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

Property risk
B.90 Changes in value of real estate may be modelled using a fac<strong>to</strong>r-based
approach, where <strong>the</strong> risk fac<strong>to</strong>rs are calibrated according <strong>to</strong> a
lognormal distribution. Its parameters (yield and volatility) can be
derived from suitable market indices. Risk capital is deduced in <strong>the</strong>
same way as for equity.
B.91 Alternatively, a scenario-based approach could be used <strong>to</strong> model
property risk. For <strong>the</strong> <strong>to</strong>tal real estate position, and taking account of
<strong>the</strong> investment policy, <strong>the</strong> institution has <strong>to</strong> determine <strong>the</strong> effect on <strong>the</strong>
surplus of a fall of for example 20% in <strong>the</strong> real estate benchmark used.
The position in real estate is <strong>the</strong> value of all long and short positions in
real estate and all financial instruments, such as real estate derivatives,
whose value is influenced wholly or partly by <strong>the</strong> value of real estate.
B.92 Under any approach, <strong>the</strong> standard formula may not distinguish
between direct and indirect real estate in <strong>the</strong> real estate portfolio or <strong>the</strong>
real estate investment subcategories for reasons of simplicity.
Interest rate risk
B.93 Interest rate risk exists for all investments and liabilities whose value is
sensitive <strong>to</strong> changes in <strong>the</strong> term structure of interest rates or interest
rate volatility. In any event, <strong>the</strong>se are fixed-income investments,
insurance liabilities, and financing instruments (loan capital) and
derivatives with a value dependent on interest rates. The value of
investments and liabilities sensitive <strong>to</strong> interest rate changes may be
established from <strong>the</strong> (prescribed) term structure of interest rates ('zero
rates'). This term structure can, of course, change over <strong>the</strong> period of a
year.
B.94 The value of <strong>the</strong> changes in <strong>the</strong> risk free interest rate could be
modelled with some interest rate model which should be chosen
according <strong>to</strong> <strong>the</strong> criterion of predictive power. The parameters of such a
model would be fixed by supervisors using his<strong>to</strong>ric time series and
allowing for current market assessments. One possibility may be <strong>the</strong>
Cox-Ingersoll-Ross model whose parameters are <strong>the</strong> drift (mean
reversion fac<strong>to</strong>r), <strong>the</strong> volatility and <strong>the</strong> mean reversion level (long term
average). 154 Then <strong>the</strong> development of <strong>the</strong> long term risk free interest
rate is given by
dr = κ ( µ − r)
dt + σ rdW,
where W denotes a Brownian motion. For determining <strong>the</strong> required risk
capital movements of <strong>the</strong> yield curve may be analysed including
parallel shifts, twists at <strong>the</strong> short end and fluctuations in <strong>the</strong> middle
range. For simplicity, parallel shifts are considered and <strong>the</strong> change in
interest rate is chosen <strong>to</strong> be <strong>the</strong> difference between <strong>the</strong> current level
and <strong>the</strong> quantile (0.5 % for a drop, 99.5 % for a rise) of <strong>the</strong>
distribution with respect <strong>to</strong> <strong>the</strong> time horizon of one year.
154 O<strong>the</strong>r interest rate models, such as <strong>the</strong> Black-Karasinski model, may also be appropriate.
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