendation 6 - Alignment of loan characteristics: In the context of the "top-down" methodology, the insurer must ensure that the characteristics (bullet loans, LTV, DSTI, repayment types, etc.) of the underlying loans used for the valuation of its mortgage loans do not differ from the characteristics of the mortgage loans to be assessed in its own balance sheet. Similarly, in the case of the "bottom-up" methodology, it is expected that the underlying parameters for determining the valuation spread are calibrated based on the characteristics of the mortgage loan portfolio or portfolios.

Recommendation 7 - Use of data: In accordance with the principles set out in Article 22 of Delegated Regulation 2015/35 concerning technical provisions, it is recommended that the insurer avoid using entity-specific information for the valuation of mortgage loans. Under normal circumstances, internal financing costs, internal equity costs, or internal commercial mortgage interest rates are not relevant for determining the price that a market participant is willing to pay for these loans. When possible, the insurance company should use market data for the valuation of mortgage loans. In the context of "top-down" valuation, the company will base its valuation on rates offered on the market, provided that the characteristics of the loans correspond well to those available on the market. However, in cases where it is impossible to obtain market rates, the company may use its own marketing rates. This approach allows reflecting market conditions and ensuring a realistic valuation of mortgage loans.

Recommendation 8 - Outsourcing: In all cases where the valuation of mortgage loan portfolios is carried out by the mortgage loan issuer or by the intermediary body between the insurance company (Belgian) and the issuer, this falls under the outsourcing described in the Solvency Law (Article 92) and in Delegated Regulation 2015/35 (Article 274). Circular NBB_2020_017 on governance sets out the various obligations regarding outsourcing in point 3 - Outsourcing. Communication - p. 6/7 NBB 2025 06 - April 15, 2025

Recommendation 9 - Documentation: Companies must maintain complete and up-to-date documentation of their valuation model. Thus, they will justify the value of all parameters they use in their valuation model and adaptations to their risk profile. These parameters will be regularly subjected to sensitivity tests and updated, if necessary.

A copy of this circular is sent to the approved auditor(s) of your company.
Please accept, Sir, Madam, the expression of our distinguished consideration.

Pierre Wunsch
Governor

Tim Hermans
Director - Secretary

Vincent Magnée
Director

NBB_2025_06 - April 15, 2025 Communication - p. 7/7