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Methodology for Risk-free Discount Rates and CPI Assumptions for Accounting Valuation Purposes

9  Review of Accounting and Actuarial Standards and Other Literature

9.1  Introduction

9.1.1 This section summarises the Treasury's consideration of the accounting standards, actuarial standards and other literature referenced in the development of the methodology in this paper. The methodology outlined in the main body of this paper is supported by, and is consistent with, this analysis and the views documented in this section.

9.1.2 The Financial Statements of the Government of New Zealand are prepared in accordance with the Public Finance Act 1989 and with New Zealand generally accepted accounting practice (NZ GAAP). For NZ GAAP purposes, the Government reporting entity is designated as a public benefit entity (PBEs). The financial statements comply with New Zealand equivalents to International Financial Reporting Standards (NZ IFRS) as appropriate for PBEs. Therefore, the accounting valuations reported in the Government's accounts must comply with specific accounting standards under NZ IFRS.

9.1.3 There are about 40 accounting standards under NZ IFRS which specify the financial reporting of certain transactions and balance sheet items.

9.1.4 The development of the methodology has focused on the financial reporting requirements of the Government's largest valuations that use present value cash flow models: the ACC Insurance obligation, the Government Superannuation Fund (GSF) pension liability and the Student Loan Scheme's loan assets. The applicable accounting standards for these are NZ IFRS 4 Insurance Contracts, NZ IAS 19 Employee Benefits and NZ IAS 39 Financial Instruments: Recognition and Measurement respectively. A review of NZ IAS 37 Provisions, Contingent Liabilities and Contingent Assets is also included because the measurement of some of the Government's provisions also uses present value cash flow techniques.

9.1.5 There are a number of IFRSs requiring or permitting measurements using present value techniques. Each standard does not have identical wording in their respective discounting sections. However, we have concluded that the methodology described in this paper complies with all the relevant NZ IFRSs requiring the use of risk-free discount rates for the purposes of the Government's financial reporting.

9.1.6 In the case of Student Loans under NZ IAS 39 a risk-adjusted rate is required. Given the absence of any market for NZ student loan assets and no suitable observable proxy, we believe it is appropriate to use the risk-free rate as a starting point on which a risk premium is added. Therefore, this analysis has relevance not only for Student Loans, but other accounting valuations where a net present value is determined by using a risk-free rate plus a risk adjustment.

9.1.7 International Actuarial Standards are guidance for actuaries to ensure that their work meets certain levels of professional standards. Actuarial standards complement accounting standards in that they provide guidance on how to apply the accounting requirements to valuations using actuarial techniques. The major valuations noted above are all valued by professional actuaries on behalf of the Government and therefore it is appropriate to review actuarial standards as part of this paper.

9.1.8 As international actuarial standards have been developed to apply under IFRS, no conflicts or inconsistencies are expected to arise between the accounting standards (ie, “what to measure”) and the actuarial standards (ie, “how to measure”). However, there are a number of international debates between actuaries on how to value insurance and pension obligations, including debates on how to determine a basic risk-free rate. If any conflict or inconsistency between the accounting and actuarial standards were to arise, the accounting standards would need to receive more weighting because the valuations must comply with NZ IFRS.

9.1.9 There have been many international articles and papers on discount rates written by actuaries and finance professionals over the years. This reflects the importance of discount rates in valuations; small movements in discount rates can have significant impacts on the financial results of entities. The use of discount rates is a very sensitive issue, particularly in Europe and the US where there are large defined benefit pension schemes and insurance obligations on balance sheets. The recent global financial crisis has further heightened this sensitivity because all bond markets have been extremely volatile and accepted historical norms about the risk-free nature of debt issuances by sovereigns have now been questioned, particularly in Europe.

9.2  Literature Hierarchy

9.2.1 There is a definite hierarchy in the literature in terms of how much weight should be given to any conclusions or guidance contained in the literature. The hierarchy is:

  • New Zealand accounting standards
  • international accounting standards
  • New Zealand actuarial standards
  • international actuarial standards, and
  • papers from international bodies. Many of these have no official status and are research and discussion papers and are not definitive.

9.2.3 Note that the actuarial standards do not refer directly to the accounting standards, and both the accounting and actuarial standards have shortcomings. The papers from international bodies are a range of discussion notes and research and also have evolving conclusions. Consequently not all of the findings in the papers have been given equal weight.

9.3  Accounting Standards

9.3.1 The specific accounting standards under NZ IFRS require a significant amount of judgment to be applied in determining discount rates for measuring valuations using discounted cash flow models.

