Practical considerations in selecting the “risk-free” curve

1. Practical considerations in selecting the “risk-free” curve • A market consistent framework requires a “risk-free” yield curve to assess the technical provisions • The swap and bond curves have been identified as potential candidates and their performance against the theoretical requirements is the subject of a Discussion Document. Both have pros and cons with the swap given a slight edge. • There are however a number of further practical implications that should be considered: • The depth and liquidity of the swap market allows for more robust interest rate risk management for complex products. This enhances potential product innovation and value generated by the industry. • Prescribing the swap curve as the industry “risk-free” curve may have a detrimental impact on government funding. • Enforcing a single risk-free curve could result in poorer returns being offered to customers. • Creating artificial barriers within the investment markets (by prescribing a curve) may dislocate the markets and make them less efficient and liquid.

2. A potential way forward • Allow companies to select either the swap or the bond curve in assessing the technical provisions of different tranches of business. • Companies should determine an internal methodology for determining which curve to apply to ensure arbitrary changes are not made. • Potentially this methodology or details of the actual risk-free curve used could be disclosed. • Instead of requiring a matching principle (i.e. basing the curve used on the backing assets) to be followed allow companies to invest as they see fit. • Ensure the SCR makes appropriate allowance for risks assumed: • A basis risk assessment should be considered to acknowledge that there are two potentially different risk-free markets and to encourage assets to be invested consistently with liabilities. • A sufficiently robust interest rate risk assessment (twists and inflections) to encourage management of interest rate risk beyond simple immunisation. • Ensure companies are able to invest in either risk-free curve without incurring a credit risk capital requirement.

3. Extrapolation and illiquidity premiums • Non-market-observable assumptions are generally not prescribed and companies are required to determine these assumptions subject to certain minimum principles • The behaviour of the “risk-free” curve beyond its last observable point or the size of illiquidity premium in an illiquid part of the market are by definition not market-observable • I propose that similar principles are applied to these assumptions as all other non-market-observable assumptions (e.g. lapse and mortality rates) • High level principles that need to be followed should be prescribed: • methods for determining which liabilities may be considered to be illiquid • requirement that the illiquidity premium does not include any credit risk • requirement that methodologies be documented, approved by the board and applied consistently to all lines of business and over time. • etc. • A requirement to disclose these assumptions could be considered • The illiquidity premiums that can be earned by companies depend on their strategy and capabilities. Following this approach allows companies to set assumptions appropriate to their business.