Gastvortrag: Solvency II, Asset Liability Management, and the European Bond Market Theory and Empirical Evidence

Risikomanagement von Finanzinstituten Gastvortrag: Solvency II, Asset Liability Management, and the European Bond Market Theory and Empirical Evidence Meik Friedrich Hannover, 16.06.2009

Gliederung Solvency II A major change in the regulatory environment Integrated Asset-Liability-Management for Life Insurers Interest rates and the bond market Empirical findings Conclusion 2

Three Pillar Approach Three Pillar Approach Pillar 1 Quantitative Capital Requirements Pillar 2 Quantitative Supervisory Review Pillar 3 Market Discipline Minimum Capital Requirement (MCR) Solvency Capital Requirement (SCR) standard formula SCR Internal model Supervision process Internal controls and embedding risk management Principles and tools Transparency Disclosures Support of riskbased supervision through market mechanisms 3

Integrated ALM Approach A L Assets to optimise at NPV Liabilities at Fair Value Equity 4

The Fisher equation i = r + E(π) + rp i: nominal interest rate r: real interest rate E(π): expected rate of inflation rp: risk premium 5

Government bond yields (10 y) in selected countries 24 20 16 12 8 4 0 65 70 75 80 85 90 95 00 05 USA UK Germany France Italy Data: Bloomberg 6

Three decades of falling inflation rates.25.20.15.10.05.00 -.05 1980 1985 1990 1995 2000 2005 US CPI Y/Y UK RPI Y/Y GERMANY CPI Y/Y Data: Bloomberg, EcoWin 7

German Government Bond Yield Spreads 1.2 1.0 0.8 0.6 0.4 0.2 0.0-0.2 95 96 97 98 99 00 01 02 03 04 05 06 07 SPREAD 7Y/5Y SPREAD 10Y/7Y SPREAD 30Y/10Y Data: Bloomberg 8

Term Structure of Interest Rates: German Government Bonds (2 Years to 10 Years) 4.4 4.0 3.6 3.2 2.8 2.4 1 2 3 4 5 6 7 8 9 10 Dec. 2002 Dec. 2003 Dec. 2004 Dec. 2005 Dec. 2006 Dec. 2007 Data: Bloomberg 9

Yield spread (government bonds) and the ifo Business Climate 110 105 100 95 1.0 0.8 0.6 0.4 0.2 0.0 2000 2001 2002 2003 2004 2005 2006 2007 SPREAD 10Y/5Y IFO BUSINESS CLIMATE (R. H. S.) 90 85 Data: Bloomberg 10

Explanations for low interest rates... New guidelines for monetary policy in the 1980s have reduced inflation rates and inflation expectations Today there is less uncertainty about future inflation because of a decreased variability of inflation The growth of government debt has diminished There may be a global savings glut Demographic change could already have reduced the real interest rate 11

... And the flattening of the yield curve Lower long-term inflation expectations Fears of a major economic downturn Pension reform and Solvency II may have increased the demand for longterm bonds (preferred habitat hypothesis) 12

Interest rates: Testing for stationarity Null Hypothesis: Time series has a unit root Time series: ADF-test statistic 5% critical value Prob.* i10: -1.725514-2.888669 0.4156 Δi10: -3.659073-2.892536 0.0063 i30: -1.250918-2.888669 0.6501 Δi30: -3.362588-2.892536 0.0148 critical values from eviews 13

Interest rates: Is there cointegration? Sample (adjusted): 1999M06 2007M12 Included observations: 103 after adjustments Trend assumption: Linear deterministic trend Series: J30 J10 Lags interval (in first differences): 1 to 4 Unrestricted Cointegration Rank Test (Trace) Hypothesized Trace 0.05 No. of CE(s) Eigenvalue Statistic Critical Value Prob.** None 0.075547 9.736423 15.49471 0.3016 At most 1 0.015849 1.645474 3.841466 0.1996 Trace test indicates no cointegration at the 0.05 level * denotes rejection of the hypothesis at the 0.05 level Critical values from eviews Unrestricted Cointegration Rank Test (Maximum Eigenvalue) Hypothesized Max-Eigen 0.05 No. of CE(s) Eigenvalue Statistic Critical Value Prob.** None 0.075547 8.090949 14.26460 0.3695 At most 1 0.015849 1.645474 3.841466 0.1996 Max-eigenvalue test indicates no cointegration at the 0.05 level * denotes rejection of the hypothesis at the 0.05 level Critical values from eviews 14

Long-/medium-term interest rate relation Δi 30 = -0.004807 + 0.788648 Δi 10 (t-stat) (-0.78) (22.92) R 2 = 0.834, Adj-R 2 =0.832, AIC =-0.265 15

Solvency II time line 2001 Start of the project 2003 Start of Phase II 2004 2005 QIS 1 2006 2005 QIS 2 2007 QIS 3 2008 QIS 4 Until 2011 Standards, Norms, Indicators, Guidelines, Implementing Regulation 2012 expected use time 10/2003 9/2003 Ending Phase of Phase I I 10/2005 10/2004 QIS QIS 1 1 5/2006 5/2005 QIS QIS 2 2 16

Testing for structural breaks: Chow tests Chow Breakpoint Test Null Hypothesis: No breaks at specified breakpoints Varying regressors: All equation variables Equation Sample: 1999M02 2007M12 2003M10 F-statistic 0.283668 Prob. F(2,103) 0.7536 Log likelihood ratio 0.587752 Prob. Chi-Square(2) 0.7454 Wald Statistic 0.567336 Prob. Chi-Square(2) 0.7530 2005M10 F-statistic 0.729104 Prob. F(2,103) 0.4848 Log likelihood ratio 1.504214 Prob. Chi-Square(2) 0.4714 Wald Statistic 1.458207 Prob. Chi-Square(2) 0.4823 2006M05 F-statistic 0.400024 Prob. F(2,103) 0.6713 Log likelihood ratio 0.827908 Prob. Chi-Square(2) 0.6610 Wald Statistic 0.800049 Prob. Chi-Square(2) 0.6703 Note: probabilities calculated using critical values from eviews 17

Testing for structural breaks: Quandt/Andrews test Quandt-Andrews unknown breakpoint test Null Hypothesis: No breakpoints within trimmed data Varying regressors: All equation variables Equation Sample: 1999M02 2007M12 Test Sample: 2000M07 2006M07 Number of breaks compared: 73 Statistic Value Prob. Maximum LR F-statistic (2004M11) 1.765280 0.9982 Maximum Wald F-statistic (2004M11) 1.765280 0.9982 Exp LR F-statistic 0.348001 0.9707 Exp Wald F-statistic 0.348001 0.9707 Ave LR F-statistic 0.629092 0.9479 Ave Wald F-statistic 0.629092 0.9479 Note: probabilities calculated using critical values from eviews 18

Conclusion Solvency II has not changed the relationship between medium-term and long-term interest rates so far Intuitively, there are three possible explanations for this finding: 1. Insurers may not have yet made any significant changes in their asset allocation policy 2. Other market participants (e.g., hedge funds) could also have reacted to the new investment policy of life insurers 3. Solvency II may not change the investment philosophy of European insurance companies at all 19

Vielen Dank für ihre Aufmerksamkeit Basse T/ Friedrich M: Solvency II, Asset Liability Management, and the European Bond Market Theory and Empirical Evidence, in: Zeitschrift für die gesamte Versicherungswissenschaft, 97, 2008, S. 155-171 20