Solvency II review may reinforce the mildly supportive backdrop for European sovereign credit

Overview

This report discusses the impact of the Solvency II review on European rates markets. The related measures are expected to be implemented by January 31, 2027. Core changes include lower capital requirements in some areas, improved treatment for long-term equity investment, adjustments to the long-term liability discount curve, enhancements to the Volatility Adjustment mechanism, and revisions to the combined shock parameters for rates and credit spreads. Goldman Sachs believes that while these changes may encourage insurers to raise allocations to equities and real-economy-related assets, they will also increase the importance of long-term market rates in liability valuation, thereby supporting demand for long-duration European government bonds.

Core views

The core view is that the net impact is supportive for European government bonds and sovereign credit. Although insurers' marginal future allocation to fixed income may decline, long-term liability valuation becoming more closely linked to market rates, long-dated bonds being cheap relative to swaps, and a regulatory framework that improves insurers' ability to withstand credit spread volatility should all help support demand for long-dated EGBs. The report particularly emphasizes that ahead of next year's elections in France and Italy, insurers may be better positioned to buy into widening domestic sovereign spreads counter-cyclically, or at least reduce pro-cyclical selling pressure.

Analysis framework

The report uses an analytical framework that combines regulatory rule changes, insurance asset-liability management, capital requirements, the choice of rates hedging instruments, sovereign spread credit risk, and the global long-end supply-demand environment. It first breaks down the effects of the Solvency II review on equities, interest rate risk, and credit spread risk, and then evaluates the market implications of these mechanisms in the context of current European long-end yields, bond-versus-swap valuations, the Dutch pension transition, geopolitical shocks, and energy price conditions.

Methodology notes

• Regulatory impact analysisSolvency II review

  Insurer capital requirements and asset-liability management constraints

  By analyzing changes in capital requirements, treatment of long-term equity investment, the liability discount curve, the Volatility Adjustment, and stress-test parameters, the report assesses how regulatory reform may alter insurers' asset allocation and hedging behavior.

• Rates market analysisLong-end rate hedging and bonds versus swaps

  Higher sensitivity of long-term liabilities to market rates

  When market rates beyond the 20-year tenor become more important for liability valuation, insurers may increase duration hedging; against a backdrop where long-dated government bonds are cheaper relative to swaps and receive more favorable regulatory treatment, bond demand may benefit.

• Sovereign credit stress analysisVolatility Adjustment and credit spread shocks

  Reducing insurers' pro-cyclical behavior during spread widening

  A higher VA mechanism that can adjust with spread moves, together with lower relevant parameters for combined rates and credit spread shocks, helps cushion pressure on capital ratios and reduces insurers' incentives to sell EGBs during periods of market stress.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• European Government Bonds (EGBs)

  Core beneficiary asset

  Strengths

  Higher rate sensitivity of long-term liabilities, long-dated bonds being cheap relative to swaps, more favorable regulatory treatment, and a stronger VA mechanism all support insurance demand.

  Weaknesses

  Insurers hold only about 10% of EGBs, limiting the overall market impact; marginal fixed-income allocation may also decline because of the shift toward equities and the real economy.

  Comparison

  Compared with swaps, long-dated government bonds are more likely to become insurers' preferred instrument for hedging duration under current valuations and regulatory treatment.

  Risks

  Global yields staying elevated, sovereign supply pressure, election risk in France and Italy, and uncertainty around regulatory implementation details.

• Long-dated EGBs versus swaps

  Positive relative-value view

  Strengths

  Although the Solvency II review and the Dutch pension transition do not give a clear signal for the direction of absolute rates, both may push long-dated bonds to outperform swaps.

  Weaknesses

  The Dutch pension transition has a more direct effect on swap hedging and is more concentrated in timing than the insurance discount curve transition.

  Comparison

  The report argues that the case for long-dated bonds to richen versus swaps is clearer than the directional call on outright rate levels.

  Risks

  If global long-end yields continue to rise or changes in swap demand exceed expectations, relative-value performance could be disrupted.

• European insurers and equity allocation

  Potential allocation direction encouraged by regulation

  Strengths

  Lower capital costs, broader eligibility for long-term equity investment, and a wider symmetric adjustment mechanism may improve capital requirement pressure during equity sell-offs.

