A few weeks ago I phoned an old colleague of mine from years back. Jean-Pierre is from Paris. For many years he worked in the asset management department of a big French insurer but now he works in Luxembourg for a large consultancy and specialises in Solvency II implementation.
The thing is, our government here in the Netherlands has proposed a new framework for pensions that takes some of its methodology straight from Solvency II. And since we seem to be heading towards Solvency II at a European level, I thought it was time I got up to speed.
Jean-Pierre has a head start on we pensions people since he has been heading the the Solvency II implementation team at his company for a number of years. But although there’s not a lot he doesn’t know about Solvency II, he is still in the dark about a number of things, along with the rest of the industry.
‘First you have to remember that Solvency II has been postponed so many times, it doesn’t actually come into effect for insurers until 2014,’ he starts off by telling me. ‘So there’s a lot we still don’t know about because local regulators have not all issued guidance.’
‘Believe me,’ I say. ‘We are well used to dealing with regulators.’
‘Exactly,’ Jean-Pierre continues. ‘We also notice that they are all taking a different approach, particularly when it comes to the internal model. Even then, given the limited number of vendors, there won’t be much variation between the internal models, which kind of defeats the purpose, I think.’
‘Tell me about the ultimate forward rate,’ I say. ‘That’s quite simple,’ says Jean-Pierre. ‘You take two elements - the long-term expectation for inflation and the long-term expectation for short-term rates. That’s your discount rate.
‘I understand,’ I reply. ‘So, for the euro-zone, that’s about 2% for inflation and 2.2% for rates?’ ‘You’ve got it. Not only that, it’s the same for other major currencies, and it’s expected to be consistent over time because it’s based on long-term forecasts.’
‘There’s just one thing,’ I tell Jean-Pierre. ‘If you add 2% and 2.2% you get 4.2%. That’s sounds suspiciously like the 4% discount rate that we used to apply before the FTK in 2007. And the FTK was supposed to solve the problems of the fixed rate!’
‘In principle that’s correct,’ replies Jean-Pierre. ‘And at first you might think you’d need less hedging with the UFR but you could have problems with the part of the rate curve beyond the last liquid point, where the market rate converges on the UFR. The methodology is quite sensitive to the steepness of the swap curve at just about 20 years.’
‘That all sounds like we’ll need expert advice,’ I think aloud. ‘You probably will. And don’t hesitate to call us,’ Jean-Pierre tells me before he rings off. ‘We are planning to offer the services of our Solvency II team to pension funds. We could be just what you need!’