The difficulty with hedging against interest rate rises

As monetary policies return to normal, insurance companies must plan for higher interest rates.  Dr. Olaf Sleijpen, a Management Board Member at EIOPA and Director of the Supervision Policy Division, De Nederlandsche Bank explores why an economic approach to hedging might be the best policy for firms.

The views expressed are not necessarily those of European Insurance Occupational Pensions Authority (EIOPA), but they do reflect the views of the Dutch Central Bank.

Insurance Investor Editorposted on Thursday, September 19, 2019

This is part two in a series – to read part one, which looks at when interest rates are likely to return to normal – click here.

This article is taken from the research report Insurance Asset Management, Europe 2019. To download the full report click here.

The Ultimate Forward Rate is (UFR) one of the few instances in life where the further out into the future we go, the more certain outcomes become.

After all, under Solvency II, Euro-denominated liabilities are discounted using market-based discount rates only up until the 20-year point, but for the UK it is 50 years.

This means that a lot of what I am talking about is relevant for insurance companies with Euro-denominated liabilities and less of an issue for UK insurers or insurance companies with Sterling-denominated liabilities.

After the 20-year point, the discount rate is extrapolated with the extrapolation being based on the UFR. The aim of UFR is to ensure a smooth discount curve and while it does stabilise discount rates, it does not necessarily do the same for the funds of an insurance undertaking.

"It may not be straightforward to hedge the UFR, since it is not a return that can be earned in the market, nor is it risk free"

In a situation where interest rates rise quickly, the UFR can cause volatility in the Solvency II own fund position of insurers.

To put it simply, under the current UFR, when interest rates are rising, the Solvency II value of liabilities does not fall as much as the value of the insurers assets causing own funds to fall.

This is true even where the cashflow of the insurers assets and liabilities are perfectly matched. This situation causes difficulties for insurance companies.

It may not be straightforward to hedge the UFR, since it is not a return that can be earned in the market, nor is it risk free.

As the UFR and the extrapolation targeted are more or less fixed, the interest risk is concentrated around what we call the last liquid point – 20 years – which may also create hedging difficulties.

This may cause substantial adjustments in hedging positions, especially when larger movements in interest rates occur.

The biggest issue is that the UFR creates a trade-off where insurers must choose between hedging their economic balance sheet on the one hand and ensuring a more stable Solvency II position on the other.

Especially when interest rates rise from lower levels, these two strategies can yield some hard choices.

"The UFR creates a trade-off where insurers must choose between hedging their economic balance sheet and ensuring a more stable Solvency II position"

When an insurer chooses to hedge their economic balance sheet, a rise in interest rates would likely cause a short-term fall in Solvency II own funds because the Solvency II value of assets falls faster than that of the liabilities.

This trade-off between economic hedging and Solvency II hedging not only causes volatility in their own funds but can affect the type of interest rates that the insurers are exposed to.

The UFR now is substantially above market rates, but as liabilities move nearer to the present, they will start to become discounted using market rates and not the extrapolated UFR.

This shift from extrapolated yields to market yields causes a substantial drop in the discount rates and has a substantial rise in the value of the liabilities.

This is the UFR drag and it causes volatility, as well as a sudden drop in the insurer’s own funds. For this reason, the Dutch Central Bank has a preference for interest rate hedging to be done on the basis of economic, market interest rates, as ultimately these are the rates that matter.

The importance of hedging

Hedging based on economic variables causes volatility in the Solvency II own funds and as such we have looked at this issue more closely in recent years. We have found that for an insurer that is economically hedged, an interest-rate shock would produce volatility in the Solvency II own funds in the short-term.

However, we also found that over time this volatility diminishes. As the UFR drag disappears, the Solvency II own funds converge back towards the level they would have arrived at had no interest rate shock occurred.

For an insurer that hedges short term Solvency II own funds, an interest rate shock would cause greater divergence from the original own funds trajectory over time.

In fact, beyond a 5-year horizon, the short-term volatility in own funds that occurs under economic hedging is smaller than the increase in volatility under Solvency II hedging.

"For an insurer that is economically hedged, an interest-rate shock would produce volatility in the Solvency II own funds in the short-term"

This means that once again, from a supervisory perspective, it is preferable for insurers to hedge their interest rate risk and manage their balance sheets on a more economic basis; i.e. based on market interest rates.

