Hedging the risk-free rate under Solvency II

David Johnson & Ross Evans

September 2012

www.dalactuarialservices.com

Say hello to our working party

Remit
Why hedge the risk-free rate?

How you hedge rates exposure in Solvency II world

Focus on best estimate liabilities Practical considerations

Working party members

Alex Probyn

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?

Why hedge the risk-free rate in the first place?

ERM ORSA
Risk appetite Strategic objectives

Solvency monitoring

Stability

Long-term guarantees package

Time is fast running out

Plenary vote on 20th November Next political trilogue on 18th September LTG report
Impact assessmen t for LTG package

Publication in the Official journal?

Adoption of Level 2 delegated acts

Source: ABI Bulletin May 2012

Compromises agreed at the ECON vote in March

Countercyclical Premium

Extrapolation

Matching Premium Symmetrical Adjustment Mechanisms

Duration Approach
7

What is the Matching Premium? Conditions!

Spread on matching assets

minus

Prior regulatory approval

Fundamental spread

Expected default & downgrade risk Floored at 75% of long-term average spread

Conditions for application of Matching Premium (Matching Adjustment)

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

What is the risk-free rate?

The risk-free interest rate curve under Solvency II (21 March 2012)
3.5% 3.0% 2.5%
Market swap rates 10bps Extrapolated curve

2.0% 1.5% 1.0% 0.5% 0.0% 0 10 20

11

Cut-off point for market data (LLP)

30

40

50

Extrapolation of the risk-free rate under Solvency II

Extrapolation beyond Last Liquid Point (LLP)

Sterling: 50yrs (50yrs, QIS5)

Euro:

20yrs (30yrs, QIS5)

Smith-Wilson technique Macroeconomic approach

Ultimate long-term forward rate = 4.2%

Convergence period:

10yrs (Parliament)
40yrs (Council & Commission) 60yrs (QIS5)
12

0.1

What this looks like in practice (21 March 2012)

4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 0 10 20
13

Forward rates

Extrapolated curve

Market swap rates Market swap rates 10bps 10bps credit risk adjustment

Cut-off point for market data (LLP)

30

40

50

Hedging some practical examples

Consider two simple cases

1. Case 1: Bullet 10yr liability cashflow

2. Case 2: Bullet 50yr liability cashflow

EUR 10m in each case

Delta hedging technique used to construct swaps hedge 21st March 2012

15

Market consistent / Economic hedges

10yr bullet liability cashflow

Hedge Notional m
12 10 8 6 4 2

50yr bullet liability cashflow

Hedge Notional m
12 10 8 6 4 2

-2 -4

1Y

2Y

3Y

4Y

5Y

6Y

7Y

8Y

9Y 10Y

-2 -4
16

10Y 12Y 15Y 20Y 25Y 30Y 35Y 40Y 50Y

Remove the swaps needed to eliminate coupons

10yr bullet liability cashflow

Hedge Notional m
12 10 8 6 4 2

50yr bullet liability cashflow

Hedge Notional m
12 10 8 6 4 2

-2 -4

1Y

2Y

3Y

4Y

5Y

6Y

7Y

8Y

9Y 10Y

-2 -4
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10Y 12Y 15Y 20Y 25Y 30Y 35Y 40Y 50Y

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

50yr bullet liability cashflow

Hedge Notional m
12 Market Consistent Solvency II

-2 -4

1Y

2Y

3Y

4Y

5Y

6Y

7Y

8Y

9Y 10Y

-2 -4
18

10Y 12Y 15Y 20Y 25Y 30Y 35Y 40Y 50Y

Slope of the market swap curve prior to the LLP

4.0% 3.5% 3.0% 2.5% 2.0% 1.5%
cut-off point 50yr S-W discount rate UP

Solvency II discount curve

15yr Market rate DOWN

1.0% 0 5 10 15 20
19

25

30

35

40

45

50

(And the other way around)

4.0% 3.5% 3.0% 2.5% 2.0%
20yr Market rate DOWN 50yr S-W discount rate DOWN Solvency II discount curve

1.5%
cut-off point

1.0% 0 5 10 15 20
20

25

30

35

40

45

50

Economic hedge vs. Solvency II hedge

10yr bullet liability cashflow

Hedge Notional m
12 Market Consistent 10 8 6 4 2 Solvency II 10 8 6 4 2

50yr bullet liability cashflow

Hedge Notional m
12 Market Consistent Solvency II

-2 -4

1Y

2Y

3Y

4Y

5Y

6Y

7Y

8Y

9Y 10Y

-2 -4
21

10Y 12Y 15Y 20Y 25Y 30Y 35Y 40Y 50Y

Material drop-off in sensitivity to interest rates PV01s

Swap curve

Solvency II
(20yr LLP, 10yr convergence)

Bullet liability 10yr

100%

101%

Bullet liability 20yr

100%

102%

Bullet liability 30yr

100%

66%

Bullet liability 50yr

100%
22

29%

Robustness of the hedge over time

Hedge notionals Large degree of volatility over past 2 years

10 8 6

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

15Y swap notional

24

20Y swap notional

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

2.0% 1.5% 1.0% 0.5% 0.0% 0 10 20

26

Forward rates far away from 4.2% Cut-off point for market data (LLP)

30

40

50

Relationship between hedge notionals and Alpha

10 8 6 0.35 0.45 0.40

Hedge Notional m

4 2 0.30 0.25 -2 0.20 -4 -6 -8 0.15 0.10

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

15Y swap notional

20Y swap notional

27

Alpha

Feb-12

Relationship between hedge liability duration and Alpha

30

Modified Duration of 50yr liability under SII Modified Duration

28

26

24

22

20 0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.45

Alpha Alpha
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Other (practical) considerations

30yr gilt yield vs. 30yr swap rate

5.5% 5.0% 4.5% 4.0% 3.5% 3.0%
30yr GBP swap 30yr UK

2.5% Jan-04

Jan-05

Jan-06 Jan-07

Jan-08
30

Jan-09 Jan-10

Jan-11

Jan-12

Government bonds Not a duration product in a swaps-based world

10% 5% 0% Jan-04 -5% -10% -15%
Net Assets

Jan-05

Jan-06 Jan-07

Jan-08

Jan-09 Jan-10

Jan-11

Jan-12

-20%
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Other practical considerations

How to construct an appropriate hedge portfolio
Conflicting metrics

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

Next steps for the working party

Q&A