06 June 2013

Risk.net: Swedish insurers warn of manipulation threat to new discount curve

Swedish insurers have welcomed a proposal for a Solvency II-based discount curve, but there are concerns about the ALM implications of the new curve and the potential for it to be distorted by speculative traders such as hedge funds.

The Swedish Financial Supervisory Authority (FSA) is consulting on the methodology for determining the discount curve. Under the proposals, liabilities will be discounted primarily using swap rates up to the 10-year last-liquid point (LLP), after which the curve will be extrapolated to an ultimate forward rate of 4.2 per cent at the 20-year point.

Jakob Carlsson, chief financial officer of Lansforsakringar Liv in Stockholm, says the proposals would improve the company's capital requirements by 3–4 per cent and would reduce the overall interest rate sensitivity of liabilities by 35–45 per cent, reducing the need for hedges. "We welcome the change. Now we have a curve that is more hedgeable", he says.

But there are concerns about the ALM implications of the new curve and the potential for it to be distorted by speculative traders such as hedge funds. Interest rate sensitivity is focused around the 10-year LLP, meaning the preferred hedge for the curve will be 10-year swaps. There has been a surge in the purchasing of 10-year contracts and speculative positioning by hedge funds for tighter long-end swap spreads since the plans were first announced in February, bankers say.

The speculative trading activity has already had an influence on shape the yield curve and is a potential cause for concern, say insurers. Håkan Ljung, group chief risk officer at Skandia Liv, says: "We will look further into the sensitivity of the suggested extrapolation method to potential market manipulation. As we see it, robustness to market manipulation should be a key requirement on the discount rate."

While the new curve will be based on swap rates rather than the average of covered bond zero coupon rates – which will make it easier to hedge – insurers are also working out how to hedge the curve effectively between the 10- and 20-year points, which is not determined by market rates.

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