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Long-Term Guarantee Impact Assessment

Tue, 29 Jan 2013 07:40:29 GMT

On 28 January 2012 EIOPA published the discount curves it wants companies to use for the Long-Term Guarantee Assessment (LTGA) exercise.  The LTGA is expected to run for 2 months, starting from 28 January 2012, with EIOPA supplying the European Commission with its findings by 14 Jun and the Commission committing to publish a report by 12 July 2012. The LTGA is intended to assess the impact of the proposed Long-Term Guarantee measures and provide quantitative input to help clear the current Omnibus II impasse.

The EIOPA discount curves are noteworthy for a couple of reasons:

  • The credit default adjustment at 31.12.11 is 35bp. The QIS 5 credit default adjustment was 10bp and a few folk had commented that a larger adjustment would result if the QIS 5 derivation were to be repeated in “current” conditions.

 Eur Forward RATE

  • The curves display a characteristic lack of smoothness (see chart - above). This is most evident when the spot curve is translated into a forward curve. In general EIOPA curves are noticeably less smooth than standard Barrie & Hibbert discount curves. This lack of smoothness results from the methodology used by EIOPA – notice how EIOPA forward curves frequently have a discontinuous first derivative at the last liquid point. We will return to the desirability of smooth curves in a future blog but for the moment just note that there is a philosophical question about whether curves should be smooth, flag a concern about the stability of the EIOPA approach and note the difficulty of fitting non-smooth curves to many commonly used stochastic interest rate models. The smoothness of EIOPA curves is not a new issue for the LTGA.

However, for the LTGA exercise to have value it is important that the EIOPA discount curves are used consistently and participating LTGA companies can obtain calibrations that fit the EIOPA curves.

Part 2 of the LTGA Technical Specification specifies the following scenarios for participating companies to complete:

  • Three different levels of counter-cyclical premium (CCP)
  • Various sensitivities around the matching adjustment
  • Sensitivities around extrapolation (last liquid point and speed of grading)
  • Transitional measures

Whilst the majority of the scenarios are as at 31.12.11 the LTGA also involves some values from 31.12.09 and 31.12.04 (although these scenarios are based upon the 31.12.11 Balance Sheet but re-valued to the earlier financial conditions - as defined by EIOPA).

Whilst the CCP sensitivities apply to all currencies a substantial part of the LTGA concerns the parameters used for extrapolating the EUR discount curve. With the GBP curve generally being accepted as liquid to 50 years there is little scope for significant LTGA measures around extrapolation in GBP – rather the debate in GBP concerns the operation of the Matching Adjustment.

Based on the Part 2 Technical Specification companies will be required to submit results for their Solvency II Balance Sheet (e.g. Assets and Technical Provisions) and data on their Solvency II Capital Requirements (e.g. SCR, MCR). The SCR values are expected to be calculated using the Standard Formula (although results calculated from an Internal Model can be submitted as supplementary information).

Since the LTGA is a Standard Formula based exercise most companies will just need economic scenarios to assist in calculating a market-consistent value on their complex, path-dependent, liabilities. Scenarios will be required for each of the appropriate LTGA scenarios to calculate the Sol II Balance Sheet and the corresponding stressed scenarios to calculate the SCR.

Whilst the scenarios any individual company has to run for the LTGA must remain the responsibility of the company we would expect, based upon the Part 2 Technical Specification, that a typical company wanting to  value their complex, path-dependant, liabilities would require scenarios on the following bases:

  • Base Scenario 0 at 31.12.11
  • Three different levels of CCP at 31.12.11 with a change in EUR extrapolation basis
  • The extrapolation scenario (LLP of 20 yrs for EUR, 40 yrs convergence) – note not needed for a GBP company - at 31.12.11
  • Base Scenario 0 at 31.12.04
  • Base Scenario 0 at 31.12.09

Each of these scenarios would require a base and stressed interest rate scenarios (up and down – unless the company can be sure which stress will “bite”) and a CCP stress. The stressed CCP scenario is a 100% instantaneous decrease in the CCP – thus the stress CCP scenario is the same for the three different levels of CCP at 31.12.11. Similarly, the CCP in the 31.12.04 curve is zero so no stressed CCP scenario is required for the 2004 calculations.

In the above analysis we have assumed, for simplicity, that complex, path-dependent, liabilities will be valued outside of the Classic Matching Adjustment and Extended Matching Adjustment.

Barrie and Hibbert is ready to assist any company participating in the LTGA.

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