28 March 2014

Risk.net: Solvency II proposals cause confusion on non-euro extrapolation

Proposed changes by the European Commission could make it harder for insurers to hedge against movements in the risk-free rate curve used to discount non-euro liabilities.

The latest draft of the delegated acts, which set some of the detail for Europe's Solvency II insurance regulation and were circulated informally to insurers on March 14, defines the technique by which the last liquid point (LLP) should be set for the euro. The LLP is the last point on the inter-bank swap curve at which insurers can use market data to construct the discount curve for their liabilities. Beyond the LLP, the discount curve is extrapolated to an ultimate forward rate set at 4.2 per cent.

The Omnibus II text voted on in February 2014 fixed the LLP for the euro at 20 years, but did not lay out the technical reasons behind this decision. The delegated acts now explain that the LLP for the euro should be set at the point beyond which less than 6 per cent of the total volume of all euro-denominated bonds is outstanding. This so-called residual volume approach (RVA) would leave the 20-year point for the euro LLP unchanged, but throws the LLPs for other currencies into doubt, as it is unclear whether this methodology will be applied to non-euro liabilities.

The delegated acts call for a consistency of approach to determining the LLP across currencies, stating that: "The principles applied when extrapolating the relevant risk free interest rate term structure shall be the same for all currencies, in particular as regards the determination of the longest maturities for which interest rates can be observed." This suggests the RVA will be used for non-euro currencies, including sterling.

Nomura estimates that if the RVA were applied to sterling, the LLP would be fixed somewhere between the 35- and 40-year point, rather than the 50-year point described in the technical specifications for Eiopa's long-term guarantees assessment (LTGA) carried out in 2013.

Ross Evans, senior insurance consultant at consultancy Hymans Robertson in London, says: "From what we hear, the latest version of the text implies on the one hand that the principles should be the same for all currencies, but on the other hand sets out a specific method to be applied to the euro. There seems to be something of an inconsistency."

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