The current low yield environment and a market consistent approach to regulation has exposed the balance sheet of many insurers and pension schemes offering long dated guarantees. The problem is particularly acute where the duration of assets and liabilities is mismatched, and solutions are now being sought to modify the valuation method of these long-dated liabilities to address the problem. In this article, Ross Evans, Neal Hegeman and Emily Penn at the Insurance and ALM Advisory team of RBS discuss the potential implications of these modifications.
Soothing solvency concernsDespite the continuing uncertainty over Solvency II, a number of insurance company and pension fund regulators in Europe have introduced significant changes to the methodology for valuing liabilities. These changes – which are a move away from pure market consistency – have, in part, been made to protect the solvency positions of insurance companies and pension schemes. In Europe, the assets held by many insurance companies and pension schemes are shorter in duration than the long-dated liabilities they are backing. Coupled with this, the regulators in several European countries prescribe a market consistent valuation of the balance sheet. Declining interest rates have therefore resulted in weakening solvency positions for insurers and pension schemes running this type of asset liability mismatch. This, in turn, has triggered increased hedging activity to protect against further declines in interest rates. The increased demand for hedging puts further downward pressure on rates, exacerbating the pressure on solvency positions and funding levels. To put the brakes on this negative feedback loop, Danish, Dutch and Swedish regulators have taken action. They have responded by adopting a key element of the current Solvency II negotiations – the extrapolation of the long end of the risk-free interest rate curve. Extrapolation of the curve gives higher and more stable long term interest rates for valuing the long-dated liabilities of insurers and pension schemes. This move away from market consistency has profound implications for the hedges required to stabilise solvency, as well as having knock-on impacts for the dynamics of the Euro swap market.
Solvency II method and impactsSince the publication of the draft specifications for the QIS5 exercise, Solvency II proposals have included a method to extrapolate the risk-free interest rate curve to an assumed “Ultimate Forward Rate” (UFR). This extrapolation is applied to forward rates rather than spot rates. [caption id="attachment_83732" align="alignright" width="281"] Figure 1a: Impact of extrapolation on forward curves[/caption] The extrapolation of the curve commences at a pre-defined “Last Liquid Point” (LLP) and converges to the UFR over a number of years. The choice of LLP should, in theory, reflect the point at which the swap and government bond markets cease to have sufficient depth and liquidity. This will obviously vary by currency. For the QIS5 exercise, the LLP was set at 30 years for Euro (EUR) and 50 years for British Pound (GBP). The LLP for EUR has been shortened to 20 years in the current draft version of the Level 1 text (“Omnibus II”) and is the base case scenario within the “Long-Term Guarantees Assessment” (LTGA). The length of the convergence period from the LLP to the UFR has been a topic of fierce debate and it is also being tested within the LTGA. The European Commission and European Council propose a 40 year convergence period, while the European Parliament favours a shorter period of just 10 years. In addition, the level of the UFR also differs by currency. For EUR and most other major currencies it is pegged at 4.2%, based on long-term assumptions for inflation and real rates of 2% and 2.2% respectively. For JPY and CHF the UFR is set at 3.2%, reflecting lower long-term inflation expectations. [caption id="attachment_83731" align="alignright" width="292"] Figure 1b: Impact of extrapolation on spot curves[/caption] Figures 1a and 1b show a graphical illustration of the impact of the extrapolation on the EUR swap curve. The extrapolated curve is noticeably higher than the swap curve for maturities beyond the LLP. Generally speaking, a shorter LLP and faster convergence period will mean less interest rate hedging as a greater part of the liability discount curve is pegged to the fixed UFR. The Solvency II method of extrapolation has attracted wide publicised criticism:
- No sensitivity to the market curve after the LLP, whereas market prices beyond this point provide valuable information.
- Large dependency on the 20 year point of the swap curve, potentially creating a market distortion around this point.
- Reverse and counter-intuitive dependency on the 15 year point of the swap curve.
- Frequent need for re-balancing as 20 year hedges roll-down and need to be replaced with new 20 year hedges.
- The value of the liabilities now exhibits sensitivity to interest rates beyond the LLP.
- The large sensitivity to the 20 year point has gone and is now spread more evenly across the curve. This also removes the frequent need to extend 20 year swaps as they roll down.
- There is no longer a counter-intuitive, reverse sensitivity to the 15 year point.