29 October 2013

Risk.net: New Swedish discount curve rejects Solvency II methodology

The Swedish financial regulator will introduce a temporary risk-free discount curve for insurers using an extrapolation methodology that contradicts Solvency II proposals, amid concerns that the latter is unworkable.

Finansinspektionen (FI) announced at the end of September a second consultation on its proposed changes to the extrapolation of the discount curve for valuing long-term liabilities. The new methodology is intended to ease the capital burden on Swedish insurers up until the implementation of Solvency II. However, the new curve is at odds with the expected Solvency II version in that it will use a linear extrapolation based on real market rates to converge on the ultimate forward rate (UFR), instead of the Smith-Wilson extrapolation favoured by Solvency II.

The Smith-Wilson method extrapolates a curve based on a predetermined last liquid point (LLP) and the UFR, disregarding market data that might exist beyond the LLP. This makes the extrapolated part of the curve sensitive to price variations at the LLP.

When consultation on the temporary discount curve was first proposed earlier this year, FI insisted it would be based on the methodology in Solvency II. But the regulator now believes this extrapolation method will have to be reviewed at the European level due to the problems it poses insurers.

Edward Akhras, head of financial risks in FI's insurance supervision division in Stockholm, remarks: "Stakeholders commented that the extrapolation method in the FI's May proposal is complex and that the extrapolation method to be used in Solvency II is not yet finalised. They advocated using a simpler method until Solvency II is fully implemented.”

The change was welcomed by the industry. Jakob Carlsson, Stockholm-based chief financial officer at Länsförsäkringar Liv, says: "The Smith-Wilson curve gives incentives for very strange hedge behaviour on the nine and 10-year points. This is clear to the industry. The linear extrapolation will allow insurers to hedge the curve without putting odd pressure on these points."

FI has also changed its approach to the credit risk adjustment for the discount curve. This will now be a fixed rather than a flexible deduction. The amount to be deducted has not been specified yet, although Carlsson estimates it will be around 20 basis points for occupational pensions and 40bp for private pensions.

The consultation closed on September 27. The Finansinspektionen board is scheduled to meet on November 12 to approve the final version of the proposal. The legislation will become effective on December 31.

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