9.3.2 Establishing the discounting principles across the relevant standards is vital. If the principles in the accounting standards are clear selection decisions in practice can be made with confidence. Such selection decisions may include:

  • choosing a suitable yield curve from New Zealand markets to proxy a risk-free rate
  • deciding whether any adjustments need to be made to the yield curve selected as a risk-free proxy, and
  • determining a risk-free rate when there are no observable yield curves in the New Zealand markets (usually for longer duration assets and liabilities)

9.3.3 When IFRS was first introduced, risk-free discount rates were very strictly interpreted as being market rates with no adjustment. As best practice has evolved, there has been significant work on how to cope with market shortcomings such as illiquid tranches.

9.3.4 In the Treasury's view, it may be appropriate to adjust an observable yield curve to be compliant with the principle of determining a risk-free rate. An example may be adjustments to government stock by giving less weight to the market rates of very illiquid tranches.

9.3.5 Below is the Treasury's analysis and interpretation of the applicable accounting standards that the Government's reported valuations must comply with.

NZ IFRS 4 Insurance Contracts

9.3.6 The discounting requirements in NZ IFRS 4 Appendix D for general insurance contracts are specified below.

IFRS 4 Appendix D - Discount Rates

6.1 The outstanding claims liability shall be discounted for the time value of money using risk-free discount rates that are based on current observable, objective rates that relate to the nature, structure and term of the future obligations.

6.1.1 The discount rates adopted are not intended to reflect risks inherent in the liability cash flows, which might be allowed for by a reduction in the discount rate in a fair value measurement, nor are they intended to reflect the insurance and other non-financial risks and uncertainties reflected in the outstanding claims liability. The discount rates are not intended to include allowance for the cost of any options or guarantees that are separately measured within the outstanding claims liability.

6.1.2 Typically, government bond rates may be appropriate discount rates for the purposes of this Appendix, or they may be an appropriate starting point in determining such discount rates.

9.3.7 The Treasury believes that the principle is clear. NZ IFRS 4 requires discounting to reflect the time value of money using current objective rates but not reflecting risks inherent in the obligations cash flow. The standard setters provide some guidance in that government bonds are typically an appropriate starting point for current observable risk-free rates.

9.3.8 Unfortunately the standard does not provide any detailed guidance on how to determine the risk-free discount rate where the term of an insurance obligation is much longer than the current observable market data, as in New Zealand.

NZ IAS 19 Employee Benefits

9.3.9 The discounting requirements in NZ IAS 19 for long-term employee benefits are specified below. NZ IAS 19 provides a mixture of rules and principles, which in the Treasury's opinion makes it a more cumbersome standard to interpret.

NZ IAS 19 - Actuarial assumptions: discount rate 78 The rate used to discount post-employment benefit obligations (both funded and unfunded) shall be determined by reference to market yields at the end of the reporting period on high quality corporate bonds. In countries where there is no deep market in such bonds, the market yields (at the end of the reporting period) on government bonds shall be used. The currency and term of the corporate bonds or government bonds shall be consistent with the currency and estimated term of the post-employment benefit obligations.

79 One actuarial assumption which has a material effect is the discount rate. The discount rate reflects the time value of money but not the actuarial or investment risk. Furthermore, the discount rate does not reflect the entity-specific credit risk borne by the entity's creditors, nor does it reflect the risk that future experience may differ from actuarial assumptions.

80 The discount rate reflects the estimated timing of benefit payments. In practice, an entity often achieves this by applying a single weighted average discount rate that reflects the estimated timing and amount of benefit payments and the currency in which the benefits are to be paid.

81 In some cases, there may be no deep market in bonds with a sufficiently long maturity to match the estimated maturity of all the benefit payments. In such cases, an entity uses current market rates of the appropriate term to discount shorter term payments, and estimates the discount rate for longer maturities by extrapolating current market rates along the yield curve. The total present value of a defined benefit obligation is unlikely to be particularly sensitive to the discount rate applied to the portion of benefits that is payable beyond the final maturity of the available corporate or government bonds.