  Weaknesses

  This may reduce marginal new allocation to fixed income and tilt insurance portfolios more toward risk assets.

  Comparison

  The benefit to equity allocation mainly comes from improved regulatory capital treatment, rather than being the report's main rates-market trade conclusion.

  Risks

  Equity market volatility, pressure on capital ratios, and uncertainty over returns on real-economy investments.

• French and Italian sovereign credit

  Stronger risk buffer ahead of elections

  Strengths

  Insurers have a strong home bias in domestic sovereign bonds, and an enhanced VA may allow them to better absorb widening in domestic spreads and allocate counter-cyclically.

  Weaknesses

  Political events may still trigger short-term spread volatility, and insurance demand cannot fully offset a rise in market risk premia.

  Comparison

  Compared with broader European sovereign bonds, France and Italy face greater event risk because of next year's elections and thus better illustrate the importance of the regulatory buffer mechanism.

  Risks

  Election outcomes, fiscal concerns, rating changes, and market liquidity shocks.

Key data

• Implementation date2027-01-31Adjustments under the Solvency II review must be transposed into national law and implemented by this date.
• Key tenor of the liability discount curve20yThe 20-year tenor is set as the First Smoothing Point where the discount rate begins converging toward the UFR; if long-end market liquidity improves, the impact of market rates could extend further.
• Government bond allocation of insurers in some countries>50%The report states that government bonds account for more than 50% of insurers' financial assets in some countries.
• Equity allocation share<10%Equities held directly or through funds by insurers are in many cases less than 10% of financial assets.
• Share of EGBs held by insurersabout 10%; about 25% for tenors above 15 yearsThis limits the effect of improved insurance demand on overall yield levels, though the correlation is higher at the long end.
• Impact of sovereign spread stress on solvency ratios50bp widening corresponds to a median of about -4.5%For the median insurer in the SXIE sample, the Solvency Capital Ratio deteriorates by about 4.5% under a 50bp spread widening.
• Combined shock correlation parameter25%, previously 50%The lower parameter in scenarios where rates rise alongside credit spread widening helps ease deterioration in capital ratios.
• Discount curve transition period2027-01 to 2032-01The impact of the new lower extrapolated discount curve on insurers' duration hedging will be phased in gradually over five years.

Impact & implications

In terms of investment implications, the report is more constructive on long-duration European government bonds and the sovereign credit backdrop than on a simple prediction of sharply lower yields. The regulatory changes may strengthen insurers' ability to allocate to long-dated bonds, absorb sovereign spread volatility, and position counter-cyclically during stress periods; however, global long-end bond supply, higher global yields, the Dutch pension transition, and near-term macro uncertainty will dilute their standalone effect on absolute yield levels. From a relative-value perspective, the logic for bonds becoming richer versus swaps at the long end is clearer.

Risks

• The policy intent of the Solvency II review may push insurers to allocate more toward equities and real-economy assets, causing marginal fixed-income allocation to decline.
• Changes in global long-end bond supply and demand and higher global yields may limit the yield-compressing effect of improved European insurance demand.
• The Dutch pension transition is still incomplete, which may make the impact on long-end rates and swap markets more complex.
• Macro uncertainty following the Iran conflict, as well as energy prices and constraints on the European front-end rate path, may disrupt views on the curve and volatility.
• Elections in France and Italy may trigger sovereign spread widening; even if insurers' pro-cyclical selling pressure declines, political risk cannot be eliminated.
• Regulatory implementation and country-specific transposition details may affect actual asset allocation behavior.

What to watch

• Country-level legal transposition and implementation details of the Solvency II review before January 31, 2027.
• Whether insurers' allocations to long-dated EGBs and holdings above the 15-year tenor increase.
• Valuation changes in long-dated EGBs versus swaps, especially around the 30-year tenor.
• Whether European rates volatility continues to decline, and whether insurers reduce passive selling during periods of sovereign spread stress.
• Domestic sovereign spread performance in France and Italy before and after next year's elections.
• Progress on completing the Dutch pension transition before end-2027 and its impact on swap demand.
• Global long-end bond supply, official-sector holding shares, and trends in long-term yields in the US, Japan, the UK, and Germany.