MEMORANDUM
TO:
Members of the CAA
FROM:
SUBJECT:
Neil Dingwall, Chairman, CAA Standards Steering Committee
Principles and Considerations for the selection of the Discount Rate Curve –
Discussion Draft
DATE:
22 April, 2013
At the 2010 Caribbean Actuarial Association Annual Meeting, Council approved the
development of a comprehensive set of Actuarial Standards that will apply to work
performed in the Caribbean region. The objectives of the project were outlined as
follows:

Caribbean Actuarial Standards will become the Caribbean Standard.
That the Caribbean Actuarial Standards will be consistent with International
Actuarial Standards.
The overriding purpose of CAA Practice Standards is to serve the public interest by
ensuring that the users of actuarial services in the Caribbean benefit from a high quality
of actuarial work. An additional motivation has come from the regulators in the region
who have expressed a desire for the C.A.A. to take an active role. As a profession, selfgovernance and self-regulation should be our preference.
In accordance with due process, Council appointed a CAA Standards Steering
Committee to produce the Standards. The CAA Standards Steering Committee has
divided the project into various segments, some of which are able to run concurrently
and some which will need to be sequential. The drafting work has been performed by
the Practice Committees and a number of new and revised standards were exposed and
adopted by the membership.
Attached is a discussion document on the Principles and Considerations for developing
the discount rate curve in preparation for the development of a separate practice
standard on this issue
Also included is the Actuarial Standards Architecture background paper.
In commenting on and reviewing the attached Discussion Draft, we would ask that, as
far as is practicable, you follow the instructions in Appendix 1 of this memo. Also, it
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CAA DD APS2.1 22 April 2013
would be of benefit to the committee, if you could answer the questions contained in
Appendix 2.
After receiving and discussing comments it is planned to draft a practice standard and
expose for comment. Sessions will be held at the Annual meeting to allow for further
discussion and allow the Practice Committees to report both the comments received and
what further amendments they would recommend in making their recommendation for
adoption by Council at their meeting.
The CAA due process for the approval of new standards requires an initial six month
exposure period. As this is a discussion paper the steering committee has set a deadline
of 30 June 2013 for receiving all comments and feedback.
Comments, suggestions, recommendations for amendments and any other feedback on
Discussion Draft APS2.1 should be submitted by email to the chairs of the Life subcommittee,
The Steering Committee looks forward to communication with the members and with
other interested parties, who wish to raise issues of concern throughout this process.
Neil Dingwall.
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CAA DD APS2.1 22 April 2013
Appendix 1: Instructions for Commenting
1.
The deadline for official submission of comments is 30 June 2013.
2.
The draft has been circulated in Microsoft Word format in a two column layout. Please insert
your comments in line with the relevant paragraph in the second column.
3.
Unless necessary, please do not use Microsoft Word’s “Track Changes” features to indicate your
changes.
4.
As part of the review process, your comments may be shared with the wider membership but
individual views will not be identified with any specific member.
5.
Submissions specific to the Principles and Considerations should be emailed to the relevant
Sub-committee Chair as outlined in the memorandum.
6.
Any comments on the overall approach or related to the CAA’s due process can be addressed to
the
Co-Chairs
of
the
CAA
Life
Committee,
Simone
Braithwaite
at
simone.brathwaite@oliverwyman.com
and
Marcia
Tam-Marks
at
mtammarks@morneaushepell.com
7.
Please include a completed version of Appendix 2 with your submission.
22 April 2013
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CAA DD APS2.1 22 April 2013
Appendix 2: Questions for Members, CAA Advisory Council,
Regulators and other interested persons.
This is a discussion draft on Principles and Considerations in determining the discount rate curve. This is
a working document and therefore your comments and feedback are required.
Q1:
Does the draft Principles and Considerations document adequately explore the issue of discount
rate setting?
Q2:
Is there any additional guidance that you would like to see included?
Q3:
Are there other issues relevant to the discussion that are not addressed in the document and
that you would like to see addressed?
Q4:
Is there any aspect of the Principles and Considerations document that you consider
inappropriate or unnecessary?
Q5:
Are there other sources of information that you would recommend we look at to facilitate the
discussion?
Q6.
The focus of the draft Principles and Considerations document is primarily with respect to the
Life Insurance practice. Do you think that the application of this discussion document should be
extended to include Pensions and Social Insurance and if so, what are the additional issues that
should be addressed?
Q7:
Do you have any comments or suggestions on the next steps in the process?
22 April 2013
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CAA DD APS2.1 22 April 2013
CAA LIFE COMMITTEE
CARIBBEAN ACTUARIAL ASSOCIATION
PRELIMINARY DISCUSSION DRAFT
Modification of Existing Standards
Caribbean Actuarial Association
Standard of Practice
APS2.1: Principles and Considerations for the selection of
the Discount Rate Curve
A Preliminary Discussion Draft of the
Committee on Actuarial Standards of the CAA
Issued: 22 April 2013
Comments Due:
30 June 2013
This Exposure Draft of a discussion paper for Actuarial Practice Standards
APS2.1 is issued by CAA Life Committee for comment.
Written comments should be addressed to:
simone.brathwaite@oliverwyman.con or
mtammarks@morneaushepell.com
by 30 June 2013
CAA DD APS2.1 22 April 2013
6.2CAA Life Committee Initial Views on UFR
Contents
7 Question 5: What is the best extrapolation method?
1 Executive Summary
2
1.1Summary Action List on Discount Rate
2
1.2Summary of Principles and Industry standard-setters
4
2 Introduction
2.1Five key questions
3 Question 1: What are the available sources of market data?
8
9
11
3.1Principle – Use of all relevant observed market data
11
3.2CAA – LC initial view
14
4 Question 2: How should credit risk, sovereign risk and illiquidity
premium be accounted for?
17
4.1International views on Credit risk and Sovereign risk
17
4.2CAA-LC Initial Views on Credit Risk and Sovereign Risk
22
4.3Illiquidity risk
23
4.4CAA-LC initial views on illiquidity risk
24
5 Question 3: At which point is the last liquidity point?
39
42
7.1How to grade from the last observed liquid forward rate to the
ultimate rate
42
7.2Principles and key criteria for the choice of the extrapolation
method
44
7.3Convergence
46
7.4Initial CAA-LC View
48
7.5The extrapolation should follow a smooth path from the entry
point to the unconditional ultimate long-term level
48
Appendix A
A.1. Survey on asset portfolio of insurance companies
Appendix B
49
49
56
B.1. Principle 1: Extrapolated market data should be arbitrage-free56
B.2. Principle 3: The extrapolation method should be theoretically
sound
56
26
5.1Summary of methods and considerations used in more developed
markets
27
5.2CAA-LC initial views on the last liquidity point
28
5.3Survey of 7 Expert practitioners in the region (TBC)
33
6 Question 4: Choice for the unconditional ultimate long-term level
35
6.1Solvency II considerations
37
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Comments
1 Executive Summary
This paper summarises considerations and principles promulgated
by the various International bodies and forums on the development
of a discount curve which could be adopted for the Caribbean
insurance industry. It also provides a discussion and outlines the
CAA Life Committee’s (CAA-LC) initial views on how these
international principles and guidance can be applied in the
Caribbean context.
