Simˈpōzēəm
![Ross Evans](https://solvencyiiwire.com/wp-content/uploads/2013/04/Ross-Evans.png)
![Neal Hegeman](https://solvencyiiwire.com/wp-content/uploads/2013/04/Neal-Hegeman.png)
![Emily Penn](https://solvencyiiwire.com/wp-content/uploads/2013/04/Emily-Penn.png)
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.
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Soothing solvency concerns
Despite 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 impacts
Since 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 Figure 1a: Impact of extrapolation on forward curves](https://solvencyiiwire.com/wp-content/uploads/2013/04/Figure-1a.png)
![Figure 1b: Impact of extrapolation on spot curves Figure 1b: Impact of extrapolation on spot curves](https://solvencyiiwire.com/wp-content/uploads/2013/04/Figure-1b.png)
- 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.
![Figure 2: Swap portfolio required to hedge typical Dutch pension scheme under economic and Solvency II discount bases Figure 2: Swap portfolio required to hedge typical Dutch pension scheme under economic and Solvency II discount bases](https://solvencyiiwire.com/wp-content/uploads/2013/04/Figure-2.png)
- 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.
![Figure 3: Impact of DNB modification on swap portfolio required for typical Dutch pension scheme](https://solvencyiiwire.com/wp-content/uploads/2013/04/Figure-3.png)
![Figure 4: Slope between 30 and 50 year points on EUR swap curve](https://solvencyiiwire.com/wp-content/uploads/2013/05/Figure-4.png)
Not an issue for Sterling? A word of caution…
Lobbying from the UK insurance industry to date has focused on the Matching Adjustment, leaving mainland Europe to fight out the debate on extrapolation. This is understandable given the relatively small volume of GBP liabilities beyond the 50 year LLP currently proposed for GBP. The 20 year LLP for EUR has been written into the draft Level 1 Directive. But for other currencies, EIOPA has the power to set the LLP within the Level 2 measures using a “holistic and consistent approach” to that used to justify the use of a 20 year LLP for EUR. This leaves a residual risk that the methodology determined by EIOPA to justify a 20 year LLP for EUR will imply an LLP for GBP that is shorter than the current proposal of 50 years. If a shorter LLP was enforced for GBP, the issues around extrapolation of the risk-free interest rate curve would suddenly become very important for the UK industry. At present, the assets of UK insurance companies are generally well matched to their liabilities. A shorter LLP could therefore force many of these insurers to unwind their long-dated interest rate swaps. Whilst the extrapolation beyond a LLP is intended to allow the Solvency II framework to cope with long-dated guarantees, there are also some potential unintended consequences. Not only might it alter the dynamics of the long dated swap market, but it may also disincentivise insurers and pension schemes from investing in long-dated, fixed income assets. — The views expressed are the authors’ own.![Extrapolation Clock](https://solvencyiiwire.com/wp-content/uploads/2013/04/Extrapolation-Clock.png)