We have in this paper chosen to look into the interest rate risk and Solvency II in the Danish pension and life insurance companies. The companies have given the customers a warranty to give a minimum interest rate. The last couple of years the companies have been through some great decreases in the interest rate, which have given them some big challenges, as they have to oblige their promise to the customers. The companies are therefore exposed to interest risk both on their assets and liabilities. When the interest rate decrease, then the value of the assets and liabilities increases. The challenge for the companies is that the provisions have a very long maturity and the companies don’t have the opportunity to invest in bonds with equal duration. By a decrease in the interest rate the companies’ liabilities therefore increase more than the assets. That is a problem because as a minimum the assets have to be equal to the provisions. By a decrease in the interest rate there will be a capital gain on the bonds. The companies have to reinvest this gain in assets with a lower interest rate and a shorter duration to the obligations. The companies are in further problems if they invest in callable mortgage bonds. When the interest rate decreases, the sensitivity on the callable mortgage bonds will decrease. The duration therefore decreases and there can be negative convexity because of the obligation to redeem the bond. By investing in financial instruments the companies have the opportunity to hedge against a increase or decrease in the interest rate. The most commonly used instruments are swaps, swaptions, caps and floors. The companies use this instruments to hedge their provisions. The hedge with financial instruments are costly and therefore it is different the companies between how much they chooses to hedge their provisions. Swaps are a good investment if the company wishes to buy duration, while swaptions give the opportunity to buy convexity. In this way the companies can hedge their provisions by the risk measures duration and convexity. Beside these the companies also need to take volatility into consideration, when they hedge their provisions. This is due to the negative coherence between the level of the interest rate and the implicit volatility which have an effect on the companies’ hedge. I sync with the decrease in the interest rate the need for hedge of the provisions increases, because the value of the obligations increases. When the companies buy more and more hedge instruments the interest rate decreases. In this way a self‐perpetuating negative spiral arises where the companies themselves pushes the interest rate downwards. Beyond the challenges with the decreasing interest rate, in January 2014 will there be implemented a new EU‐directive which is Solvecy II. This will cause greater challenges for the companies because they get a higher capital requirement. The companies with high interest rate guarantees will face a considerable higher capital requirement with the new directive, than the companies with a lower interest rate guarantees. Furthermore will companies which invest in 100% bonds have a lower capital requirement than companies who ex invests in 80% bonds and 20% equities. The companies will therefore face a tradeoff between return and capital. The capital will be a scarce factor and the companies will therefore need to change their investment strategy when the new directive becomes implemented.
|Educations||MSc in Business Administration and Management Science, (Graduate Programme) Final Thesis|
|Number of pages||88|