It is true that if and when interest rates go up, economic hedging will cause short-term volatility and downward pressure on the insurer’s Solvency II position.

We are willing – up to a point – to look through these short-term effects because one of the advantages of economic hedging is the substantial advantages found over the medium to long-term.

It is also important to note that our views on economic hedging versus Solvency II hedging in no way mean that we are gold plating Solvency II.

"Taking a more economic perspective to insurers balance sheets, evaluations might reveal different views on which insurance undertakings are over or under-valued"

To the contrary: Solvency II for us is the benchmark and when it comes to the Solvency Capital Ratio (SCR) the minimum requirement is 100% not more and not less. When the Solvency II ratios indicate that supervisory actions are required, we will act.

Firstly, the capital position will be sounder and more stable both from an economic and Solvency II perspective and secondly, the hedging and investment strategies are much easier to execute from the asset manager’s perspective, so it is a win-win situation.

It would be helpful if analysts and financial markets understood this better, as it would lead to a better assessment of insurance undertakings’ financial positions. Taking a more economic perspective to insurers balance sheets, evaluations might reveal different views on which insurance undertakings are over or under-valued.

That’s the VA to do it

The next issue is around the Volatility Adjustment (VA), which in Solvency II represents a markup of a certain number of basis points that insurers may add to the risk-free discount rate used to value liabilities.

The original idea of the VA was to insulate insurers’ own funds from volatile movement in prices of insurers’ investments and large shocks in spreads.

The VA can cause volatility in the Solvency II position of an insurer, especially when spreads increase substantially as they may do following monetary normalisation. The origin of this volatility lies in the difference of movements in the value of assets and liabilities as spreads rise.

The investment portfolio on which the VA is based, is on the average investments of various insurance companies. In the case of the Euro area, this means the portfolios of many insurers spread across a multitude of countries. This makes it unlikely that the VA reference portfolio will match the investment portfolio of any one insurer.

"The VA can cause volatility in the Solvency II position of an insurer"

For Dutch and German life insurers, investment portfolios are very often based on investments in Dutch and German government bonds. This means that the investment strategies of these insurance companies are quite often much more conservative than that of the VA reference portfolio.

If monetary policy is normalising, it is likely that spreads on bonds, especially riskier bonds, which have been suppressed in recent years, will increase.

Where such increases are sudden and substantial, this could well lead to situations where spreads in the VA reference portfolio rise more substantially than those in the insurers’ investments.

Since the VA is added to the liability discount rate, this will cause the value of liabilities to fall more substantially than that of the assets, which, in turn, will result in volatile own funds.

In this case, insurers would be over-compensated for the increase in spreads. For Dutch insurers and others, this overcompensation effect is substantially amplified by the fact that the average duration of their liabilities is longer than that of their assets.

As a result, we witnessed the overshooting effect in the 2016 EIOPA stress test for several insurance companies, in particular, Dutch insurance companies, where the shock of seeing an increase in spreads actually led to a large improvement of the solvency position of insurance companies.

"Replicating the VA portfolio for the Dutch and German markets implies investing in riskier assets"

This is good news and nice for insurance companies, but such an outcome would not be in line with economic reality. So, we look at how the balance sheet would develop were the VA not applied.

The VA could also give rise to another concern that we have as supervisors, which is that it provides a possible incentive when it comes to the investment strategy: insurers may try to hedge for movements in the VA by simply replicating the VAs reference portfolio within their own investment strategy.

Firstly, we do not want insurers to put all of their eggs in the same VA basket. Moreover, replicating the VA portfolio for the Dutch and German markets implies investing in riskier assets.

Therefore, the VA reference portfolio may not be the right investment portfolio for that insurance company in terms of cash flow matching or risk appetite.

We therefore tend to look through such strategies and consider instead the underlying characteristics of the investments and the risks that this brings for the insurance company.

In part three of this series – Dr Sleijipen explores the bigger picture and why the Solvency II framework should be adjusted to better account for economic realism. To read it click here.

This article is taken from the research report Insurance Asset Management, Europe 2019. To download the full report click here.