Summary Action List on Discount Rate
1.1
1. Agree on Principles (Life Committee).
2. Develop a document with the CAA-LC’s initial views on Principles
and Guidance that should underlie the development of the discount
curve in the Caribbean market.
3. Conduct research on what could be considered all relevant
observable market data in the Caribbean market to base the
discount curve on.

Many insurers have the available longer tenor local government
bonds in their asset portfolio. These bonds while typically not
very liquid can give a good reflection of the cost of the
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Comments
replicating portfolio and should therefore be considered in
building the risk free curve.

Research:
¯
Nature of the most common and/or highest quality assets
commonly used to support life insurance liabilities
¯
Request companies to provide more detailed information
on feasible reinvestment strategies – target mix, duration
etc.
4. Liaise with Central Banks and other industry experts in the region to
solicit their input on what could be considered as the last liquidity
point for each currency.
5. Test and create an appendix comparing potential extrapolation
approaches/methods for the development of a discount rate curve.
6. Draft a Practice Standard for the Development of the Discount Rate
Curve based on the information gathered, discussions held, and
comments received.
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1.2
Summary of Principles and Industry standard-setters
1.2.1
Draft Principles and Educational Notes which are to be
considered
Body
Key Reference
papers
Issue Date
Link
IASB -IFRS
Phase 2
Update on
changes to 2010
ED
April 2012
http://www.ifrs.org/CurrentProjects/IASBProjects/InsuranceContracts/Documents/compar
isonEDApri2012.pdf
IASB IFRS
Phase 2
Feedback on
Discount rate
decisions
December
2011
http://www.ifrs.org/CurrentProjects/IASBProjects/InsuranceContracts/Documents/7Bdisc
ountrate.pdf
IASB-IFRS
Phase 2
Exposure draft
July 2010
http://www.ifrs.org/CurrentProjects/IASBProjects/InsuranceContracts/Exposure-draft2010/Documents/ED_Insuran
ce_Contracts_Standard_WEB.
pdf
IAA
IAA Educational
Monograph_2012
0810 FINAL
September
2012
http://www.actuaries.org/CTT
EES_ACTSTD/Documents/Disc
ount_Rate_Monograph_Cover
ing_Note.pdf
EIOPASolvency II
QIS5 Technical
Specification –
Risk-free interest
rates & Omnibus
2
June 2012
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Comments
EIOPASolvency II
CEIOPS-L2-FinalAdvice-on-TPRisk-freerate[1].pdf –
CEIOPS-DOC-3409
CRO forum
October
2009
https://eiopa.europa.eu/publi
cations/sii-final-l2advice/index.html
http://www.ceiops.eu/conten
t/view/14/18/
MCEV (CFO
forum)
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1.3.
CAA Life Committee initial views on the most Frequently
Referenced International Principles
Principles
Source
Details
CAA-LC View
Reflects the
characteristic
of the
underlying
liability cash
flows
IFRS 4
An insurer shall adjust the
future cash flows for the time
value of money, using discount
rates
that
reflect
the
characteristics of the insurance
contract liabilities. Such rates:
a. Shall be consistent with
observable current market
prices for instruments
with cash flows whose
characteristics
reflect
those of the insurance
contract liability, in terms
of, for example, timing,
currency and liquidity.
b. Exclude any factors that
influence the observed
rates but are not relevant
to the insurance contract
liability (e.g. risk not
present in the liability but
present in the instrument
for which the market
prices are observed).”
Agree with the
Principle. It is
high-level but
all
encompassing
Exclude credit
risk/Sovereign
risk
IFRS/Solv
ency II
The proposed IFRS 4 Phase II
rules [Ref 12] suggest the use
of discount rates derived from
market values where the
impact of credit risk is minimal,
i.e. “risk free interest rates”.
Agree to
exclude credit
risk where
possible/
measurable.
The exclusion of
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Hence, if the underlying asset
used has credit risk associated
with it, the impact of the credit
risk on the yield must be
removed to produce the
discount rates used
Include a
matching
adjustment or
illiquidity
premium
Proportionality
:Keep method
simple and
pragmatic
Sovereign risk is
subject to
debate
Agree where
characteristic of
the underlying
liability
warrants and
where
quantifiable
EIOPA –
L2 Advice
on the
risk free
interest
rate term
structure
The choice of the risk-free rate
should not depend on the
nature, scale and complexity of
the risks of the undertaking.
However, as all undertakings
should be able to discount
their liabilities, consideration
needs to be given to how the
risk-free interest rate term
structure should be made
available, particularly for small
and
medium
sized
undertakings which might not
be in a position to derive the
term structure themselves.
EIOPA believes that it is
necessary to provide both the
term structure and the
methodology used to derive
the term structure for all major
currencies.
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APS2.1: Principles and Consideration of the selection of the Discount Rate Curve
Comments
2 Introduction
A properly chosen discount rate would provide the value of insurance
liabilities being adequate and market consistent. In small economies this
is difficult to achieve due to the unavailability of deep and liquid market
for bonds.
There exist industry papers, other academic investigations and modern
practices dealing with the question of discounting in insurance
accounting and for solvency purposes. However, a very small part of the
studies really touch such a sensitive subject as the choice of the relevant
discount rate in the small economy environment, where the securities
denominated in the local currency are not traded in a liquid and deep
market.
We appreciate that most of the key questions to be answered in the
development of an appropriate discount rate vector are fundamentally
the same in all markets as such the CAA will aim to be consistent with
international principles and educational notes were possible.
However, the challenge is that to date, despite comprehensive analysis
of the related issues by various bodies, there is no clear
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Comments
guidance for setting up the interest rate term structure for non-Euro
zone smaller economies.
As such, the CAA-LC is aiming to develop a proposal that will be
reflective of the economic characteristics of the Caribbean and that
needs to be pragmatic given our specific limitations. We will also need
to be explicit as to the reasons for any deviation from international
standards and principles.
