Application of the UFR in valuing profit-sharing schemes and options

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Question:

In valuing options and guarantees for the purpose of the adequacy test, may insurers let the forward rates separately converge to the Ultimate Forward Rate (UFR) in every interest rate scenario?

In valuing options and guarantees for the purpose of the adequacy test, may insurers let the forward rates separately converge to the Ultimate Forward Rate (UFR) in every interest rate scenario?

Published: 19 December 2013

Answer:

1 - No, they may not. The UFR relates solely to the current interest rate curve used to discount insurance liabilities in the adequacy test. As the UFR and its calibration bear no relationship to expectations about the level and volatility of future yield curves, the UFR does not affect the interest rate volatilities applied in the adequacy test.

2 - No, they may not. Doing so is incompatible not only with a consistent application of the yield curve in the method to value options and guarantees but also with the theorem of arbitrage-free pricing. The current yield curve by which cash flows accrue interest must be equal to the yield curve by which they are discounted.

In valuing options (e.g. the options of policyholders which are implicit in the insurance) and guarantees for the purpose of the adequacy test, insurers apply a range of methods including economic scenario generators and closed form formulas. The introduction of the UFR in the current interest rate curve of the adequacy test is not intended to make immediate changes to the methods used to value options and guarantees, including the adjustment of interest rate scenarios such that the forward rates separately converge to the UFR in every scenario. Any changes to the valuation method for options and guarantees must be applied consistently and must be reconcilable as much as possible with the theorem of arbitrage-free pricing.

Naturally, insurers must explain how they value options and guarantees in the adequacy test.

Insurers may use the Good Practice – Adequacy Test for Life Insurers when valuing options and guarantees and drafting the related explanatory notes.

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