Duration gap and multiple considerations for insurance investors
Enrico Conti, Finance Specialist, Reale Mutua, explains the duration gap for insurers, especially within the current era of increasing interest rates.
Enrico Contiposted on Thursday, December 08, 2022
Why is the duration gap – along with its calculation and evaluation – important for insurance companies?
When assessing current changes to the financial structure of insurance investments, we also need to consider the effects of increasing interest rates. This means we need to look at several facets of the duration gap, including what it does.
"One of the liabilities is necessary to estimate the effective duration through discounting cash flows and considering the randomness of the technical hypothesis present."
The duration measures the average life of a bond considering distribution of generated cash flow over time. Modified duration, on the other hand, is used to verify how the market value of cash flows changes as interest rates vary.
One of the liabilities is necessary to estimate the corresponding effective duration through discounting cash flows and considering the randomness of the technical hypothesis present in the result.
The gap measures the difference in duration between assets and liabilities. A positive outcome means that the company is asset sensitive - while a negative gap shows liability sensitivity. Financial managers use the duration gap to calibrate the positioning of assets – compared to the technical side – to reach the target driver.
Scenarios to test the duration gap
This Asset-Liability Management analysis – alongside Planning & Control and Risk Management goals – uses duration gap modelling as a quasi-measure of portfolio sensitivity to interest rates to evaluate how the financial margin is affected by market conditions, for instance, in the ALM observations. This means that this analysis otherwise estimates volatility on balance sheets – as well as shareholder equity – from movements in rates, as the impact on the capital requirement in Solvency II is more intensive and floating for duration mismatches.
The next methodological implication of the duration gap is coming soon, with the new IFRS9 and IFRS 17 legislation, which is being introduced to the market as a market-value-based accounting standard. The amount of duration gap will power the release of contractual service margin (CSM) on changing interest rate period.
If this happens, a positive gap with a move up of the curve will see a negative effect on the unit of account, while the same interest rate movement in a negative duration gap will benefit - with a profitable CSM release - the consequence in volatile earnings.
"The review could mean we see a downside shock scenario when compared to the based example, therefore deleting the zero-rate floor in the calculation."
The new Solvency II regime
Lastly, the ongoing process of reviewing the EU Solvency II framework in the alternative extrapolation method risk-free curve could also impact the Best Estimate Liabilities.
The review could mean we see a downside shock scenario when compared to the based example, therefore deleting the zero-rate floor in the calculation. Based on the foregoing considerations, an average duration of liabilities greater than that of assets would be impacted by this change, especially since the worsening of the shock down will generate an increase in technical reserves greater than the corresponding increase in the market value assets and negatively affecting own funds.
In the present scenario – with interest rates increasing – an insurance company’s tactical-flexible capacity is functional at its past duration gap management in the low-interest scenario, where the difference between asset and liability duration has been maintained negative.
"Topics such as methodological consequences and scenario situation are attractive entry points to the discussion on closing the existing duration gap."
With this, it could then have a market advantage, even if precedence meant that it had endured a tight capital cost due to the gap, which could always be recovered with its closing.
Topics such as methodological consequences and scenario situation are attractive entry points to the discussion on closing the existing duration gap, which is typically created by asset exposures with shorter durations than liabilities. When defining asset allocation strategy and monitoring drivers – both on the portfolio management and accounting side – assessing the duration gap can help reduce mismatches and manage interest-rate exposure.