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

8.48 Three alternatives can be considered :
• absence of discounting, i.e. remaining with <strong>the</strong> actual standards;
• using a deterministic approach <strong>to</strong> discounting (with a duration or
a term-structure approach);
• developing s<strong>to</strong>chastic discounting techniques.
These options bring in different implications.
8.49 The main argument against <strong>the</strong> first alternative is <strong>the</strong> need for
consistency between <strong>the</strong> valuation of assets and liabilities. However, it
should be noted that discounting is an appropriate operation if flows
are certain as <strong>to</strong> <strong>the</strong>ir timing and amount, although any uncertainty
about <strong>the</strong> present value of claims should be reflected in <strong>the</strong> risk margin
in provisions. Fur<strong>the</strong>rmore <strong>the</strong> adoption of discounting techniques may
delay supervisory action as, in comparison <strong>to</strong> insurers with <strong>the</strong> same
equity, and in <strong>the</strong> case of a financially inadequate management, deficits
in <strong>the</strong> margin emerge slowly (and even more sluggish in <strong>the</strong> case of
slow claims paying insurers).
8.50 A deterministic approach could lead <strong>to</strong> problems associated with
choosing a particular discount rate: from a practical viewpoint <strong>the</strong>
subjective elements on <strong>the</strong> measurement of future cash flows would
need <strong>to</strong> include assumptions (implicit or explicit) on <strong>the</strong> timing of
payments and <strong>the</strong> rates of interest <strong>to</strong> be used. For example, with a
duration approach, selecting a risk-free rate would require <strong>the</strong> isolation
of premiums for credit and liquidity risk. Conversely, one of <strong>the</strong> main
alternatives – using a replicating portfolio assumption <strong>to</strong> derive <strong>the</strong>
discount rate – would be relevant only at a discrete point in time.
8.51 However, <strong>the</strong> difficulties of <strong>the</strong> deterministic approach should not be
overestimated. In most countries Government bonds can be regarded
as risk-free and <strong>the</strong>ir yield can be used <strong>to</strong> derive a suitable yield curve.
To address <strong>the</strong> fact that <strong>the</strong> uncertainty of <strong>the</strong> final amount tends <strong>to</strong>
increase with <strong>the</strong> time horizon, an explicit margin in <strong>the</strong> discount rate
(forming part of <strong>the</strong> margin in provisions) might be envisaged.
8.52 S<strong>to</strong>chastic techniques <strong>to</strong> discounting could offer greater realism. This
may be useful where yield curves are subject <strong>to</strong> frequent change.
However, it would involve important practical difficulties, which may be
of particular concern for less complex undertakings.
8.53 Ano<strong>the</strong>r issue arising from discounting is that <strong>the</strong> recognition of
discounting effects could have a negative impact on <strong>the</strong> harmonisation
of technical provisions, if <strong>the</strong> discount rate reflects only <strong>the</strong> home state
of <strong>the</strong> insurance undertaking. Different economic conditions prevail in
individual Member States, and should influence <strong>the</strong> level of technical
provisions. To ensure a level playing field, <strong>the</strong> calculation of technical
provisions – including <strong>the</strong> relevant discount rate – should reflect <strong>the</strong>
location and <strong>the</strong> currency of <strong>the</strong> liability.
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