18 September 2014

Risk.net: Solvency II: insurers study hedging options for volatility adjustment

The volatility adjustment should help insurers by smoothing the impact of market swings on the balance sheet. But firms are struggling to understand how it will work in practice. Hedging the discount rate for liabilities under the directive is challenging to begin with.

UK insurers received a fillip on August 6 as a Treasury consultation paper provided reassurance that those who wish to use the Solvency II volatility adjustment (VA) will be able to do so.

This is welcome news for firms because access to the VA will allow them to reduce the impact of spread volatility on their Solvency II balance sheets. The adjustment applies a parallel upward shift in the risk-free rate that firms use to discount liabilities – the higher the rate the lower their liabilities.

The VA was introduced in the long-term guarantees package at the end of 2013 to replace the counter-cyclical premium, which some policy-makers argued was too rigid a mechanism to sufficiently reduce the effect of market volatility on insurers’ balance sheets. However, despite its improvement on this measure, the VA complicates the already tortuous method of hedging the Solvency II risk-free rate. Those firms looking to use the adjustment now face the difficult decision of choosing the best way to immunise themselves against fluctuating liability valuations.

Part of the difficulty is that the calculation of the risk-free rate is far from straightforward even before taking the VA into consideration. Although the risk-free rate is based on interbank swap rates (Libor in the UK and Euribor on the Continent), an alteration applies in the form of the credit risk adjustment (CRA). This reduction to the rate is calibrated as 50% of the average spread between six-month swaps and overnight index swaps (OIS) calculated over a one-year period and subject to a floor of 10 basis points and a cap of 35bp. This makes the risk-free rate a “messy hybrid” of swaps and OIS, according to Russell Ward, senior life insurance consultant at Milliman in London.

Firms, therefore, have a decision to make on whether OIS or the six-month rate offers the most appropriate hedge. The argument can be made that OIS is a truer reflection of risk-free as the curve reflects minimal credit risk. Furthermore, the CRA acts to bring the risk-free rate closer to OIS. However, the inclusion of caps and floors, not to mention the 50% haircut, means a close match is impossible.

An additional factor insurers must take into consideration is that OIS instruments are illiquid beyond short durations. This makes them unsuitable hedging instruments for life insurers, who need large quantities of long-duration assets to match their long-term liabilities.

As firms face this challenge of handling a curve that is already difficult to hedge, the use of the volatility adjustment threatens to add further complication.

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