9.3.10 In its supporting comments in the basis for conclusions, the International Accounting Standards Board (IASB) discusses and rejects using a risk-adjusted discount rate. It states “Therefore, the Board decided that the discount rate should reflect the time value of money but should not attempt to capture those risks….The rate that best achieves these objectives is the yield on high quality corporate bonds. In countries where there is no deep market in such bonds, the yield on government bonds should be used” (paragraph BC31). “The reference to market yields at the balance date does not mean that short-term discount rates should be used to discount long term obligations.” (Paragraph BC34)

9.3.11 Treasury’s conclusion is that the principle in NZ IAS 19 is to discount employee benefit obligations reflecting the time value of money using current objective rates but not reflecting risks inherent in an obligation’s cash flows. This is the same principle as in IFRS 4 Insurance Contracts. Reading paragraph 78 of NZ IAS 19 in isolation is unhelpful, in Treasury’s view, in determining the principle because it is a rule. However, by reading paragraphs 79 to 81 together with the IASB’s basis of conclusion, Treasury believes the principle is clearer.

9.3.12 Some commentators, reading paragraph 78 in isolation, believe that discounting of employee benefits does require a risk-adjusted rate because all corporate bonds, regardless of the quality, include some risk. Treasury disagrees with this interpretation of the principle of NZ IAS 19. Treasury believes that the IASB was attempting to provide some guidance as to how to achieve a risk-free rate by referencing to high-quality corporate bonds or, failing that, to reference to government bonds. The Treasury believes that NZ IAS 19 has been poorly drafted in this instance and has made a submission to the IASB on this subject before.

9.3.13 Having said that, the approach adopted in this paper is to determine the discount rate by reference to government bonds (there is no deep market in high quality corporate bonds in New Zealand currency) consistent with the term of the obligation's cash flows. Despite the issue with the drafting of paragraph 78, the Treasury considers that our methodology is compliant with the letter of the standard.

9.3.14 Some of the key IASB comments in the basis of conclusion that Treasury has relied on in coming to a view on the principle of NZ IAS 19 are:

  • discount rates should reflect the time value of money but should not attempt to capture risks associated with a plan's defined benefit obligation (paragraph BC 31)
  • discount rates should be determined by reference to market yields at the balance sheet date (paragraph BC 33)
  • the reference to market yields at the balance date does not mean that short-term discount rates should be used to discount long term obligations (paragraph BC 34), and
  • the discount rate should reflect market yields (at the balance sheet date) on bonds with an expected term consistent with the expected term of the obligations (paragraph BC 34).

9.3.15 While the New Zealand Government is not required to comply with International Public Sector Accounting Standards (IPSASs), certain IPSASs do provide authoritative support for some items in the Government’s financial statements. The IPSAS Board interpreted the discount rate to use when they recently issued IPSAS 25, their equivalent of NZ IAS 19. IPSAS 25 is based on the requirements of NZ IAS 19, modified where appropriate for the public sector. The IPSAS Board modified NZ IAS 19 by removing the reference to the corporate and government bond “rule” in paragraph 78 and replacing it with the principle that entities must apply a rate that reflects the time value of money. The IPSAS Board considered that entities should be left to determine the rate that best achieves that objective. This is consistent with the Treasury’s view of the principle in NZ IAS 19.

9.3.16 The Australian Accounting Standards Board’s equivalent of NZ IAS 19, AASB 119, includes a modification that requires not-for-profit public sector entities to discount post-employment benefit obligations using market yields on government stock.

9.3.17 Some commentators believe that, in the absence of a high quality corporate bond market it is not appropriate to look to the country’s government bonds but to construct an artificial corporate bond yield curve by referencing a bond market in another country or currency and using a currency swap market. Treasury disagrees with this interpretation of NZ IAS 19 because the standard specifies a hierarchy to be applied in the domestic market. This alternative view is not compliant with the requirement that the currency of the bond must be consistent with the currency of the obligation.

9.3.18 NZ IAS 19 provides very little guidance about how to determine inflation assumptions. CPI and salary inflation are important assumptions in both the ACC and GSF valuations. However NZ IAS 19 does provide some principles below.

NZ IAS 19 Actuarial Assumptions

72 Actuarial assumptions shall be unbiased and mutually compatible.

75 Actuarial assumptions are mutually compatible if they reflect the economic relationships between factors such as inflation, rates of salary increase, the return on plan assets and discount rates. For example, all assumptions which depend on a particular inflation level (such as assumptions about interest rates and salary and benefit increases) in any given future period assume the same inflation level in that period.

9.3.19 This standard reinforces the importance of the internal consistency between the discount rate and inflation rate assumption and therefore, the importance of the real rate of return assumption. Determining the real rate of return assumption, particularly in the long term, is a significant assumption addressed by the methodology.

