We have two questions regarding the valuation of assets in context of calculating the capital charge for interest rate risk:
Firstly, the calculation of the capital charge for interest rate risk in the standard formula requires stressing the value of the products on the asset side of an insurer which are sensitive to changes in interest rates. For this purpose, assumptions on risk-free interest rates have to be made. Should these assumptions take into account a volatility adjustment, in case such an adjustment is applied on the liability side?
Secondly, as regards the revaluation of assets in the shock scenario for interest rate risk, does this require that we have to derive implicit spreads out of the market values of the assets using the interest rate term structures, which are then used in the discounting of asset cash flows in the shock scenarios?
Regarding your questions, we want to point to Guideline 4 of the “Guidelines on the treatment of market and counterparty risk exposures in the standard formula” (EIOPA-BoS-14/174 EN).
“Guideline 4 – Interest rate risk sub-module
1.12. Undertakings should include all interest rate sensitive assets and liabilities in the calculation of the capital requirement for the interest rate risk sub-module.
1.13. The technical provision should be recalculated under the scenarios using the risk free interest rate term structure after the shock, which is determined by stressing the basic risk free interest rate term structure and adding back matching adjustment, volatility adjustment or transitional measure on the risk free rate under Article 308 (c) of the Solvency II Directive, if applicable.
1.14. The assets value should be recalculated under the scenarios by stressing only the basic risk free interest rate term structure and any spreads over the basic risk free interest rate term structure should remain unchanged. This may involve using a mark to model valuation for determining the value of the assets under the stresses.
1.15. Insurance and reinsurance undertakings should ensure that the values of assets before the stresses obtained by using a mark-to-model valuation are consistent with the quoted market prices of relevant assets in active markets.”
The Guideline specifies that indeed a revaluation of the asset side takes place with the stressed risk-free interest rate term structure. Therefore, in a pre-stess situation, implicit spreads have to be determined to ensure consistency to the mark-to-market valuation.
In our consideration a revaluation on the asset side takes place without volatility adjustment, which is only relevant for the valuation of liabilities.