27 February 2013

Risk.net: Swedish Solvency II discount rate move 'must address sensitivity concerns'

The Swedish financial regulator should use an extrapolation methodology that reduces interest rate sensitivity at the last liquid point when it puts forward its proposals for implementing a Solvency II-based discount rate in 2014, the Swedish insurance industry has urged.

Finansinspektionen announced last week that it would introduce Solvency II's discount rate methodology for calculating the value of life insurance and pension fund liabilities next year. It plans to consult on the design of the discount rate methodology later this year.

Swedish insurers are concerned that the methodology for extrapolating the risk-free rate in the illiquid part of the interest rate curve focuses interest rate sensitivity around the 15- and 20-year points, which has implications for hedging programmes.

Insurance Sweden says that while the fundamental principles of the Solvency II extrapolation method are sensible, it was crucial that the methodology is "robust" and that it enables the insurance industry to manage its solvency positions.

Finansinspektionen has yet to provide details of the precise design of the discount rate methodology, but says its intention is to implement a method that in practice is very similar to what will be implemented in Solvency II. The regulator plans to consult on the proposal in the spring, with the new regulation coming into force on December 31, 2013.

Consultants say the long-term guarantees assessment (LTGA) currently being undertaken by the European Insurance and Occupational Pensions Authority, and which is testing Solvency II's discounting rate methodology, will help insurers understand the impact of the methodology the Swedish regulator is likely to use.

The Solvency II discount rate curve consists of two parts. Market rates are used for maturities that have deep, liquid, active and transparent markets, while the interest rates for longer maturities beyond a last liquid point (LLP) converge toward the UFR, which is the long-term equilibrium rate.

European legislators have suggested an LLP of 20 years and a UFR of 4.2 per cent – a figure that reflects an assumed long-term average real yield of 2.2 per cent and expected inflation of 2 per cent.

The Danish and Dutch regulators introduced Solvency II's risk-free rate methodology last year in response to low interest rates. The Dutch central bank subsequently implemented an amended version for Dutch pension funds, to counteract the interest rate sensitivity in and around the 20-year point and avoid possible market disruptions. The new Dutch interest rate term structure incorporates the 20-year LLP and 4.2 per cent UFR but also uses market rates beyond the 20-year point.

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