NZ IAS 39 Financial Instruments: Recognition and Measurement

9.3.20 The discounting requirements in NZ IAS 39 are specified below.

NZ IAS 39 Application Guidance

No active market: valuation technique

AG 79 In applying discounted cash flow analysis, an entity uses one or more discount rates equal to the prevailing rates of return for financial instruments having substantially the same terms and characteristics, including the credit quality of the instrument, the remaining term over which the contractual interest rate is fixed, the remaining term to repayment of the principal and the currency in which payments are to be made. Short-term receivables and payables with no stated interest rate may be measured at the original invoice amount if the effect of discounting is immaterial.

Inputs to valuation techniques

AG 82 An appropriate technique for estimating the fair value of a particular financial instrument would incorporate observable market data about the market conditions and other factors that are likely to affect the instrument's fair value. The fair value of a financial instrument will be based on one or more of the following factors (and perhaps others).

(a) The time value of money (ie, interest at the basic or risk-free rate). Basic interest rates can usually be derived from observable government bond prices and are often quoted in financial publications. These rates typically vary with the expected dates of the projected cash flows along a yield curve of interest rates for different time horizons. For practical reasons, an entity may use a well-accepted and readily observable general rate, such as LIBOR or a swap rate, as the benchmark rate. (Because a rate such as LIBOR is not the risk-free interest rate, the credit risk adjustment appropriate to the particular financial instrument is determined on the basis of its credit risk in relation to the credit risk in this benchmark rate). In some countries, the central government's bonds may carry a significant credit risk and may not provide a stable benchmark basic interest rate for instruments denominated in that currency. Some entities in these countries may have a better credit standing and a lower borrowing rate than the central government. In such a case, basic interest rates may be more appropriately determined by reference to interest rates for the highest rated corporate bonds issued in the currency of that jurisdiction.

(b) Credit risk. The effect on fair value of credit risk (ie, the premium over the basic interest rate for credit risk) may be derived from observable market prices for traded instruments of different credit quality or from observable interest rates charged by lenders for loans of various credit ratings.

9.3.21 Student loans, which are largely interest-free, are reported in the Government’s accounts in accordance with NZ IAS 39. The Government’s accounting policy for these loans is to recognise them initially in the accounts at fair value plus transaction costs and subsequently measure them at amortised cost using the effective interest rate method.

9.3.22 As there is no active market for student loans assets, their initial fair value is measured using a valuation technique incorporating the present value of estimated future cash flows. This involves, among other things, determining a risk-adjusted discount rate to calculate the present value. As there are no observable market rates for student loans, nor any suitable yields to proxy in New Zealand, the discount rate is hypothetically derived by establishing a risk-free rate and adding an adjustment for credit risk.

9.3.23 NZ IAS 39, paragraph AG 82, provides some guidance and discussion on how a risk-free discount rate or “basic” rate might be derived. NZ IAS 39 states that the basic interest rates can usually be derived from observable government bond prices but offers some alternative yield curves for practical reasons. Treasury has concluded that New Zealand government bonds are the most representative risk-free rate in New Zealand. Therefore, the methodology outlined in this paper is applicable for determining the risk-free component of the Student Loan Scheme discount rate.

NZ IAS 37 Provisions, Contingent Liabilities and Contingent Assets

9.3.24 The discounting requirements in NZ IAS 37 are specified below.

NZ IAS 37 - Present value

45 Where the effect of the time value of money is material, the amount of a provision shall be the present value of the expenditures expected to be required to settle the obligation.

46 Because of the time value of money, provisions relating to cash outflows that arise soon after the reporting period are more onerous than those where cash outflows of the same amount arise later. Provisions are therefore discounted, where the effect is material.

47 The discount rate (or rates) shall be a pre-tax rate (or rates) that reflect(s) current market assessments of the time value of money and the risks specific to the liability. The discount rate(s) shall not reflect risks for which future cash flow estimates have been adjusted.

9.3.25 There may be some provisions on the Government’s balance sheet that use valuation techniques such as present valuing future cash outflows and therefore the requirements in NZ IAS 37 are considered for completeness.

9.3.26 It is likely that entities valuing provisions using cash flow techniques will reflect the risk in adjusting the cash flow and discount at the risk-free rate. This is normally easier than adjusting the discount rate for risk, which is complex and often requires significant amounts of judgment.

9.3.27 Therefore, Treasury believes that the methodology outlined in this paper is appropriate in determining a risk-free rate where it is required for valuing provisions under NZ IAS 37.

Qualitative Characteristics

9.3.28 As described above, the Treasury considers that the methodology outlined in this document provides an approach that complies with NZ IFRS 4, NZ IAS 19, NZ IAS 37 and NZ IAS 39. In addition, taking a single approach to this issue is the best application of the principle qualitative characteristics and therefore will result in the most fair presentation of financial information.

