Answers to the European Commission on the ... - Eiopa - Europa

Discounting
7.22 The present value of <strong>the</strong> expected cash flows is equal <strong>to</strong> <strong>the</strong> value of an
investment with identical cash flows <strong>to</strong> <strong>the</strong>se expected cash flows which
will be paid with certainty. Such an investment replicates <strong>the</strong> expected
cash flows of <strong>the</strong> liabilities. A more efficient way <strong>to</strong> arrive at this
present value is via discounting. An undertaking’s insurance liabilities
cash flows might be discounted using a term structure of interest rates
which has <strong>to</strong> be based on <strong>the</strong> effective yields on default-free capital
market instruments.
7.23 A risk-free interest rate curve might be determined using <strong>the</strong> yield on
<strong>the</strong> highest quality government bond issues available in <strong>the</strong> currency of
denomination of <strong>the</strong> liability. Where <strong>the</strong> risk-free yield cannot be
determined with sufficient confidence (for example because long
duration bond issues are not available in a particular currency) <strong>the</strong>n
reference may be made <strong>to</strong> proxy measures, such as <strong>the</strong> swap curve.
However, in such circumstances, <strong>the</strong>re should be appropriate
adjustments for <strong>the</strong> differences observed between government bond
yields and <strong>the</strong> observed proxy yields.
7.24 It may even be more efficient if <strong>the</strong> nominal term structure of interest
rates for <strong>the</strong> various currencies in <strong>the</strong> EU is prescribed (such as <strong>the</strong>
Euro spot rate term structure). Various central banks already publish
such term structures. This would allow insurers <strong>to</strong> value <strong>the</strong>ir liabilities
using a prescribed term structure. Transparency is fostered by this
method. If <strong>the</strong> capital market does not have <strong>the</strong> financial instruments
available <strong>to</strong> replicate <strong>the</strong> longer term liabilities of insurers, prudent long
term spot rates <strong>to</strong> arrive at a prudent extension <strong>to</strong> <strong>the</strong> market induced
term structure of interest rates may be prescribed. Ano<strong>the</strong>r option is
not <strong>to</strong> impose <strong>the</strong> discount rate <strong>to</strong> be used but <strong>to</strong> set principles for this
rate, notwithstanding <strong>the</strong> possibility for <strong>the</strong> supervisor <strong>to</strong> advise on a
market-related rate for a given book of business. This approach is likely
<strong>to</strong> be more flexible in taking in<strong>to</strong> account capital market developments,
but could have <strong>the</strong> effect that different insurance undertakings
interpret <strong>the</strong> principles differently.
7.25 However, valuing technical provisions with a risk–free interest rate
curve may not allow for 'sufficient prudence' technical provisions (as
expressed in CfA 7). It might weaken <strong>the</strong> position of policyholders, if
<strong>the</strong> provisions plus margins for risk do not reach <strong>the</strong> present level of
provisions. An alternative may be that <strong>the</strong> supervisor prescribes or
approves <strong>the</strong> term structure including a margin of prudence <strong>to</strong> calculate
<strong>the</strong> insurance liabilities. But using margins in <strong>the</strong> discount rate for
valuing liabilities may not be a satisfac<strong>to</strong>ry means of achieving an
explicit level of prudence. For example, using a discount rate of 60% of
<strong>the</strong> yield of a specified bond (an apparently explicit margin) in fact
implies using varying implicit risk margins because <strong>the</strong> actual margin
changes as interest rates change and is <strong>the</strong>refore not properly risk
related.
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