01 May 2012

Risk.net: The extrapolation conundrum

One of the most fundamental points of Solvency II still remains one of the most contentious. Blake Evans-Pritchard reports on how the risk-free rate has moved from the technical to the political

The cornerstone to predicting future cashflows is working out the rate at which market instruments should be discounted, so as to derive the best approximation of market values. This is not a problem when there is sufficient market data, but past a certain point reliable data can become scarce. When this happens, prices have to be extrapolated from the last reliable data point – and it is working out a suitable extrapolation for all markets that has been causing such sleepless nights for Europe’s actuaries.

Concerns over the extrapolation process vary between Member States, depending on how long the liquid structures are for each market, says Per Jakobsson, an actuary at Finansinspektionen, the Swedish financial supervisory authority, in Stockholm and current chair of the European Insurance and Occupational Pensions Authority (EIOPA) working group on Solvency II technical provisions. “Countries with a longer liquid structure would generally favour longer extrapolation periods, whereas a shorter period might be more appropriate for those markets where liquidity vanishes quite quickly”, says Jakobsson.

On March 21, the European Parliament’s Economic and Monetary Affairs Committee voted through a compromise Omnibus II text, which includes a proposal for how the extrapolation of the risk-free rate should be handled. The proposal will be considered in the trialogue negotiations between the Parliament, European Commission and Council, which will result in an agreed Omnibus II text for Parliament to vote on in plenary session.

Under the proposal, the last liquid point, after which artificial extrapolation is necessary, is set at 20 years for the eurozone, far earlier than some countries – such as the Netherlands – had wanted. After this point, the yield curve is extrapolated over a period of 10 years, until an ultimate forward rate (UFR) of 4.2 per cent is reached.

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