Extract of the New Zealand Framework for Financial Reporting

Paragraph 24

Qualitative characteristics are the attributes that make the information provided in financial statements useful to users. The four principal qualitative characteristics are understandability, relevance, reliability and comparability.

9.3.29 Our methodology ensures that:

  • there are not separate definitions and rates that are “risk-free”. This increases the understandability and comparability of the information
  • the use of market information, where it is available, ensures the relevance and reliability of the information, and
  • relevance and reliability are not compromised because more than one rate purports to represent the same economic phenomenon.

9.4  Actuarial Standards

9.4.1 Actuaries apply financial and statistical techniques to value certain assets or liabilities for various purposes, including financial reporting under IFRS. Therefore, some professional bodies or societies of actuaries issue professional standards, both technical and ethical in nature, which attempt to provide detailed guidance on valuing obligations under accounting standards. These professional standards are therefore generally consistent with accounting standards.

9.4.2 The New Zealand Society of Actuaries (NZSA) issues professional standards for actuaries in New Zealand. There are different standards for general insurance business, life insurance business and superannuation.

General Insurance Business

9.4.3 NZSA Professional Standard No. 4 applies to General Insurance Business. The standard applies to every actuary preparing a report on the technical liabilities required for, or on the financial soundness of, a general insurance undertaking (eg, ACC). An extract of PS No.4 that is relevant to the methodology outlined in this paper is shown below.

NZSA PS4 - General Insurance Business

4.14 The risk-free rate of return, which is the rate of return on a portfolio of assets matched to the liabilities, must be the starting point for determining the appropriate discount rates. The Actuary should explain the reasons for adopting rates that differ from the risk-free rate.

9.4.4 PS4 is entirely consistent with the NZ IFRS accounting standards, in that the starting position is the risk-free rate of return on a portfolio of assets matched to the liabilities. However, NZSA PS4 does not provide any guidance on how to deal with market shortcomings (eg, when the liability duration exceeds the market observable rates of a portfolio of assets).

9.4.5 The International Association of Actuaries (IAA) has also issued Professional Standard 300 Actuarial Reports and Advice on General Insurance Technical Liabilities (PS300). The relevant paragraphs are extracted below:

IAA PS300 - General Insurance Business

8.2.2 Legislative and/or regulatory requirements may prescribe whether Claim Payments are to be discounted. The Member must consider the purpose of the valuation and document whether the future Claim Payments are to be discounted. Discount rates used must be based on the redemption yields of a Replicating Portfolio as at the valuation date, or the most recent date before the valuation date for which such rates are available.

8.2.3 If the projected payment profile of the future Claim Payments cannot be replicated (for example, for Classes of Business with extended runoff periods), then discount rates consistent with the intention of Paragraph 8.2.2 must be used.

9.4.6 ‘Replicating Portfolio' means a notional portfolio of current, observable, market-based, fixed-interest investments of highest rating, which has the same payment profile (including currency and term) as the relevant claim liability being valued.

9.4.7 To be consistent with paragraph 8.2.2 of IAA PS300, actuaries must consider if the purpose of the valuation is an accounting valuation for financial reporting and if so look to comply with accounting standards. As discussed above, the accounting standards require that the discount rate is the risk-free one.

Superannuation Schemes

9.4.8 NZSA Professional Standard No.2 applies to actuarial reporting of superannuation schemes but has no specific guidance on discount rates.

9.5  Technical Papers from International Bodies

International Association of Actuaries Technical Papers

9.5.1 The IAA is the worldwide association for national professional actuarial associations and their individual actuaries. The IAA exists to encourage the development of a global profession and as such publishes articles and discussion papers for the international actuarial profession to consider.

9.5.2 One such paper is the IAA’s Measurement of Liabilities for Insurance Contracts: Current Estimates and Risk Margins. This paper is fairly extensive and discusses some topics that are relevant to the methodology outlined in this paper. We have used this paper as guidance in developing our methodology because it is one of the internationally recognised discussion documents on the topic of determining discount rates for valuing insurance contracts.

9.5.3 The IAA’s insurance contract paper discusses the components of a risk-free rate. It states that the risk-free rate is made up of:

  • real interest rate
  • plus inflation
  • plus sovereign provision (country credit risk)
  • minus other elements, including extreme market risk aversion and cost of safe keeping.

9.5.4 The IAA’s paper states that there are a number of different sources for risk-free rates, including:

  • government stock rates
  • government stock rates plus an adjustment
  • corporate bond rates minus an adjustment
  • SWAP rates minus an adjustment, and
  • SWAP rates.

