DNB introduces the UFR method
In early July, DNB announced that as of 30 June 2012 insurers, in determining their financial position, must value their liabilities by a method that will also apply under the new Solvency II framework.
The adjusted yield curve is based on an alternative extrapolation method using an 'ultimate forward rate' or UFR. The UFR is based on the idea that short-term interest rates will converge, in the long run, to a stable level. The UFR method assumes that one-year forward rates will, starting from the last available maturity point (the 'last liquid point'), converge over a certain period to a stable long-term level – the UFR. Although this does not imply that the liability discounting rates will converge to the UFR over that same period, the new method does establish a more stable rate for long maturity liabilities. As a result, insurers' solvency positions will fluctuate less with interest rate developments.
In applying a UFR for yield curve calculation, DNB anticipates the arrival of Solvency II. This new European regulatory framework will include a similar method for yield curve extrapolation. The use of a UFR is in itself no longer disputed in the consultations on Solvency II; this is one of the reasons why Denmark also decided recently on early introduction of a UFR. The discussion on the quantitative details of Solvency II, however, has not been completed. As regards the quantitative aspects of the UFR, DNB has opted for a prudent variant within margins expected to correspond to Solvency II.
The yield curve and long maturities
Insurers hold technical reserves to ensure they will be able to meet all their obligations under insurance contracts into the future. When determining what amount to reserve for future payments, insurers discount expected future payments by a current risk-free yield curve. Published regularly by DNB, this yield curve indicates what rates should be used to discount liabilities with various maturities. Especially life insurers may have (very) long-term liabilities, such as pension liabilities.
Given the current persistence of exceptional market conditions and the faltering liquidity in the long tail of the market, risk-free rates cannot reliably be derived from market information. Especially where the longest maturities are concerned, there may be no or at best limited market activity, amid low availability of negotiable risk-free instruments. As a result, the yield curve consists of a part where the current risk-free rates can be derived from available market information, and a part where reliable market information is scarce. For this latter part beyond the 'last liquid point', rates are calculated by the UFR method. Under the old method, unavailable maturity points were estimated by assuming a constant rate equal to the last know forward rate.
Three elements play key roles in this method. First, the stable final level of the UFR itself, secondly the last available liquid maturity point, and thirdly the converging period until the UFR is reached. In determining its discounting method, DNB has opted for a variant with a UFR of 4.2% (based on a 2% long-term inflation expectation and a 2.2 % expected real short-term rate), a last available liquid maturity of 20 years and a convergence period of 40 years. The fact that the forward rate beyond 60 years is fixed at 4.2% does not mean that this applies also to the rate by which liabilities must be discounted. This latter rate converges at an ever slowing rate to 4.2%, without ever actually attaining that value (in the 100 years maturity point the rate is about 3.7%).
Figure 1 shows the consequences of the new method for the yield curve. Under the new method, it is especially the long-term rates that become higher. For instance, the rate on liabilities with a 60-year maturity amounts to 3.3 under the UFR method, against less than 2.5% under the traditional method.