After more than a decade of historically low rates, this has come as something of a shock to insurers accustomed to stability. Given the experience of the past 12 months, we can now compare Solvency II’s prescribed “rates up” stress to what has actually transpired. This may well cause insurers to rethink their approach.
Based on the Standard Formula approach, the charts cover the period October 2021 to October 2022:
EIOPA risk-free rates as at 31st October 2021 – the blue lines
Where interest rates actually ended up on 31st October 2022 - the pink lines
99.5th percentile 1 year stress as at this date - the green lines
99.5th percentile 1 year stress - the purple lines - under EIOPA’s proposed interest rate stress methodology (the “2020 review”)
Treatment of interest rates under Solvency II
For those insurers operating under Solvency II there are well documented barriers to navigating a rising rate environment. From a technical perspective, downward rate stresses are limited when rates are low while beyond 20 years, in EUR, the discount curve has historically been elevated (compared to swap rates or bond yields) as risk-free rates are extrapolated towards the Ultimate Forward Rate (UFR). This means that EUR-based insurers have not had to discount long-term liabilities at current market discount rates.
The relatively low magnitude of the “interest rates up” stress is due to it being multiplicative. In other words, it is based on multiplying current rates by pre-determined factors, and applying a floor of 100bps to the stress. It follows from this that the current interest rate up stress is more severe than it was in Q4 2021, given that current rates are now much higher.
What is clear is that the actual change in interest rates (pink minus blue) was much greater than either EIOPA’s current or proposed stresses would imply. In fact, across Euro, USD and GBP, the 5 year point moved around three times the current EIOPA stress. For Euro in particular, market interest rates have been volatile beyond 20 years, whereas EIOPA risk-free rates appear more stable due to the influence of the Ultimate Forward Rate. This means the yield used to mark the price of 30 year government bonds has actually moved further than illustrated in the chart resulting in larger asset value falls.
The consequence of all this is that Standard Formula capital requirements for interest rate risk have been too low, and will now rise (mechanistically). The consequences for insurers using the Solvency II Standard Formula are:
- Rather than simply rely on mechanistic Standard Formula capital requirements, to ensure they are adequately protected, they should determine an approach to interest rate risk they are comfortable with.
- Notwithstanding the significant impact of changes in inflation we have observed, the same holds for any inflation risk they are exposed to, since insurers are not required to hold inflation risk capital under Solvency II.
- Liquidity needs should be carefully managed. For example, interest rate rises may lead to derivative margin calls on interest rate swaps, beyond what one might expect by considering Standard Formula interest rate stresses in isolation.
- Optionality in both assets and liabilities should be carefully considered. By way of example, lapses and withdrawals may increase significantly, given the difficulty in predicting customer behaviour as the economic environment worsens.
Mercer’s Insurance Solutions team helps clients navigate the regulatory, capital and market environment. We support our clients design and develop their investment strategy, asset allocation, and portfolio implementation, to take into account a wide range of economic scenarios.
In this appendix, we show the same charts for the Norwegian krona, Danish krona, Swedish krona and Swiss franc. It should be noted that because the last liquid points for NOK and SEK are quite short at 10 years, the EIOPA yield curve generally exhibits less market-related movements, whereas the last liquid points are 15 for CHF and 20 for DKK.
The picture for the Swedish krona and Danish krona is quite similar to that of the euro in that the rate movement has been significantly larger than the current and proposed stresses. The picture for Norway and Switzerland is different as the movement has been similar to the 1 in 200 Solvency II stress. However, we do not think that insurers in these countries can afford not to take steps to mitigate risk — the experience for a multitude of other currencies has shown that yield curve movements can be large and sudden.
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