9.5.5 In developing the methodology, we have discussed some of the IAA’s options, while simultaneously ensuring that the methodology is compliant with the accounting standards. While NZ IFRS 4 states an example of one source (eg, typically government bonds are an appropriate starting point in determining a risk-free rate), this IAA paper introduces other sources for determining risk-free rates. In our view the IAA is recognising that different jurisdictions will have different sources of risk-free rates and the reliability of these rates may vary across those jurisdictions.

9.5.6 The IAA paper then goes on to detail the various adjustments that can be made in each of these cases. The most relevant in relation to the Treasury’s methodology are the adjustments to government stock rates required due to:

  • short supply at the long end of the yield curve, and
  • the ability of government stock to be used as general collateral or repurchase (repo) transactions, which allows the holder to earn an extra premium and will lower market yields.

9.5.7 Although the accounting standards do not deal with market shortcomings, the IAA paper is authoritative technical support for adjusting New Zealand’s observed government stock rates in certain cases. In the development of the methodology we have included indications of what cases may warrant such an adjustment.

9.5.8 The IAA’s paper states that the simplest approach to extending the yield curve is by using the last available rate. This paper has largely been superseded by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) papers which have a more developed discussion of the issues.

The Committee of European Insurance and Occupational Pensions Supervisors

9.5.9 CEIOPS is a level-3 committee of the European Union which is participating in the wider process to develop financial service industry regulations used by the European Union. Consequently the CEIOPS views carry considerable weight and can be regarded as authoritative.

9.5.10 CEIOPS published in November 2009 Advice for Level 2 Implementing Measures on Solvency II: Technical Provisions - Article 86 b - Risk-free interest rate term structure that is of interest to the Treasury in developing our methodology. While we are interested in the principles of this technical paper, we are conscious that it is focused only on the European Union. The conclusions of this paper may not always be automatically transferable to different jurisdictions like Australia and New Zealand. Papers such as CEIOPS have no formal status for New Zealand actuaries. However, for any issue that is not covered by New Zealand actuarial standards it is generally good practice to get support for any principles, methodology or assumptions used from overseas guidance or research so long as it is appropriate to New Zealand.

9.5.11 The CEIOPS paper discusses many of the same issues as the IAA’s paper. However, it introduces some other concepts that have been used as technical support for the methodology. These concepts include: criteria for a robust risk-free rate, the three-stage process and long maturities. These three topics are summarised below.

Criteria for a robust risk-free rate

9.5.12 The CEIOPS paper, in paragraph 3.3, states that the criteria for a robust risk-free rate include:

  1. no credit risk
  2. realism – it should be possible to actually earn these rates
  3. reliability of method to determine term structure
  4. high liquidity of reference stock
  5. no technical biases
  6. availability for all relevant currencies, and
  7. proportionality – there exists a process to centrally determine rates for entities too small to do it themselves.

9.5.13 The criteria a) to e) are all relevant to New Zealand and helpful in guiding our methodology. Criteria f) is not important to us and criterion g) may or may not be relevant but will be satisfied nonetheless by the publication of this paper and regular publication of rates.

The three stage process

9.5.14 The CEIOPS paper also introduces a three stage process to determining risk-free discount rates as follows:

  1. If government stocks are available that meet the criteria then use them.
  2. If government stock are available but do not meet the criteria, then they should be adjusted for their deficiencies.
  3. Failing 1 and 2, other instruments should be used but adjusted for credit risk.

9.5.15 This three stage approach is consistent with the methodology adopted, in that government stock rates broadly meet the criteria but there are times when it is appropriate to adjust government bond rates to cope with market shortcomings such as illiquid tranches of government stock.

Long maturities

9.5.16 The CEIOPS paper is one of the few to develop principles for determining appropriate extrapolation techniques for the interest rate curve of long maturities. It states extrapolation should take account of:

  • realism, ie, it should be possible to earn this return in a risk-free manner, and
  • volatility in long term discount rates can lead to substantial changes in values of liabilities and consequent pro-cyclical effects. The choice of extrapolation method should take account of the effect on financial stability.

9.5.17 Treasury agrees with these principles and they have been reflected in our methodology. Extrapolation is of crucial importance for our long-term insurance and pension obligations (ACC and GSF) where slight differences in the extrapolated part of the yield curve may lead to significant differences in the valuation. We have applied the principle that the ultimate extrapolated long-term forward rate should be stable over time and only change due to fundamental changes in long term expectations.

