15 August 2012

Risk.net: The UFR curve conundrum

An ultimate forward rate (UFR)-based extrapolation of the euro risk-free rate curve now seems very much on the cards for Solvency II, but is also being introduced for Danish pension funds and Dutch insurers ahead of the formal adoption of Solvency II. This has profound implications for the swap hedges required to stabilise solvency, as well as having knock-on impacts for the euro swap market.

All of the parties negotiating Solvency II – the European Commission, European Parliament and European Council – have included a variation of the UFR-based extrapolation in their proposal for Solvency II. Under each proposal, the euro risk-free rate curve is based on the market swap curve up to 20 years, but extrapolated thereafter. The extrapolation is calibrated so that the forward rates converge to a level of 4.2 per cent (the UFR) after 10 years (Parliament) or 40 years (Commission and Council). These proposals result in a risk-free rate curve that sits significantly higher than the market swap curve beyond 20 years onwards.

The extrapolation of the Solvency II curve beyond 20 years leads to a significant reduction in the volume and tenor of swaps needed to hedge liabilities past this point. The size of this reduction is driven, to a large extent, by the value of ‘alpha’ – the parameter used to control the speed at which the extrapolation converges to the UFR.

Alpha is closely related to the level of the forward rate immediately before the 20-year cut-off point, as well as the required speed of convergence. In particular, the further away the forwards are from 4.2 per cent at the 20-year point, the bigger alpha needs to be.

Hedging the Solvency II risk-free rate is not straightforward, due to the dependence of duration on forward rates. For insurers, there is also the added complication of managing the trade-off between capital stability and capital minimisation, which may require non-linear solutions.

The current proposals should drive a steepening of the euro swap curve between 20 and 50 years, as pension funds and insurers look to shorten their euro swap hedges.

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