Hedging the risk-free rate under Solvency II. Eamonn Phelan & Ross Evans May 2012

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1 Hedging the risk-free rate under Solvency II Eamonn Phelan & Ross Evans May 2012

2 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 Angelina Lai Eamonn Phelan David Johnson Emily Penn Oliver Firth 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 Society of Actuaries in Ireland 2

3 Why hedge?

4 Why hedge the risk-free rate in the first place? ERM ORSA Risk appetite Strategic objectives Solvency monitoring Stability 4

5 Latest timetable & ECON Compromise

6 Latest edition of the Solvency II timeline 6 Source: ABI Bulletin May 2012

7 Compromises agreed at the recent ECON vote Countercyclical Premium Extrapolation Matching Premium Symmetrical Adjustment Mechanisms Duration Approach 7

8 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 8

9 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

10 What is the risk-free rate?

11 The risk-free interest rate curve under Solvency II (21 March 2012) 3.5% 3.0% 2.5% 2.0% Extrapolated curve Market swap rates 10bps 1.5% 1.0% 0.5% 0.0% Cut-off point for market data ( LLP )

12 Extrapolation of the risk-free rate under Solvency II Extrapolation beyond Last Liquid Point (LLP) Euro: now 20yrs (30yrs, QIS5) Smith-Wilson technique Macroeconomic approach Ultimate long-term forward rate = 4.2% Convergence period: 10yrs (Parliament) 40yrs (Council & Commission) 60yrs (QIS5)

13 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% Cut-off point for market data ( LLP ) Forward rates Extrapolated curve Market swap rates Market swap rates 10bps 10bps credit risk adjustment

14 Hedging some practical examples

15 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 21 st March

16 Market consistent / Economic hedges 10yr bullet liability cashflow 50yr bullet liability cashflow Hedge Notional m Hedge Notional m Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y -2 10Y 12Y 15Y 20Y 25Y 30Y 35Y 40Y 50Y

17 Remove the swaps needed to eliminate coupons 10yr bullet liability cashflow 50yr bullet liability cashflow Hedge Notional m Hedge Notional m Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y -2 10Y 12Y 15Y 20Y 25Y 30Y 35Y 40Y 50Y

18 Economic hedge vs. Solvency II hedge (after removing swaps needed to eliminate coupons) 10yr bullet liability cashflow 50yr bullet liability cashflow Hedge Notional m Hedge Notional m Market Consistent Solvency II Market Consistent Solvency II Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y -2 10Y 12Y 15Y 20Y 25Y 30Y 35Y 40Y 50Y

19 Slope of the market swap curve prior to the LLP 4.0% 50yr S-W discount rate UP 3.5% 3.0% Solvency II discount curve 2.5% 2.0% 15yr Market rate DOWN 1.5% 1.0% cut-off point

20 (And the other way around) 4.0% 3.5% Solvency II discount curve 3.0% 2.5% 50yr S-W discount rate DOWN 2.0% 1.5% 1.0% 20yr Market rate DOWN cut-off point

21 Economic hedge vs. Solvency II hedge 10yr bullet liability cashflow 50yr bullet liability cashflow Hedge Notional m Hedge Notional m Market Consistent Solvency II Market Consistent Solvency II Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y -2 10Y 12Y 15Y 20Y 25Y 30Y 35Y 40Y 50Y

22 Material drop-off in sensitivity to interest rates PV01 s 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% 29% 22

23 Robustness of the hedge over time

24 Hedge notionals Large degree of volatility over past 2 years Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 Feb April 2010 Hedge Notional m 15Y swap notional 20Y swap notional Feb 2012

25 30 April % 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Cut-off point for market data ( LLP ) Solvency II discount curve Forward rates close to 4.2% = 0.1 Market swap rates

29 February 2012 4.5% = 0.4 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.

26 29 February % = % 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Cut-off point for market data ( LLP ) Solvency II discount curve Market swap rates Forward rates far away from 4.2%

27 Alpha 0.25 Relationship between hedge notionals and Alpha Feb-12 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11 Hedge Notional m Dec-11 15Y swap notional 20Y swap notional Alpha 27

28 Relationship between hedge liability duration and Alpha Modified Duration Modified of 50yr Duration liability under SII Alpha 28

29 Other (practical) considerations

30 Yields on 10yr EU government bonds 20% 18% 16% 14% 12% 10% 10yr EUR swap 10yr Ireland 10yr Spain 10yr Portugal 10yr Italy 8% 6% 4% 2% 0% Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 30

31 Government bonds Not a duration product in a swaps-based world 10% 0% Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12-10% -20% -30% -40% -50% -60% Net Assets 31

32 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 Next steps for the working party 32

33 Q&A

Technical Specifications part II on the Long-Term Guarantee Assessment Final version

EIOPA/12/307 25 January 2013 Technical Specifications part II on the Long-Term Guarantee Assessment Final version Purpose of this document This document contains part II of the technical specifications