Solvency II and Derivatives – Part 3

Part 3: Risk Mitigation

Continuing our short series exploring how Solvency II (SII) applies to the use of derivatives within a pure relative value investment strategy, this third paper looks closely at their use under the classification of risk-mitigation. The first paper laid the groundwork for the series by outlining how we understand the core principles of SII as they relate to derivatives in a pure RV context, while the second paper looked closely at the Prudent Person Principle and derivatives in the context of Efficient Portfolio Management (EPM).

From here we then look to what defines a derivative strategy or instrument as Risk Mitigating as opposed to contributing to Efficient Portfolio Management. Any security that transfers risk (whether that be interest rate risk, spread risk, currency risk etc.) away from the insurance undertaking is considered a ‘risk mitigating technique’. Any instrument looking to reduce risk in some way in the portfolio can be considered risk mitigating. From here there is specific Solvency II treatment that dictates the permitted hedging capacity of these risk mitigating techniques depending on their expiry.

The Solvency Capital Requirement serves as a safeguard for capital, ensuring that an insurance company can fulfil its obligations with a 99.5% certainty over the upcoming 12 months. It is specifically structured to assess potential losses within this 12-month timeframe. What follows is that securities that have an expiry less than 12 months in the future have more complex treatment of their hedging capacity.

Expiry over 12 months away

If a derivative has an expiry of more than 12 months in the future, then the full impact of any hedging benefits will apply. For example, consider a long bond future position with expiry 2 years in the future. Under the interest rates market risk module, the option will experience upwards and downwards interest rate shocks. In the upwards shock case, the option will lose value and thus contribute to increase the Solvency Capital Ratio (SCR). Naturally then in the downwards shock case the option will gain value and thus reduce the overall SCR to its full capacity.

Let’s say for the sake of simplicity that the option loses 1% of value in the case of an increase in rates and gains 1% of value in the case of a decrease in rates. This will contribute +1% SCR and -1% SCR respectively.

Expiry within the next 12 months

If a risk mitigation technique (derivative strategy) covers a period of less than 12 months, then there are certain requirements that it must meet to account for its complete risk mitigation capacity in the calculation of the Solvency Capital Ratio.

Rolling Hedges
Any derivative that ‘isn’t in force for at least 12 months’ must adhere to some qualitative criteria to deem it as a rolling hedge and thus account for its full hedging capacity. The criteria are as follows:

1. There must be an intent to replace the technique with ‘a similar arrangement’
2. There’s a written policy on replacing the ‘technique’
3. Replacement of the ‘technique’ is not more often than every 3 months
4. Replacement is not conditional on future events i.e. liquidity problems
5. Changes to the cost of replacing the ‘technique’ is accounted for

We assume ‘technique’ is referencing a singular derivative position and ‘similar arrangement’ means rolling the derivative hedge into a new position mitigating the same risks. We also assume any distinct rolling hedge program where each hedge is held for at least 3 months as deemed to be “risk mitigating”. The legitimacy and impact of these assumptions will be discussed later in this piece.

Consider a long bond future with an expiry of 6 months. If qualifying as a rolling hedge, then say the option loses 1% of value in the case of an increase in rates and gains 1% of value in the case of a decrease in rates. This will contribute +1% SCR and -1% SCR respectively.

Other Hedges – not classified as rolling
Naturally then, any risk-mitigating techniques with an expiry less than 12 months away that do not fall under this rolling hedge classification will then have their risk mitigating impact reduced. This reduction is on a pro rata temporis basis, reducing by whatever fraction of the next 12 months the position is held for.

Again, let us take the same long bond future position with an expiry only 6 months away. If qualifying as a rolling hedge, then again say the option loses 1% of value in the case of an increase in rates and gains 1% of value in the case of a decrease in rates. The increase in value i.e. the SCR reducing component of the shock will be reduced by a factor of 0.5 as this security is only active for half of the next 12-month period. Thus, this will contribute +1% SCR and -0.5% SCR respectively.

Conclusion

Solvency II provides a clear framework for recognising risk-mitigating derivative strategies, with the treatment differing based on expiry and whether a position qualifies as a rolling hedge. Longer-dated derivatives receive full credit for their hedging benefits, while shorter-dated instruments face more complex requirements to achieve the same recognition.

In the next paper (Part IV), we will provide detailed worked examples showing how these rules are applied in practice, and how different classifications impact the calculation of capital charges under the Solvency II framework.

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