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Focus Sweden: What If A Solvency II Style Curve Is Introduced?‏

ByDanske Markets
Published 01/29/2013, 03:34 AM
Updated 05/14/2017, 06:45 AM

After the plunge in long-term interest rates in mid-2012, Denmark and the Netherlands introduced Solvency II (S2)-type discount curves for their insurance companies and pension funds, resulting in solvency relief as well as drastically reduced interest rate risk and convexity for the liabilities. In Sweden the FSA introduced the discount rate floor. This temporary floor is set to expire in June this year, and the question is, what will the effect from a S2 discount rate curve be if implemented instead?

Current discount rate curve and a Solvency II discount rate curve
We assume that such an S2 discount curve (if introduced) would be based on swaps and that the last liquid point would be the 10y swap, as outlined in the QIS5. This would result in a delinking of market and discount rates beyond the 10-year. The major differences between the two discount rate mechanisms are the changes to the dynamics of interest rate hedging, specifically the convexity as well as the volatility of the hedge ratio. From the perspective of the reduced convexity, this would to a larger extent involve linear instruments (e.g. swaps) rather than non-linear instruments. The hedge ratio is set to almost double from 35% to 60% if an S2 curve is introduced (this is an estimated effect on our “model company”, which approximates the whole sector). Although we doubt that such a high hedge ratio is desired given the low interest rates, we nevertheless assume that companies will accept a slightly higher hedge ratio, say 40%.

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