2.1
Five key questions
The five key questions which need to be addressed in the development
of a discount rate vector for insurance liabilities in all markets are:
1. Which assets categories are appropriate for use as a starting point
to develop market based risk free rates?
2. How should credit risk, sovereign risk and liquidity premium be
accounted for? What methods and what source of information is
available and what process would be appropriate?
3. At which point is the last liquidity point-: At what duration does the
data become unreliable and where extrapolation becomes
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Comments
necessary?
What is the appropriate method and process for
determining this point?
•
For each currency, the “last liquid point” needs to be
determined – i.e. the point at which we ignore market data and
start to extrapolate.
4. What is an appropriate approach for determining the ultimate
forward rate?
5. What is the best extrapolation method?
Each of the following sections aims to address the five questions in the
context of the Caribbean market giving consideration to proposed
international standards, educational papers and any relevant useful
methods already in use in the regional insurance industry.
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Comments
3 Question 1: What are the available sources of
market data?
3.1
Principle – Use of all relevant observed market data
A fundamental principle for the development of an appropriate
discount curve is the use of all relevant market data.
The principle is fundamental as if ignored then objectivity of the
valuation would be compromised and the cost of the replicating
portfolio would differ from the calculated liability.
3.1.1
Relevant market data as per International guidance
Solvency II – criteria and 3 stage approach
Ideal characteristics for risk free rates:
Solvency II Criteria1
1.
No credit risk: the rate should be free of credit risk
2.
Realism: It should be possible to earn the rates in practice
3.
Reliability: the determination of the rates should be reliable and
robust
4.
High liquidity: the rates should be based on financial instruments
from deep, liquid and transparent market
5.
No technical bias
CEIOPS' Advice for L2 Implementing Measures on SII: Technical Provisions Risk free interest rate
1
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Comments
Government bonds rates of AAA rated governments should be
considered as the benchmark for credit risk-free rates. Swap rates are
not credit risk-free and for this reason unadjusted swap rates should not
be used to discount technical provisions. For each currency, CEIOPS
proposes to follow a three stage approach to determine the relevant
risk-free interest rate term structure:
First stage
If government bonds are available that meet the risk-free criteria as
defined (minimal credit risk, reliable, realistic etc.)then government
bonds should be used to determine the relevant risk-free rates.
Second stage
If government bonds are available, but they do not meet the risk-free
rate criteria, then they should be adjusted for their deficiencies relating
to these criteria. The adjusted rates should approximate government
bond rates which meet the risk-free criteria. The adjusted rates should
be used to determine the relevant risk-free rates.
Third stage
If government bonds are not available or if government bond rates
cannot be adjusted to meet the risk-free rate criteria for practical or
theoretical reasons, other financial instruments can be used to derive
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Comments
the risk-free interest rates. These instruments should be as similar to
government bonds as possible. Their rates should be adjusted for credit
risk and any other deviations from the criteria with the objective to
approximate government bond rates which meet the risk-free criteria.
Where government bonds do meet the risk-free rate criteria (or can be
adjusted to meet them) for some maturities but not for all maturities,
they should be used to derive the relevant risk-free rate for these
maturities only.
CRO forum
Definition of relevant market data [ref CRO forum]
Applicable to
Caribbean
Market instrument has characteristics that are
similar to a component of the liability
Yes?
Data is from a liquid market – that is, participants
can rapidly execute large-volume transactions with
little impact on the price OR
No
Based on expert judgment allow to include market
data that does not meet the strict liquidity
requirements, but is still considered to be a good
reflection of the cost of the replicating portfolio
Yes
Market data is reliable, trade and quote information
of these prices is supplied by third parties and
accessible and verifiable (e.g. multiple providers
similar price) to market participants
No
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Comments
IFRS Phase 2
The proposed IFRS 4 method allows for the use of either the top-down
or bottom up approach to developing the risk free discount curve. The
IAA monograph does not indicate a preference for one approach over
the other.
The bottom up approach – is a “build up” approach – to the appropriate
discount curve, which is possible if there is a reliable liquid market
source for “risk free rates” e.g. such as high quality Government bonds
and swaps.
The top down approach is a “peel back” approach whereby, market
rates on a greater set of assets can be used as a starting point however
those elements not characteristic of the liability cash flows must be
identified quantified and eliminated.
In theory, the top-down approach should provide more flexibility but
that is only to the extent there are other appropriate sources of liquid
assets available to be used as a starting point.
3.2
CAA – LC initial view
In most Caribbean currencies there are no available assets that would
meet the criteria of “risk free” without needing adjustment. In
particular, the AAA rating benchmark criteria is difficult to meet in the
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current environment anywhere. However based on the applicable
guidance from the EIOPA Solvency II/CRO forum and the IFRS proposal,
there are possible other sources of market data in the Caribbean market
to consider as an appropriate starting point and are listed in the table
below:
Asset type
Appropriateness as a
starting
point
Available
Liquidity/
Reliability
Comment
Government
bonds/T bills
Yes
Yes but
Limited
Limited
Potential need to be
adjusted for sovereign
risk and possibly
technical bias at some
maturities to proxy
risk free
Swaps other
derivatives
Yes
No
N/A
Corporate
bonds
Yes
Limited
Limited
Publicly rated
corporate bonds can
be adjusted to proxy
risk free
Mortgages
No
Yes
No
Subject to
prepayment risk
Policy loans
No
Yes
Yes
Equity
No
Yes
Limited
Not reflective of NonPar liability
characteristics
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Based on our survey of the supporting asset portfolios of selected
insurance companies in the Caribbean market – we have observed that
Government bonds are still the primary asset type followed by
mortgages and corporate bonds. CAA life committee believes that this is
a reflection of what is available and probably most appropriate in the
local capital markets. See Appendix A for survey of asset portfolios of
insurance companies in the region.
3.2.1. Initial Recommendation:
CAA Life Committee recommends that Government bonds (both on-therun and off-the-run securities) and Corporate bonds be considered as
possible starting points to develop appropriate discount rate.
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4 Question 2: How should credit risk, sovereign
risk and illiquidity premium be accounted
for?
4.1
International views on Credit risk and Sovereign risk
Body
Position on credit risk
Position on Sovereign
risk
IFRS
Exclude –
Exclude
Solvency II
Exclude
Depends on materiality
IAA
Exclude
Exclude
The IFRS principles suggest that all elements of the market rate used
which are not characteristic of the insurance liability be removed.
As credit risk is not relevant to nonparticipating insurance contract
liabilities, a risk-free rate is usually used as the base discount rate. A
risk-free interest/discount rate represents a limiting point so in general
it is accepted that it would contain minimal risk and exclude credit risk
and sovereign risk [Ref IAA monograph].
