How to mitigate against the impact of interest rate changes and, is it worth it?
As a result of the move away from the Solvency I actuarial approach to deriving the valuation discount rate from the yield on backing assets, Solvency II has introduced some new dynamics to the Solvency II balance sheet which merit careful consideration. This article focuses on the potential impact of changes in the EIOPA-prescribed risk free rate, how these changes might be mitigated and whether the costs involved ultimately provide a commensurate benefit for the policyholder.
|The Difference between Capital Required to meet the SCR versus Capital Requirements to ensure Compliance with the SCR|
At first glance, these two things may appear to be the same so let me explain further. The Solvency Capital Requirement is calculated by stressing the Best Estimate Reserve and the assets on the balance sheet. It therefore tests the resilience of the particular entity to pay claims in a stressed scenario. The level of the interest SCR will therefore be driven by how well matched the asset and liability cashflows are, the profile of assets backing Own Funds and other product specific considerations such as investment guarantees.
In practice, the impact of changes in interest rates will have implications for each entity’s solvency ratio beyond that which is assessed by the SCR calculation, particularly for entities with long tailed liabilities. The SCR calculation does not consider the impact of interest rate changes on the Risk Margin or the SCR, both of which may be significant. Putting aside practical difficulties; this may appear to be a shortcoming of the SCR but I do not believe this to be the case as the SCR calculation is only focussed on the impact of a stress on the entity’s ability to pay claims. It is quite feasible for a well matched entity to be subject to the interest up shock under the SCR calculation (due to the reduced value of Own Funds) but which could be highly sensitive to a fall in interest rates in terms of its solvency ratio due to the impact on the present value of Risk Margin and SCR cashflows.
Clearly, none of this exonerates any entity from meeting SCR requirements so entities will need to decide how to manage the total balance sheet impact of actual changes in interest rates.
|Managing Interest Rate Volatility under Solvency II|
For the purposes of this article, I have assumed that the entity in question follows a policy to closely match its liability cashflows and mitigate investment guarantees. The remaining volatility is likely to be driven by changes in the Risk Margin and SCR with a downside exposure to falls in interest rates.
In relation to the SCR, the shocked liability cashflows are likely to have a duration equal to or greater than the underlying liability portfolio. This is not consistent with the existing practice of many entities to hold low risk, shorter duration assets in their Own Funds which will not be as interest sensitive and therefore will not offset increases in SCR when interest rates fall.
Risk Margin is more complicated. A fall in interest rates will impact the Risk Margin in two ways:
- Underlying SCRs will increase due to the lower discount rate being applied to discount cashflows. These SCRs then feed in to the Risk Margin calculation and increase projected capital levels
- The discounting of the future projected Cost of Capital will then be performed at the lower discount rate (excluding any Long Term Guarantee adjustments)
These two impacts combine to produce a non-linear dependency which is very difficult to manage or mitigate. It is also likely that, in most cases, the Risk Margin will have a longer effective duration than the SCR or the underlying best estimate liabilities resulting in increased interest rate sensitivity.
Possible methods of managing interest rate volatility in respect of the SCR and Risk Margin include:
- Holding extra capital: As part of regular stress testing, the impact of interest rate changes on solvency should be monitored and stress tested and an appropriate buffer held above the minimum level.
- Adjusting the Investment Strategy: The investment strategy could be revised to increase the duration of Own Funds and assets backing the Risk Margin in order to reduce solvency ratio volatility. However, this may increase the interest SCR requirement, would result in increased volatility in terms of the value of Own Funds and would negate benefits if interest rates were to rise from their current level.
- Derivatives: Interest rate derivatives could be purchased to reduce interest rate exposures. This option may be expensive and would require regular monitoring and revision. Demand for long dated swaps has pushed up the price, making this option potentially expensive to implement.
- Reinsurance: Transferring exposure to a third party via a straight quota share or swap arrangement would reduce interest rate exposure but would also likely reduce profits. More innovative solutions are also available including reinsurance products such as longevity stop loss arrangements which can result in the obligation to pay longer term stressed annuity cashflows in the tail of the SCR calculation being transferred to the reinsurer and will thereby reduce the duration of both the SCR and Risk Margin whilst allowing the ceding entity to retain more of the underlying business. In most jurisdictions, more innovative arrangements are likely to be subject to regulatory scrutiny in order to confirm that genuine risk transfer has taken place.
How does all of this Ultimately Impact the Policyholder?
The approach to managing balance sheet volatility as a result of potential interest rate changes is both necessary and complex and comes with a cost that is ultimately paid for by the policyholder. So, what is the policyholder getting for his\her money?
In terms of mitigating the SCR requirement, the policyholder receives reasonable assurance that the insurance entity, of which they are a customer, is likely to be able to continue paying claims for the foreseeable future in a 1-in-200 stress event. One might argue that there is a direct and relatively tangible benefit to the policyholder in this case. Whether this represents value for money is a more complex question.
As mentioned above, mitigation of volatility within the Risk Margin due to interest rate movements is complicated and, therefore, likely to be more costly than mitigation of the SCR. The Risk Margin is an amount on top of the Best Estimate Reserve plus the SCR and therefore provides a level of cover beyond a 1-in-200 stress from the policyholders’ perspective. Ignoring the cost of holding the Risk Margin, would a knowledgeable customer be happy to incur an extra cost to cover Risk Margin volatility in the knowledge that they are already protected for a 1-in-200 event or would a measure that is less interest sensitive be preferable for all parties?
Management of interest rate risks in a Solvency II environment is still evolving as companies become more familiar with the implications and sensitivities of the Solvency II capital structure. As always, this difficulty is likely to prove to be an opportunity for some but as the cost of interest rate management and mitigation becomes more apparent, it will be interesting to see what will be the preferred approach to manage volatility and whether the European Commission’s review of the Standard Formula, to be completed before December 2018, will result in lower overall interest rate sensitivity for long-tailed liabilities.
Eamonn Mernagh is CRO with Canada Life International Re and a member of the SAI’s Enterprise Risk Management Committee
The views of this article do not necessarily reflect the views of the Society of Actuaries in Ireland, the Enterprise Risk Management Committee, or the author’s employer. The article was edited by the Communications Subgroup of the Enterprise Risk Management Committee.