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Dr Florian Ueltzhöfer

Actuary DAV/IVS

Teoman Kaplan

Actuary DAV

Discussing the effects of the TTP (Transitional Measure for Technical Provisions) and searching for a reason to explain Solvency movements of the “losers”, the Ultimate Forward Rate (UFR) seems to play a crucial role. Let’s see why and how:

When the Solvency II project started “decades” ago, yields were still existent. The actuaries have had to discuss how to model the long end of the yield curve as, in some countries, liabilities have very long maturities of up to 100 years. Taking market data only has not been an option, as there are hardly any instruments (e.g., swaps) traded with the necessary liquidity for all the required maturities. Somewhat arbitrarily, a Last Liquid Point (LLP) has been determined for each currency (e.g., 20 yrs. for EUR). Beyond the LLP, it is assumed that no observable market data exists.

So how shall long-term liabilities be discounted? Well, this called again for the actuaries to come up with a maximally complex way to extrapolate the yield curve, while leaving enough “free” parameters to be chosen by the regulator, such that any desired term structure could be achieved. The most important of these is the UFR which, in simple words, is the value that yields are always ultimately expected to come back to. Based on a mixture of historical growth rates and inflation expectations, the UFR for the Euro was set to 4.2%, and this is, once and for all, going to be the forward rate for all maturities of 60 yrs. and beyond! If you think that is already quite complex and weird, fasten your seatbelts, as we are going to analyse how this has made some of the countries look like “losers” during Q1/2020!

1. The overall drop in swap rates has certainly not been beneficial. Combined with a Volatility Adjustment (VA) increase of 39 bps., the applicable rates up to the LLP of 20 yrs. have at least increased between 1 and 41 bps (see (1)) and compensated for the drop in yields.
2. Since 2018, the UFR is no longer ultimately fixed, but a moving target calculated annually. In 2019 it was 3.90%; in 2020 it was 15 bps. less. Just like in all other first quarters, this has put a substantial strain on the Solvency ratios in the countries with longer than 20 yrs. liabilities. In the extrapolation phase (see (2)), the QTD change is mostly driven by the UFR already being worse than -10bps. from 70 yrs. onwards.
3. Despite the overcompensating effect of the VA described in our previous episodes, in Germany, France, Austria and Norway, other losses in Solvability appear to have massively exceeded the support by the VA. Moreover, the annual amortisation of the TTP is added on top. By construction, 1/16th of the initial TTP applied is added to the Technical Provisions (TP), as described in our last post. This increase of the TP also leads to a very strong decrease of Own Funds.

Since we haven’t said a word about the Nordics so far, let’s briefly start with Norway, which is hit quite hard by the effects described, despite having its own currency and VA. The LLP for the NOK discount curve has been set to 10 yrs. only. Therefore, the NOK-VA is also applied for maturities up to 10 yrs. only, the point where the extrapolation takes over. Combined, this weakens the VA, and strengthens the UFR impact.

Again, this short analysis won’t capture all the reasons why we have seen these strong movements in Solvency ratio, but should be the basis for further thoughts.

LOOKING FORWARD TO FUTURE DISCUSSIONS ON THIS CHANNEL!

Development of risk-free interest rate term structure (incl. VA) in Q1/2020

Source: EIOPA, Risk-free interest rate term structures, Monthly technical information Dec 2019 and Mar 2020; own calculation.

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