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Denmark and Netherlands imposed the UFR curve for discounting long-term L&P liabilities in 2012. This had some unintended implications in the market that required risk managers to change their hedging strategies. These effects will much likely increase when the Solvency II framework comes into force for EU member countries.

38 Before the new discount curve was implemented in Denmark, the typical ALM strategy was to invest in long-term bonds to match the long maturities of their liabilities; hence the demand for bonds with a long duration was generally high with corresponding low yields. A consequence of the implemented curve is that liabilities cannot be closely matched since the discount curve is

constructed and uninvestable. This had major impacts on the risk to L&P companies with

considerable changes in their interest rate sensitivity. As a result risk management was faced with shifts in their hedging strategies in order to meet the new SW regulation in the best possible way.

7.2.1 Market Distortions

In June 2012 Danish L&P companies adopted the SW method, where the market responded immediately. Because of the fixed UFR, the regulatory changes decreased the interest rate risk for long-term liabilities significantly, and L&P companies eliminated the risk exposure beyond the LLP.

Beyond LLP, market fluctuations will be ignored in the SW forward rates, so a liability with 60- year maturity will behave similar to a 30-year liability in terms of interest rate sensitivity. The segment of the curve that now needs to be hedged is the part before the LLP, i.e. 0-20 years, and one of the reactions to the new regulation was increasing yields on long-term bonds. A reason for the increased yields was a decreased demand for long-term bonds due to a lower need of hedging long maturities. In other words, the demand for duration was not as strong as before, resulting in increased long-term yields. For example, the yield on Danish 30-year bonds was especially affected by the announcement of 12th of June, and from June 11 to June 13 in 2012, the yield increased by almost 14 basis points (Investing.com).

The Danish long-term bond yields were not the only one affected by the regulation of June 2012. The 30-year euroswap rate increased significantly with 11 basis points after the announcement, resulting in an increased yield spread with the 10-year euroswap by 14 basis points (Becker 2012). This effect was amplified by the Dutch regulators announcement of a similar method for Dutch insurers in July 2012, where the spread steepened with additional 12 basis points. By September 2012 the spread between the 10 year and 30 year euroswap rate reached the highest level since 2005, with 42 basis points. It is interesting to see how strong effect only two countries had on the euroswap curve, as a result of the introduction of the SW discount method. Based on this, how will the market react when Solvency II implements the UFR curve for all EU countries?

7.2.2 New Hedging Strategies

Compared to interest rate sensitivity under market-based valuation, the SW method will create a huge exposure to the LLP interest rate. The sensitivity at this point is actually more than 10 times higher than with a marked based valuation (Rebel 2012), since all the interest rate risk for liabilities with maturities beyond LLP is concentrated at this particular point. Since LLP is the point where the extrapolation of the long-term discount curve starts, a fall in the market interest rate at this point will push the extrapolated curve down, hence hedging instruments at this point are required.

39 The increased demand for interest rates instruments at the 20-year point in the SW method will reduce this yield and push down the extrapolated curve. An interesting implication by this hedging strategy is that the present value of a 40-year liability would be affected by changes in the 20-year swap rate, but not by changes in the 30-year swap rate, which is in conflict with a market consistent method.

To enlighten this by an example, an interest rate hedge could be constructed for a 40-year pension liability. In this hedge there be would no point in hedging with matching 40-year maturities; because of the data beyond LLP is only partial market consistent. The correct hedge would be to invest in the 20-year point, i.e. the LLP. When one year goes by, there is still 39 years left of the liability, so the long-dated liability will still be exposed to the LLP. However, the remaining maturity of the swap will be 19 years, which makes the hedge ineffective. So every year the hedge needs to be rebalanced with a new 20-year swap. But the increased demand for the 20-year segment has pushed the yield on these instruments down, while an upward pressure is put on the 19-year yield. If this effect is significant, this will push the extrapolated part of the yield curve down, which will increase the present value of liabilities and worsen the funding ratio for the L&P sector. The slope of the extrapolated curve beyond LLP is mainly determined by the two last observed market interest rates before LLP, the 15-year and the 20-year points. We have already explained the high concentration of interest rate sensitivity at the 20-year point, but the market interest rate prior to LLP, the 15-year rate, are also sensitive to changes in the interest rate, but in a reversed manner. Hence an increase in the 15-year rate, with an unchanged 20-year rate, will make a drop in the steepness of the curve between these two points. This will affect the extrapolated curve beyond LLP by forcing the yield curve down, which will increase the present value of the liabilities. This is the reason why L&P companies base their hedging strategies around the 15-year and 20-year point, to hedge away the risk of decreasing market interest rate at the 20-year point and increasing market rates at the 15-year point. So a rise in interest rate at the 15-year point, will lead to increased values of liabilities with maturities longer than 20 year, which is counter intuitive seen from an economic fair value perspective.

The new hedging strategies resulted in reduced long-term investments in exchange for long

positions in swaps and bonds with 20 years maturity, to hedge against falling interest rates at LLP. In addition, L&P companies should hedge against a rising 15-year rate, due to the reversed

sensitivity at the point before the LLP. The new regulatory hedges could then include swap

contracts of receiving a fixed rate at the 20-years point and paying the floating leg to hedge against decreasing interest rates, and take a short position at the 15-year point.

The difference between the new and the old hedging strategy is illustrated in the figure below, taken from (Evans, Hegeman et al. 2013):

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Figure 7: New vs. old hedging strategy

The figure shows the portfolio of interest rate swaps needed to hedge L&P liabilities. In the first case the liabilities are discounted with the market swap curve, which is compared with the second case where they are discounted with the SW curve. With SW as the discount method, a large amount is invested to hedge interest rate risk at the 20-year and 15-year point. None of these positions are needed in the same degree when discounting with the swap curve, where the hedging investments are evenly spread out across maturities. This illustrates the market distortions imposed by the new constructed discount curve.

7.2.3 Economic- and Regulatory Hedges

The implementation of the SW discount curve resulted in substantial differences between regulatory- and economic hedges. An economic hedge is constructed to remove or reduce the economic risk in the balance sheet, like interest rate risk, credit risk, foreign currency etc.

Regulatory hedge on the other hand, has the purpose of limiting the exposure towards changes in political regulations.

For example, the current UFR target is sat at 4,2%, but it can change to 3,2% or 5,2% based on expected inflation in a country. A sudden political decision like this would impose large changes in the present value of L&P companies’ liabilities, which is a political risk. A consequence of the imposed SW discount curve is that L&P companies get encouraged to invest in regulatory hedges instead of economic hedges, which leads to a distorted risk profile that does not reflect the real economic risk of L&P companies.

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