9.5.18 The CEIOPS taskforce in March 2010 issued another paper the main purpose of which was to update the previous November 2009 paper by specifically discussing the liquidity premium for both assets and liabilities. However other purposes included an update on extrapolation methods and the choice of basic risk-free interest rate curve.

9.5.19 On the matter of the basic risk-free rate structure the CEOIPS March 2010 Task Force Report on the Liquidity Premium reached the opposite conclusion to the previous paper for the starting point for risk-free rates. They have now advised the risk-free rate should be bank SWAP rates adjusted downwards for credit risk.

9.5.20 The Treasury believes that the CEIOPS latest view on the starting point for risk-free rates is conceptually inferior for valuing ACC’s insurance and GSF pension obligations and would not be practical to implement for the Government’s financial reporting. In New Zealand markets it would be very difficult to reliably quantify the credit risk for the purpose of adjusting the basic SWAP rates by. The proposal also introduces a complexity for readers of the Government’s accounts when it is widely accepted that New Zealand government bonds are a more reliable proxy of risk-free rates in New Zealand than bank SWAP rates.

9.5.21 The updated March 2010 CEIOPS paper also provided 11 principles for extrapolating the basic risk-free interest rate term structure building on the high level principles indentified in the March 2009 paper. Of particular interest for our methodology are the principles stated in No 3, 5, 6, 7 and 8 on page 25 of the Task Force’s document (refer below). These support, in particular, the use of a fixed long-term rate.

Extract of CEIOPS Task Force Report on the Liquidity Premium http://www.ceiops.eu/content/view/724/1/

Principles for extrapolating the basic risk-free interest rate term structure - Page 25

#1. All relevant observed market data points should be used.

#2. Extrapolated market data should be arbitrage-free.

#3. Extrapolation should be theoretically and economically sound.

#4. The extrapolated part of the basis risk free interest rate curve should be calculated and published by a central EU institution, based on transparent procedures and methodologies, with the same frequency and according to the same procedures as the non extrapolated part.

#5. Extrapolation should be based on forward rates converging from one or a set of last observed liquid market data points to an unconditional ultimate long-term forward rate to be determined for each currency by macroeconomic methods.

#6. The ultimate forward rate should be compatible with the criteria of realism as stated in CEIOPS advice on the risk free interest rate term structure and the principles used to determine the macro-economic long term forward rate should be explicitly communicated.

#7. Criteria should be developed to determine the last observed liquid market data points which serve as entry point into the extrapolated part of the interest curve and for the pace of convergence of extrapolation with the unconditional ultimate long-term forward rate.

#8. Extrapolated rates should follow a smooth path from the entry point to the unconditional ultimate long-term forward rate.

#9. Techniques should be developed regarding the consideration to be given to observed market data points situated in the extrapolated part of the interest curve.

#10. The calibration of the shock to the risk free interest rate term structure used for the calculation of the SCR should be reviewed in order to be compatible with the relative invariance of the unconditional ultimate long term forward rate.

#11. Extrapolation should be arbitrage-free across different currencies, taking into account forward and spot foreign exchange rates observable in the financial markets.

9.5.22 Principle 10 is not relevant because the CEIOPS paper’s purpose is primarily relating to solvency calculations which include the impact of interest rate shocks.

9.5.23 Our methodology for extrapolating to the long-term has been developed on similar principles to those outlined by the CEIOPS Task Force in the March 2010 paper.

9.5.24 The main purpose of the Task Force’s March 2010 paper was to consider the implication of including a liquidity premium in the risk-free rate for technical insurance valuations. The Task Force concluded that “the illiquidity of an insurance liability measures the extent up to which its cash flow are certain in amount and in timing, due consideration being given the resilience to forced sales”. The Task Force believe most life insurance liabilities can be considered to be at least partially illiquid.

9.5.25 In the Treasury’s opinion the settlement of our insurance liabilities is too uncertain to be regarded as illiquid. Therefore, for the purposes of the Government’s financial reporting under NZ IFRS, we do not think it is appropriate to make a liquidity adjustment. This is currently a relatively new area of debate and may need to be reassessed as the international position is updated.

Australian Prudential Regulation Authority (APRA)

9.5.26 APRA has been following the European debates on discounting insurance obligations and the discussions of CEIOPS in developing insurance regulation in Australia. APRA has recently issued Discussion Paper - Review of capital standards for general insurers and life insurers on 13 May 2010. This recent paper has useful sections on both risk-free discount rates and liquidity premiums that reflect recent developments.

