09 December 2013

Risk.net: 'Unhedgeable' risk-free curve extrapolation method implied in Omnibus II text

The final compromise text of the Omnibus II Directive, agreed last month, outlines key elements of the risk-free yield curve to be used by insurers for discounting long-term liabilities. These include the preferred starting point of extrapolation (known as the last liquid point or LLP), ultimate forward rate (UFR) and rate of convergence for euro countries. No mention was made of what methodology should be used to extrapolate the risk-free curve beyond the LLP.

Actuaries say the language of the Omnibus II compromise text implies the controversial Smith-Wilson technique remains the preferred method for extrapolation. The Smith-Wilson approach has caused dissent among some national regulators and insurers, as the resulting curve has proved to be extremely sensitive to interest rates at the LLP and just before it, while at the same time ignoring any market data after the LLP. This has resulted in a curve that is difficult to hedge economically, according to actuaries.

The 40-year convergence period specified in the Omnibus II compromise text is most suited to a Smith-Wilson extrapolation. In addition, the final wording does not accommodate other extrapolation methods, such as the Dutch ‘UFR Commission' method for pension funds, which specifies a 20-year ‘first smoothing point' and a 50-year LLP, says Paul Fulcher, managing director, ALM structuring at Nomura in London. Furthermore, a condition in Omnibus II specifying that the extrapolated forward rate should not differ by more than three basis points from the ultimate forward rate is, say experts, a direct reference to how the Smith-Wilson method converges to the UFR.

Even if the Smith-Wilson technique is used, there may be discretion to amend the extrapolation methodology, according to some. The Omnibus II compromise text contains two caveats: the first that the LLP will be set at 20 years "under market conditions similar to those at the date of adoption of the Omnibus II directive", which suggests the LLP could change at times of economic turbulence. The second caveat is that the LLP, UFR and speed of convergence outlined in Omnibus II are only for liabilities denominated in euros, meaning countries using different currencies will have greater discretion over setting their own extrapolation methodology.

EIOPA is known to favour the Smith-Wilson method of extrapolation, having used it to determine the rates to be used for the long-term guarantees impact assessment.

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