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There are more consensuses among the international standard-setters
that spreads related to credit risk are not characteristic of the
underlying liability and should be removed.
There is more debate on whether sovereign risk, the illiquidity risk
premium and other non-credit related spreads should also be
eliminated.
Solvency II
The credit standing of an AAA rated government should serve therefore
as a benchmark… An adjustment should be made only in cases where
government bonds are inappropriate, for example because of technical
bias or liquidity considerations. This adjustment should be made
following a clear, reliable and well-established methodology
IAA
In the past, actuaries measured and analyzed credit risk by looking at
historical experience. The historical experience was presumed to be
reasonably reflective of expected future conditions and was therefore
used to project credit risk and defaults. However, the historical approach
is of limited use when analyzing sovereign risk. Among other factors,
historical experience of sovereign default is extremely limited
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and the facts and circumstances of each country are unique. The
following approaches are sometimes used to measure sovereign risk:
credit default swaps, Z-spreads, the Solvency II approach, historical data
and expert opinion.
Since 2009, mounting fears over a Eurozone sovereign debt crisis have
lengthened risks of sovereign debt restructuring and outright default.
More globally, the financial turmoil in these years has also changed the
classical view to the ‘risk-free’ notion of default on government bonds.
For this reason, government bonds are no longer immediately accepted
as “risk-free”.
Measurement of Credit risk and Sovereign risk
The components of the market spread over the risk-free rate consist of
risk premiums for credit risk/sovereign risk, illiquidity risk and other
residual items.
However, trying to separate credit-risk and the non-credit related risk
premiums in the market spread is not an easy task. There is substantial
academic discussion on the measurement of credit risk in the return on
financial instruments. Several approaches for the quantification of
credit spreads separately from the other spread components could be
considered. It appears that the more sophisticated methods require a
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liquid market as well. Best practice which would ensure comparable
quantification outcomes has not yet emerged.
Current quantification methods: credit risk
It would be ideal to develop a method which would derive a basis point
adjustment to the observed rate corporate bonds based on their rating.
Methods which rely on a CDS market are not feasible; as such the
traditional historical factor approaches, despite the cons (outlined in the
IAA monograph) are still the most realistic option to be applied in this
region. Given the lack of historical data specific to the region, we may
still need to rely on the assumptions used for other bonds with similar
ratings.
Currently some Caribbean insurers rely on North American benchmark
factors for the credit spread based on the public rating of the bond.
These benchmark factors for credit risk are generally taken from
analysis and actuarial guidance developed in North America based on
North American credit markets over 10 years ago.
Even though the market data is outdated and is not specific to the
Caribbean market, the rational is that the qualitative analysis to develop
a public rating on a security is generally the same and as such the use of
updated North American benchmarks for credit spread by rating (and
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possibly maturity) may still be the most pragmatic option until adequate
credible risk data specific to the Caribbean is available.
Current quantification methods: sovereign risk
There is a growing literature on sovereign default risk premia for
developed countries, which show that the government’s ability and
willingness to service its debt is country specific. The ability can be
assesses by looking at the macroeconomic indicators, but not the
“willingness” cannot be assessed solely by looking at these indicators
the political factor is to be considered which varies by country.
Given the lack of readily available literature on the sovereign default
risk premium in smaller economies and the country-specific nature of its
assessment, we recommend that the CAA Life Committee to liaise with
and review the methods of, regional agencies, such as, CDB CariCRIS,
which also rate sovereign debt and regional corporate debt before
adopting the ratings of International rating agencies. The CDB recently
conducted a study on sovereign risk in the region from which we may
also be able to leverage.
As mentioned above, before this is quantified we need to assess at what
level of provisioning against sovereign risk in the reserves is necessary
and appropriate.
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4.2
CAA-LC Initial Views on Credit Risk and Sovereign
Risk
CAA-LC also believes that the main objective for the derivation of the
risk-free term structure is to ensure that it includes as little credit
spread from the private sector instruments as possible.
With respect to sovereign risk, Government bonds in many regions are
generally accepted as risk-free because the likelihood of government
failing to honor their commitments is extremely low in most cases. The
credit standing of an AAA rated government and AAA rated corporate
bonds should serve therefore as a benchmark. In the Caribbean,
Government bonds are currently rated well below this, see table below.
Given the current lack of higher quality fixed instruments in the region,
these government bonds are still the best starting point. We need to
assess whether insurers should be required to insure against sovereign
risk in this context and to what extent. That is, CAA-LC believes that we
first need to agree in principle as to what level of provision for sovereign
risk is appropriate if any and whether it should be held in reserves
and/or in capital. To the extent that insurance companies are required
to insure against sovereign risk and/or the risk is “insurable”, then the
use of government bonds to derive the underlying discount rate may
not eliminate the need for a potential allowance for sovereign risk.
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S&P Current Country
Rating2
Outlook
Date of rating
Jamaica
B-
Negative
2011-11-29
Trinidad
A
Stable
2011-11-29
Barbados
BBB-
Negative
2012-02-20
Bahamas
BBB-
Stable
2012-02-20
4.3
Illiquidity risk
The concept of the illiquidity premium is associated with the
“predictability” of the liability cash flows. There is less consensus in the
global insurance industry on the principles related to its inclusion or
exclusion and its measurement.
2
Body
Position on
inclusion/exclusion
Position on
measurement
IFRS
Include
Not clear
Solvency II
Include
Referred to as Matching
adjustment
IAA
Not clear
None
CRO Forum
Include
For S&P, a bond is considered investment grade if its credit rating is BBB- or
higher. Bonds rated BB+ and below are considered to be speculative grade,
sometimes also referred to as "junk" bonds.
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4.4
CAA-LC initial views on illiquidity risk
At a theoretical level, the CAA Life Committee understands the rationale
behind the inclusion of an illiquidity premium and agrees with the
Solvency II CEIOPS task force principles on illiquidity which state that:
(1)
The products to which the adjustment is applied have no future
premiums, no possibility of lapse (or if so, there is a surrender value such
that no loss is made) and the only underwriting risks that exist are
longevity and expense. Therefore, we are basically looking at immediate
annuity contracts.
(2)
principle #3 states that “The liquidity premium applicable to a
liability should not exceed the extra return which can be earned by the
insurer by holding illiquid assets free of credit risk, available in the
financial markets and matching the cash flows of the liability.”
