An analysis of the Solvency II regulatory framework’s smith-wilson model

An analysis of the Solvency II regulatory framework’s smith-wilson model

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for the term structure of risk-free interest rates      

Speaker(s): Peter Løchte Jørgensen (Aarhus University)

In the European Union financial regulation requires that life and pension (L&P) companies use the Smith-Wilson (2000) model for the term structure of risk-free interest rates when valuing their liabilities and long term guarantees. Since the Smith-Wilson model is not one of finance theory's standard term structure models, we introduce the model and we describe how the European Solvency II regulation came to embrace this particular model.

The paper moves on to document how the regulation also imposes quite detailed and tight restrictions on how the Smith-Wilson model should be parameterized and applied. We argue that many of these implementation instructions seem biased in the same direction and that this could indicate a systematic attempt to "lift" the term structure curve up and away from its true location. The result of the bias is not only significant undervaluation of L&P liabilities but also a peculiar contradiction of the Solvency II overall objective of enhancing financial stability and of protecting policyholders via the promotion of economic valuation in accordance with market consistent principles.

The paper's analysis is accompanied by valuation illustrations based on data on the liability composition of an actual medium-sized Danish pension fund.

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