The authors of the study, Theo Kocken, Bart Oldenkamp and Joeri Potters, propose that the damaging consequences of the changes can be avoided through minor adjustment of the proposed extrapolation method.
Recently, both insurance and pension regulators in Europe have been moving away from market-consistent valuations of long-dated liabilities. Market-consistent valuation was intended to bring transparency to the balance sheet, but it also brought low interest rates and high balance-sheet volatility. Given the lack of liquidity of ultra long-dated interest rate swaps, European policy-makers have suggested that the illiquid part of the curve, beyond the so-called ‘last liquid point’ (LLP), be replaced by a more theoretical curve, which gradually converges to a long-term ‘ultimate forward rate’ (UFR).
The proposed method under Solvency II to obtain a UFR curve is the Smith-Wilson algorithm. As a first step in this method, the longest maturity is determined, which is still deemed sufficiently liquid – the LLP. Under the Solvency II proposal, which is being negotiated between the European Parliament, European Commission (EC) and Council of the European Union, the LLP is set at 20 years for the eurozone.
As a next step, the forward curve is used to construct the discount curve beyond the LLP through interpolating between the forward rate within the LLP and the predetermined UFR. The current proposals contain a UFR of 4.2 per cent, simply the sum of a long-term real yield of 2 per cent and a long-term inflation rate of 2.2 per cent.
A final mechanism in the method relates to the speed of convergence from the LLP to the UFR. For Solvency II, convergence periods from 10 years (as proposed by the European Parliament) up to 40 years (proposed by the EC and Council) have been put forward.
The authors see two types of impact on insurance-liability cashflows of this approach:
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First, introducing UFR-based liability valuation has a direct valuation impact.
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A second type of effect, the risk impact, is essentially based on the considerable change in interest-rate sensitivity of the liabilities.
They analyse the risk impact and how it translates to an impact on a macro, sector-wide level. They therefore assume that insurance companies will decide to adjust their hedging policies to embrace the UFR framework as much as possible.
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