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

B.95 In a scenario-based approach, <strong>the</strong> aim of <strong>the</strong> interest rate stress test is
<strong>to</strong> establish <strong>the</strong> sensitivity of <strong>the</strong> surplus <strong>to</strong> movements in <strong>the</strong> term
structure and <strong>the</strong> desired solvency for interest rate risk derived from it.
The stress test <strong>to</strong> be computed relate <strong>to</strong> a general 'rise' and 'fall' in <strong>the</strong>
term structure of interest rates as used <strong>to</strong> discount <strong>the</strong> insurance
liabilities.
B.96 The value of <strong>the</strong> liabilities and investments is again determined
comprehensively, assuming <strong>the</strong> prescribed higher or lower term
structure of interest rates. The scenario with <strong>the</strong> largest loss has <strong>to</strong> be
computed. This applies <strong>to</strong> both scenarios if it cannot be said with
certainty in advance whe<strong>the</strong>r an interest rate increase or fall is <strong>the</strong>
more unfavourable for <strong>the</strong> financial position of <strong>the</strong> institution. The
change in <strong>the</strong> surplus (difference between <strong>the</strong> value of <strong>the</strong> investments
and <strong>the</strong> value of <strong>the</strong> liabilities) is established for each scenario. The
greatest loss is included when determining <strong>the</strong> capital charge for
interest rate risk.
B.97 Yield curves movements (rising and falling) for <strong>the</strong> standard formula
may be prescribed. Two aspects may have <strong>to</strong> be taken in<strong>to</strong> account in
determining <strong>the</strong> stress tests. Firstly, <strong>the</strong> volatility in 'zero rates' for long
periods is relatively less than for short periods. The higher <strong>the</strong> initial
'zero rate', <strong>the</strong> larger <strong>the</strong> expected change. Both characteristics are
commonly observed empirically.
B.98 Alternatively, a fac<strong>to</strong>r-based approach could be used <strong>to</strong> model interest
rate risk. The concept of modified duration may be applied for <strong>the</strong>
actual assessment. Following a drop in interest rates (negative), both
<strong>the</strong> market values of fixed income securities and <strong>the</strong> value of liabilities
increase. The capital requirement <strong>to</strong> cope with <strong>the</strong> interest rate shock
amounts <strong>to</strong>
mod
SCR = max[ 0,
−∆
⋅ ( TP ⋅ D − MV ⋅ D
TP
FI
mod
FI
where MVFI denotes <strong>the</strong> market value of fixed income securities, TP <strong>the</strong>
value of <strong>the</strong> liability, SCR <strong>the</strong> risk capital, D mod <strong>the</strong> modified duration
and ∆ <strong>the</strong> drop in interest rates. The indices refer <strong>to</strong> technical
provisions (TP) and fixed income (FI).
B.99 For a rise in interest rates, <strong>the</strong> concept of modified duration yields <strong>the</strong>
capital requirement
mod
SCR = max[ 0,
∆ ⋅ ( MV ⋅ D − TP ⋅ D
FI
FI
B.100 Since a drop and a rise in interest rates cannot occur simultaneously,
risk capital should be taken as <strong>the</strong> maximum of both.
mod
TP
)],
)],
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