However, there are also other allowances within that spread which do
not relate to default, downgrade or liquidity. To avoid debate about
whether the “premium” actually relates to liquidity or other elements as
well, the term “liquidity premium” was replaced by “matching
premium”. More recently, it has been viewed that the term premium
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is potentially confusing and therefore, the latest Solvency II text refers
to a “matching adjustment”.
4.4.1. CAA-LC initial recommendation
The Caribbean capital market is very illiquid and transaction costs are
high. As such most insurance companies utilize a buy and hold strategy,
especially for Government bonds and other high-quality/investment
grade securities. As such the “matching adjustment” is usually earned
unless there is a default.
Given this practice, for the sake of pragmatism, until there is more
direction from international on the separate quantification of the
illiquidity premium to be added under the “Bottom-up approach”, the
Life committee will not be proposing a separate method to identify and
quantify an illiquidity premium which is to be added to the risk-free
rate.
Initial Recommendation
CAA
life
committee
advocates
the
inclusion
of
illiquidity
premium/matching adjustment to the extent it can be reasonably
estimated separately from default/credit spreads
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5 Question 3: At which point is the last liquidity
point?
That is, at what duration does the data become unreliable?
The most available instruments in the region are typically short duration
instruments. However, insurance liabilities are typically of a significantly
longer duration. Therefore, it is necessary to determine the longest
duration on the for which we have reliable data and extrapolate until
we have a curve that is of long enough duration to be usable for
discounting insurance liability cash flows (A Whole Life product to a
woman aged 25, the cash flows could easily extend for 70 years).
For each currency, the “last liquid point needs to be determined. – i.e.
the point at which we ignore market data and start to extrapolate.
Currently, under the proposed Solvency II the last liquid point for the
major currencies has been assumed as follows:
Currency
Last Liquid point
EUR
20 years
GBP
50 years
USD
30 years
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Summary of methods and considerations used in
more developed markets
5.1
Solvency II regulators and international accountants (IASB/FASB) have
drafted rules and guidance with the aim of defining which prices should
be used and in what circumstances unreliable prices may be replaced
with other valuation measures. However, the current rules and
guidance are not well aligned (between SII and IASB/FASB) and there is
a dearth of detailed thinking on how to turn aspirational regulation into
practical reality.
IASB/FASB (FAS 157/IFRST 7 Fair value Hierarchy
•
Active Markets:
─ Level 1 – Mark-to Market using quoted prices
•
No Active Market
─ Level 2 - Mark-to model using observable inputs
─ Level 3 - Mark-to-model using significant unobservable inputs
Where an active market provides for “quoted prices which are readily
and regularly available from an exchange, dealer, broker, industry
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group, pricing service or regulatory agency, and those prices represent
actual and regularly occurring market transactions on an arm's length
basis.”
EIOPA- Solvency II (DLT test)
As stated in the CEIOPS—DOC-35/09 advice on the calculation of
technical provisions as a whole (Article 86c of the Level 1 text), 'deep,
liquid and transparent markets', are required to meet all the following
requirements:
1. DEEP & LIQUID - market participants can rapidly execute largevolume transactions with little impact on the prices of the
financial instruments used in the replication
2. TRANSPARENT - current trade and quote information of those
prices is readily available to the public
5.2
CAA-LC initial views on the last liquidity point
Most of us would struggle to say where the cut-off lies for Level 1Active market vs. Level 2/3-No Active market under the accounting
guidance. Solvency II DLT criteria is even more problematic in practice
which define that reliable prices must trade in deep, liquid and
transparent markets. It seeks to measure properties of the market that
are difficult to assess in even developed capital markets:
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•
Depth: requires an understanding of the normal market size of
trades – is this an absolute or relative amount, and if relative,
relative to what?
•
Liquidity – this can be interpreted as a measure of the impact of
abnormal trade sizes – again this requires clarification of what
would considered abnormal relative to the definition of normal
above
•
Transparency – some further qualification on the information
required which would make a market transparent is needed.
Even with further future clarification on the DLT criteria from EIOPA, our
apriori assumption is that, in the Caribbean market, very few
instruments would pass this strong DLT test. However, where market
prices are observable but fail the DLT requirement we believe that some
weight should be given to these points in the observed part of the
curve.
There is not a very clear line between market data points that are
liquid/active and should be fully incorporated in the observed part of
the curve and market data points that are not liquid/not active and
should not be taken into account. As such, the CAA life committee
believes that it is difficult to develop easy to apply “criteria” and
“techniques.” We should rather refer to “considerations” that need to
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be taken into account for determining the last observed liquid data
point.
Some level of expert judgment will ultimately be required to determine
the last liquid market data point based on such considerations. Key is
that the market data used should be “a good reflection of the cost of
the replicating portfolio”. Below are a summary of some considerations
and a survey of opinions of various practitioners in the regional
industry.
5.2.1. Key Considerations
Below a few considerations on how to deal with data points before and
after the last liquid market data point.
1. Use of multiple data sources
•
CAA-LC recommends the use of Government bonds market in
assessing the last liquidity point. However, if other relevant
data (Corporate bonds, swaps) has availability at tenors
beyond Government bonds then this should also be used.
•
The question is how these extra market data points from
different sources can be included in the risk free yield curve
while maintaining consistency with the principles of yield
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curve extension; In particular avoiding discontinuities in the
curve that could result in arbitrage opportunities. One should
also take into account that both sources of market data (e.g.
corporates and government bonds) show a difference
(spread) for the observed part of the curve.
─ Given the importance of the slope of the forward curve
as the starting point for the extrapolation one has to be
careful in fitting the slope between two market data
points based on different sources
2. The actual investment of insurance companies
•
Especially in less developed market (E.g. Caribbean) there is
often no deep and liquid market. However, many insurance
companies have the available longer tenor local government
bonds in their asset portfolio. These bonds while typically not
very liquid can give a good reflection of the cost of the
replicating portfolio and should therefore be considered in
building the risk free curve.
3. Consider quantitative measures if available
•
Quantitative measures include bid-ask spread, trading volume
or frequency. However, not straight forward to
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arrive at a consistent rule-based approach that works for all
economies/currencies.
4. Consider the circumstance under which the market price was
arrived
•
Market data that is biased because of a forced liquidation or
distress sale should not be directly used.
5. The slope of the last observed liquid forward rate should be
relatively stable
•
CRO Forum – Extrapolation Paper recommends that market
data points that are subject to significant unbalanced market
conditions will promote unnecessary instability in the liability
and should be ignored. Extrapolation starts from the last
observed liquid market data. So any instability in such point is
extended to longer tenors.
•
The mechanism that provides stability is that in a crisis
situation the transition point of where market data is used
and where extrapolation starts is moved to an earlier point.
