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September 2012
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Remit
Why hedge the risk-free rate?
Derek McLean
Eamonn Phelan Emily Penn
Oliver Firth
Angelina Lai
David Johnson
Paul Collins
Ross Evans
The views expressed in this presentation are the collective views of the working party They do not reflect the view of any individual member, nor their employer, nor the Actuarial Profession
2
Why hedge?
ERM ORSA
Risk appetite Strategic objectives
Solvency monitoring
Stability
Plenary vote on 20th November Next political trilogue on 18th September LTG report
Impact assessmen t for LTG package
Countercyclical Premium
Extrapolation
Duration Approach
7
minus
Fundamental spread
Expected default & downgrade risk Floored at 75% of long-term average spread
ASSETS
Bond like Fixed cash flows (or inflation linked) Currency matched to liabilities Investment grade only Limits on BBB Buy-and-hold (Prevents active trading of portfolio) Tight cash flow matching No issuer optionality (Assets with prepayment risk unlikely to qualify for Matching Premium)
LIABILITIES
No future premiums Only underwriting risks are: Expense, Longevity & Revision risk
No surrender option where surrender value could exceed value of underlying assets
OTHER
Assets and liabilities must be ring-fenced without possibility of transfer 2 month window to restore compliance Restricted to insurance activities in country of authorisation
9
The risk-free interest rate curve under Solvency II (21 March 2012)
3.5% 3.0% 2.5%
Market swap rates 10bps Extrapolated curve
30
40
50
Euro:
Convergence period:
10yrs (Parliament)
40yrs (Council & Commission) 60yrs (QIS5)
12
0.1
Forward rates
Extrapolated curve
Market swap rates Market swap rates 10bps 10bps credit risk adjustment
30
40
50
15
-2 -4
1Y
2Y
3Y
4Y
5Y
6Y
7Y
8Y
9Y 10Y
-2 -4
16
-2 -4
1Y
2Y
3Y
4Y
5Y
6Y
7Y
8Y
9Y 10Y
-2 -4
17
Economic hedge vs. Solvency II hedge (after removing swaps needed to eliminate coupons) 10yr bullet liability cashflow
Hedge Notional m
12 Market Consistent 10 8 6 4 2 Solvency II 10 8 6 4 2
-2 -4
1Y
2Y
3Y
4Y
5Y
6Y
7Y
8Y
9Y 10Y
-2 -4
18
1.0% 0 5 10 15 20
19
25
30
35
40
45
50
1.5%
cut-off point
1.0% 0 5 10 15 20
20
25
30
35
40
45
50
-2 -4
1Y
2Y
3Y
4Y
5Y
6Y
7Y
8Y
9Y 10Y
-2 -4
21
Swap curve
Solvency II
(20yr LLP, 10yr convergence)
100%
101%
100%
102%
100%
66%
100%
22
29%
30 April 2010
29 Feb 2012
Hedge Notional m
4 2
-2 -4 -6 -8
Jun-10
Aug-10
Jun-11
Aug-11
Apr-10
Oct-10
Apr-11
Dec-09
Dec-10
Oct-11
Dec-11
Feb-10
Feb-11
Feb-12
30 April 2010
5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 0 10 20
25
= 0.1
Solvency II discount curve Market swap rates
Forward rates close to 4.2% Cut-off point for market data (LLP)
30
40
50
29 February 2012
4.5% 4.0% 3.5% 3.0% 2.5%
Market swap rates Solvency II discount curve
= 0.4
Forward rates far away from 4.2% Cut-off point for market data (LLP)
30
40
50
Hedge Notional m
Alpha
Jun-10
Aug-10
Jun-11
Aug-11
Apr-10
Oct-10
Apr-11
Dec-09
Dec-10
Oct-11
Dec-11
Feb-10
Feb-11
Alpha
Feb-12
28
26
24
22
20 0.10
0.15
0.20
0.25
0.30
0.35
0.40
0.45
Alpha Alpha
28
2.5% Jan-04
Jan-05
Jan-06 Jan-07
Jan-08
30
Jan-09 Jan-10
Jan-11
Jan-12
Jan-05
Jan-06 Jan-07
Jan-08
Jan-09 Jan-10
Jan-11
Jan-12
-20%
31
Implementation
Active management of interest rate risk? Central clearing (ESMA) Individual circumstances Interaction with interest rate risk sub-module Potential for changes to the UFR
32
Q&A