•
How can such an unbalance be observed?
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6. Considerations for using interest rate data points that are not
fully incorporated.
Market data points not included in the observed part of the
curve. Such points should give a sensibility check on the slope of
the extrapolated part of the curve.
5.3
Survey of 7 Expert practitioners in the region (TBC)
Currency
Apriori view on liquidity point
Trinidad TT$
20 yrs (3 responses) 15 yrs ( 2 responses)
Barbados
15 yrs (1 response)
Bahamas
1 yr (1response)
5.3.1. Initial recommendations and next steps
Possible Considerations
CAA-LC View
Action/Timeline
The actual investments of
insurance companies
Yes – survey
completed
2012
Quantitative measures –
such as bid- ask spread
N/A
None
The circumstance under
which the market price was
arrived at – cannot use
forced liquidation or distress
sale data
Agree
None
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Market best practice on last
liquid data point
Yes – market opinion
to be surveyed
annually
2012 –market opinion
survey by currency
September 2012
Market data beyond the last
observed liquid market data
point
Agree
None
Extrapolation using multiple
data sources
Agree –
Subject to peer review
by Life Committee
Stressed market conditions
Agree
None
OTC markets
N/A
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6 Question 4: Choice for the unconditional
ultimate long-term level
In the previous section the CAA Life Committee is in agreement that the
extrapolation should follow a smooth path from the entry point to the
unconditional ultimate long term level. Both the entry point and the
unconditional ultimate long term level are key assumptions. The entry
point assumption is addressed in Section 4. The unconditional ultimate
long term level is addressed in this section.
There is still much global industry debate regarding the ultimate
forward rate (UFR) Theoretically the view on the ultimate long-term
level should be forward looking, reflecting:
•
market analysis,
•
future expectations expected real interest rates and inflation,
•
economic theory and
•
historic experience.
This view should be documented appropriately and regularly reviewed.
In practice, The UFR is driven by the long term expected interest rates
and long term expected inflation. The other theoretical
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drivers of the long term forward rate are ignored and are not often
explicitly considered.
One can distinguish three types of extrapolation:
Method
Application
Use
Applicable to
Caribbean
1. A simple direct
extrapolation of the
market price; Keeping
the last observed liquid
market forward data
point constant for the
entire extrapolation
Short
extrapolations
Investment
banks
Not
appropriate
where
extrapolations
longer than 5
years from
last liquid
point are
required. for
long-term
insurance
liabilities
beyond 5-15
years
depending on
the currency
2a. Solvency II approach
-components of the
market price are
extrapolated based on a
macro-economic view of
the long-term market
price (i.e. not
necessarily the same as
in the last observed
liquid market data).
Insurance
liabilities
Solvency II
Yes
Considered
best practice
by Solvency II
Irrelevant of
the amount of
market data
available
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2b. extrapolation to a
best-estimate long-term
level; i.e. expected “real
world” realization of
interest rates or
volatilities.
Current
Canadian
approach
where UFR is
based on
rolling
average of
historic rates
Life insurance
Practical but
no
econometric
link to future
rates
Conservative
approach
when rates
are rising
Solvency II considerations
6.1
Under SII principles the unconditional long-term forward rate should be
relatively stable over time and only change due to fundamental changes
in long-term expectations and should not be affected materially by
short-term economic changes.
The unconditional long-term forward rate is the sum of forward looking
expectations of the:
i.
Long-term Inflation Level
ii. Long-term Real Rate
iii. Long-term Term Premium
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The current Solvency II regulations set a UFR of 4.2% for every economy.
This is split as 2.2% long term growth and 2% inflation.
The 2% long term inflation assumption is consistent with the inflation
target of most central banks, although there are various economists
who argue that this inflation target (particularly for the European
Central Bank) is unrealistically low and should be revised.
The current Solvency II regulations assume that the UFR is the same for
all economies. Again, this assumption is open to debate. Work
performed for QIS5 demonstrated that there should be at least 3
different “buckets” of economies to reflect different long term inflation
environments – for example, Japan should arguably have a lower long
term inflation assumption given the long period of deflation seen there,
whereas Turkey has had consistently high inflation and has had a target
of between 5% and 7.5% over the last 4 years.
The long term real growth rate assumption is also seen to be quite
different across economies over the long term. Even when considering
only the second half of the 20th century (the first half being heavily
impacted by high inflation due to the wars), real returns ranged from
1% in the Netherlands to 4.7% in France. However, the
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average return over all economies over the second half of the century is
2.3%, which gives some justification to the 2.2% assumption.
CAA Life Committee Initial Views on UFR
6.2
In the Caribbean context, we have situations where there are only
observable interest rate forwards for the first 5-10 years. This creates a
number of complications:
•
Yield curves tend to be steep on the shorter end of the curve.
This could result in extrapolation to extraordinary levels.
•
Yield curves tend to be more volatile in the shorter end of the
curve. This could result in extraordinary volatility in the
extrapolated curve.
•
The fact that the liquid curve ends at 5 years indicates that
there is no natural supply of long dated fixed income.
•
Any rational player who would offer a 45 year guarantee would
be exposed to a very large amount of risk and would want to be
compensated for this in excess of the best estimate level.
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For this type of situation it is desirable to use SII method, as it allows
taking into account the long term nature of the product and can be
based on external economic forecast.
6.2.1. Initial CAA-LC Recommendation on UFR
Extrapolation should be based on forward rates converging from one or
a set of last observed liquid market data points to an unconditional
ultimate long-term forward rate to be determined for each currency by
macro-economic methods (e.g. a long term growth assumption plus
long term inflation assumption). The table below provides the 2016 (4th
year) forecast rates of real GDP and inflation (from Oxford Economics)
which would be an indication of their long term view. Other regional
sources should be used and compared before setting the UFR.
Country
Expected long term
Real GDP forecast
Expected
inflation
UFR
Bahamas
2.6%
2.5%
5.5%
Barbados
3.0%
2.2%
5.2%
Jamaica
1.7%
5.2%
6.9%
Trinidad
3.9%
3.3%
7.2%
United States
2.9%
2.3%
5.1%
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We are also of the view that should the UFR should be relatively stable
over time and only change due to fundamental changes in long-term
expectations and should not be affected materially by short term
economic changes.
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7 Question 5: What is the best extrapolation
method?
7.1
How to grade from the last observed liquid forward
rate to the ultimate rate
Defining an ultimate rate translates the extrapolation problem of yield
curves into an interpolation (“grading”) problem so that it can be
treated with known methods as described in the following. The grading
methodology chosen has a large effect on the variation in yields beyond
the last observed liquid market data point. Spurious variation in these
yields can feed through to give excessive balance sheet and valuation
variation that should be avoided.
With this in mind it becomes important to develop a robust
extrapolation method that reflects both current market conditions and
empirical views of long rate volatility, while simultaneously displaying
adequate stability.
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There are many different extrapolation methods in existence which
have been considered by international standard setters:
1. The Smith-Wilson method
2. The Nelson-Siegel method
3. The Svensson method (in a macroeconomic formulation)
4. The method used and developed by Barrie & Hibbert
5. A linear approach (as adopted for QIS5)??
Body
Position on Extrapolation method
Solvency II
The Smith-Wilson method is currently the one being
proposed for use by Solvency II
CRO forum
The CRO Forum supports the grading method based on
Nelson-Siegel developed by B&H as being appropriate,
but alternatives can be evaluated in order to achieve
the goal of a curve with the desired properties with less
technical efforts.
IASB
No preferred method identified
IAA
No preferred method identified
As with any extrapolation method, certain assumptions are required –
the key assumptions being:
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1. Entry point of extrapolation (i.e. last liquid point as discussed in
Section X)
2. The ultimate forward rate (UFR) (i.e. the rate that the curve
should converge, addressed in Section X)
3. The maximum period of convergence (i.e. at what point the
curve will be considered close enough to the UFR)
4. The speed of convergence (i.e. how quickly the curve will
converge)
Each of these assumptions is open to judgment – for example, we have
already discussed the considerations on determining the entry point of
extrapolation.
7.2
Principles and key criteria for the choice of the
extrapolation method
Once we know where we start (last liquidity point) and where we
should converge to (UFR), we then need to determine how that should
happen and how quickly.
The extrapolation method determines the grading process, the shape
and speed of convergence to the UFR.
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Principles on extrapolation promulgated by international standard
setters and other bodies/educational notes are listed below and should
be considered in the choice of method to grade from the entry point
(last observed liquid forward rate) to the ultimate forward rate.
Principle
Source/Body
CAA Life
Committee
view
1
Use all relevant observed market
data where
available
CRO forum
Agree
2
Extrapolated market data should
be arbitrage free
CRO forum
Agree. Where
possible
3
Extrapolation method –
theoretically sound
CRO forum
Agree. Where
possible
4
Extrapolation should follow a
smooth path from the entry point
to the unconditional ultimate
long term level
From a financial stability
perspective extrapolation
methodology is important as it
can exuberate or dampen
volatility in the
financial markets into the entire
industry
CRO forum
Agree
5
Keep method simple and
pragmatic
9
The extrapolated part of the basis
risk free interest rate
Agree
Solvency IICEIOPs
Agree
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10
7.3
curve should be
calculated and published by a
central institution, based on
transparent
procedures and methodologies,
Taskforce
report 2010
The ultimate forward rate should
be compatible with the criteria of
realism and the principles used
to determine the macroeconomic long-term
forward rate should be explicitly
communicated.
Solvency IICEIOPs
Taskforce
report 2010
Agree
Convergence
As the last observed liquid forward rate is the starting point of the
extrapolation, such forward rate has a high impact on the start and
direction of the forward curve. Therefore, it is key that in fitting the
curve to the observed market data that there is some smoothing
mechanism that avoids that small inconsistencies in the last observed
liquid market data points can result in big swings in the level and the
shape of the last observed liquid forward rates.
The Economic Monetary Affairs Committee (ECON) has suggested that
the risk free curve should converge to the UFR (or, at least, not be
materially different) 10 years after the last liquid point. However, EIOPA
have suggested that the period of time should be 40 years.
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Clearly these are significant differences in approach that could have
material impacts on the technical provisions.
For the Euro, this would mean that we would assume that after 30 years
we reach the ultimate forward rate (i.e. the last liquid point is 20 years
and the period to convergence is 10 years). Some observers have noted
that this is too short a period of time and it is worth noting that the
shorter the period of time until the UFR is reached, the more sensitive
the extrapolated portion of the yield curve is to the choice of UFR.
Note that the Wilson-Smith model does not specify a point when the
UFR is reached – instead it incorporates a speed of convergence (∝).
The Solvency II default value for ∝ is 0.1.
Furthermore, the extrapolation method should not result in abrupt
changes in the shape of the forward curve. This would result in spurious
volatility in the extrapolated part of the curve. Any method used should
be back-tested for a range of currencies over a significant time horizon
(5 years) to show that the volatility in the extrapolated part of the curve
shows the same declining pattern as observed in the observed part of
the curve.
Lastly, there are often market instruments available beyond the last
liquid market data point. Therefore, such instruments lie in the
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extrapolated part of the curve. Although these instruments are not
extremely liquid, they can still be used in effectively managing the risks.
7.4
Initial CAA-LC View
7.4.1. Initial recommendation and next steps on extrapolation
method:
The two extrapolated methods recommended by CRO forum and
Solvency II – the Smith Wilson and Nelson-Siegel method developed by
B&H should be back-tested. If both methods are equivalent in their fit –
perhaps the most simple method should be used – or alternatively a
linear method can be developed as done for QIS5 in Solvency II (TBD).
The speed of convergence should consider the strength and reliability of
the available market data, specifically the last liquidity points. The
impact of variance convergence speeds should also be tested and
understood.
See Appendix B for further background on extrapolation.
7.5
The extrapolation should follow a smooth path from
the entry point to the unconditional ultimate longterm level
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Appendix A
A.1.
Survey on asset portfolio of insurance companies
Asset distribution data in the life insurance industry was gathered for
the following countries:
Asset distribution data in the life insurance industry was gathered for
the following countries:
•
Jamaica –2011 data for 3 companies
•
Trinidad and Tobago – 2011 data from the Central Bank of
Trinidad and Tobago mid-year report
•
Barbados – 2010 data for 1 company, published financials
•
Bahamas – 2011 data for 3 companies, 2 published financials, 1
regulator
•
Belize - 2010 data for 6 companies, from regulator
•
ECCU – 2011 data for 1 company, published financials
Asset Category
Bahamas
Cash
2%
Short term
Deposits
6%
Barbados
9%
Belize
ECCU
Jamaica
3%
3%
1%
56%
56%
2%
T&T
8%
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Government
Securities
27%
50%
16%
16%
67%
Regional Bonds
4%
Extra Regional
Bonds
0%
48%
Corporate Bonds
5%
0%
4%
4%
2%
16%
Equities
4%
7%
1%
1%
1%
13%
Preferred Shares
2%
Mortgages
20%
25%
5%
5%
Policy Loans
10%
8%
2%
2%
1%
Fixed Assets
5%
-
4%
4%
1%
Subsidiaries
2%
-
3%
3%
1%
Receivables
9%
-
3%
3%
13%
Goodwill
1%
-
Investment
Properties
8%
-
Mutual Funds
Longest Bond
Term
4%
2037
6%
2046
The objective was to determine the category of assets backing the
liabilities and the distribution of these assets among the various
categories. The information would also serve as an indicator of the
availability of types of assets.
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Another point of observation was to determine the longest term of
government bond being held by the companies.
Based on the above, we also gathered information from the various
Central Bank websites to determine the duration of the Government
bonds being issued and those that are outstanding.
Outstanding Bond Issues
As at September 30 2011
Country
Type
Yrs to Maturity
Local Currency
Barbados
Fixed Rate (Gov't)
22.8
Jamaica
Fixed Rate (Gov't)
12.4
Floating Rate (Gov't)
20.4
Fixed Rate (Gov't)
13.4
Floating Rate (Gov't)
17.0
Fixed Rate (Gov't Agency)
18.7
Floating Rate (Gov't Agency)
11.3
Fixed Rate (Corp)
11.8
Floating Rate (Corp)
18.8
St. Lucia
Fixed Rate (Gov't)
6.8
St. Vincent
Fixed Rate (Gov't)
4.9
Bahamas
Floating Rate (Gov't)
26.0
Belize
Fixed Rate (Gov't)
18.0
Trinidad and Tobago
US$
4.4
15.6
6.0
Sources:
First Citizen's Investment Services: Fixed Income IQ 30 September 2011
Central Bank of Bahamas
Central Bank of Belize
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Country
Maturity of existing issues
Term of new Issues
1
Bahamas
2029
Barbados
20342
Belize
n/a
ECCU
20183
90 days
180 days
2
Jamaica
2032
Trinidad and Tobago
20302
19 yrs in 20114
1
Central Bank of Bahamas
2
Fixed income IQ September 2011, First Citizens Investment Services
3
Easter Caribbean Central Bank
4 Central
Bank of Trinidad and Tobago
Our research indicated that there are at least 2 agencies that develop
yield curves for Barbados, Jamaica and Trinidad and Tobago on a regular
basis.
•
First Citizens Investment Services Research Department
(CMMB) publishes quarterly its own development of the yield
curve and a list of bonds in the marketplace and their
corresponding yields. Here is a list of the bond information
available at September 2011, for Trinidad and Tobago,
Barbados, Jamaica and other countries in the region.
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─ Government of Trinidad & Tobago Fixed Rate Bonds (TT$)
─ Government of Trinidad & Tobago Fixed Rate Eurobonds
(US$)
─ Government of Trinidad & Tobago Floating Rate Bonds (TT$)
─ Government of Trinidad & Tobago Agency Fixed Rate Bonds
(TT$)
─ Government of Trinidad & Tobago Agency Floating Rate
Bonds (TT$)
─ Trinidad and Tobago Agency Amortizing Fixed Rate Bonds
(TT$)
─ Trinidad & Tobago Corporate Fixed Rate Bonds (TT$)
─ Trinidad & Tobago Corporate Floating Rate Bonds (TT$)
─ Trinidad and Tobago Zero-Coupon Bonds (TT$)
─ Government of Barbados Fixed Rate Bonds (BB$)
─ Regional Fixed Rate Bonds (US$, TT$ & EC$)
─ Government of Jamaica Fixed Rate Bonds (J$)
─ Government of Jamaica Fixed Rate Bonds (US$)
─ Government of Jamaica Floating Rate Bonds (J$)
The following method is used to determine the Spot (Zero) Curve:
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‘The spot curve used in the calculation outlined above is generated by
our proprietary valuation system. The Research Department uses recent
market issues and market reads to construct a par yield curve each
month. These par rates are uploaded into our valuation model upon
approval of the Group’s Market Risk Committee. Our valuation model
generates the key points on the zero curves using a bootstrapping
methodology and uses cubic spline interpolation to generate all the
points between the key points.
For example if the 30 day, 90 day , 1 year, 2year…..20 year par points
are uploaded, the system will generate the matching zero points and use
cubic spline interpolation to determine the points between 30 day, 90
day , 1 year, 2year…..20 year spot rates.
The spot rates generated are entered in the respective sheets in the
bond pricing model. Further cubic spline interpolation is done between
the points generated using an excel Spline function to get the exact yield
for the respective time to the cash-flow.’
•
Bourse Securities out of Trinidad and Tobago produces similar
information. It is not clear with what frequency the yield curve
is developed.
The Central Bank of Trinidad and Tobago has recently issued a guideline
for determining residential real estate mortgage reference
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rates. These rates will be calculated quarterly by the Central Bank and
would be based on applicable Treasury bond yields and the cost of
funds in the banking system. Banks are to use this as a reference rate as
they negotiate the actual mortgage rate with the individual which would
include a risk premium for individual credit rating, term and amount of
the mortgage, etc. As at the end of June 2012 the rate is 3.25%.
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Appendix B
B.1.
Principle 1: Extrapolated market data should be
arbitrage-free
B.1.1. Rational
Arbitrage opportunities should be avoided to ensure that the bestestimate is appropriate. For example, when the interest rate curve is
extrapolated based on the last observed liquid spot rate this implies in
most cases that you observe an abrupt changing in slope of the curve,
which implies a jump in the instantaneous forward interest rate. Any
arbitrage free extrapolation therefore should have a continuous curve
plus a continuous forward curve.
Extrapolating based on forward rate achieves this by construction and is
therefore a good starting point for any extrapolation method.
B.2.
Principle 3: The extrapolation method should be
theoretically sound
B.2.1. Rational
It is important that the chosen method is theoretically sound.
Extrapolation methods that are in violation of generally accepted
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economic theory or clearly observed historical patterns should be
avoided.
From
a
financial
stability
perspective
extrapolation
methodology is important as it can exuberate or dampen volatility in
the financial markets into the entire industry.
The extrapolation method should not result in spurious volatility.
Volatility arises from genuine changes in expected levels of long-term
best-estimates and changes in risk premia. Thus the results of the
extrapolation method should be consistent with the observed patterns
of market data. For example, realized interest rate volatility is typically
declining with the tenor of the rate and the result of the extrapolation
method should be consistent with that.
Theoretical models calibrated using available market data typically try
to capture well described properties of market data such as mean
reverting behavior. Therefore such theoretical models provide a solid
basis for any extrapolation method. Moreover, by construction such
models are arbitrage-free.
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