APRA - Review of capital standards for general insurance and life insurers

Risk -free rates

“For Australian-denominated liabilities, APRA regard the zero coupon spot yield curve of Commonwealth Government Securities (CGS) as the best proxy for risk-free rates. In forming this view, APRA has considered the views of the Reserve Bank of Australia (RBA) on the appropriateness of CGS yields as a proxy for the risk-free rate. The RBA has indicated that no persuasive evidence exists to suggest that the nominal CGS yield curve exhibits any downwards bias or that a shallow market exists.”

Liquidity Premium

“The existence of a ‘liquidity premium' in the valuation of assets is generally accepted by market participants. A liquid asset is believed to have a higher market value than an equivalent but illiquid asset with the same expected cash flows and credit risk.

In relation to liabilities, the argument has been made by some market participants and observers that if future cash flows from insurance obligations are illiquid, it may be appropriate to add to the risk-free rates an allowance for a liquidity premium. The argument is that if the future cash flows of an insurance liability are certain, then in theory an insurer could purchase a portfolio of relatively illiquid securities to exactly match the quantum and duration of the liabilities and wait until maturity to realise the value of those assets. As long as this portfolio of assets was free from credit risk and there was no chance that the assets would need to be realised early to meet the liability cash flows, then this portfolio might be considered risk-free.

APRA is following the international debate on liquidity premiums and the risk-free discount rate. APRA may consider allowing a liquidity premium adjustment to the risk-free rate for discounting lifetime annuities with no provision for voluntary termination, provided that APRA can arrive at a robust method for quantification of the liquidity premium. APRA considers that any general insurance or life insurance liabilities (other than annuities with no provision for voluntary termination) are unlikely to meet the certainty criterion required for allowance of a liquidity premium adjustment.”

9.5.27 APRA’s conclusion that, for the purposes of capital reporting, the risk-free rate should be a term structure derived from Government securities, and that a liquidity premium is unlikely to be justified. While APRA’s conclusion is for regulatory purposes only, it is consistent with the Treasury’s view on the subject of a suitable proxy and liquidity premium for reporting under NZ IFRS.

Other International Papers

9.5.28 Annex E of the first CEIOPS paper is a discussion of macroeconomic extrapolation methods that we believe is applicable in developing our methodology.

9.5.29 The Swedish and Norwegian markets are similar to New Zealand markets in that there are no government stocks beyond 10 years and no reliable information on SWAP rates beyond 15 years. The method discussed in Annex E uses unconditional fixed forward rates after a selected duration. It quotes research done on the macro-economic arguments by Barrie and Hibbert A Framework for estimating and extrapolating the term structure of interest rates, Sept 2008.

9.5.30 The following issues, which are of interest to the Treasury in developing our methodology, are discussed under the headings:

  • at what maturity should the fixed forward rate be set, and
  • which method should be used to interpolate between the last observable liquid rate and the fixed forward rate.

9.5.31 The Norwegian macroeconomic model that is used for extrapolation uses the forward rates from the yield curve up to year 10 and then smoothes linearly to an unconditional macroeconomic target for all maturities over a given threshold. In the example the target is 4% after 20 years.

9.5.32 The Treasury believes this is a useful reference and clearly articulates principles, adjustments required and the projection of yield curves. CEIOPS’s conclusion about the model described above is that it is:

  • adequate from a theoretical point of view; almost all academic literature is based on extrapolating forward rates and not spot rates
  • adequate from a practical point of view, as using forward rates is standard in financial pricing and analysis
  • very simple to implement and very transparent
  • producing a term structure that will be based on assumptions which are cautious, fairly undisputed and robust over time, and
  • forward looking; some of the excessive volatility of the term structure (due to distortions) is taken out at the long end, but a large part of the volatility in the rates is left. The spot rates for a given maturity are an average over all one-period forward rates up to this maturity. Longer periods with very high or very low short-term interest rates (up to 10 years) are thus anticipated, and do not need any frequent adjustments of parameters.

9.5.33 The Dutch Actuarial Association and Actuarial Institute has issued Report in Principles for the Term Structure of Interest Rates (undated but approx June 2009). This paper addresses similar issues to the other European papers, but does not address the issue of extrapolating the curve. The paper is more of an overview and discusses the same issues as the other papers but there are less useful principles.

9.5.34 The Institute of Actuaries of Australia Life Insurance & Wealth Management Practice Committee Information Note: Risk-free Discount Rates under AASB 1038’, March 2010 states that:

  • government stock may provide the rates or be the starting point
  • it may be appropriate to allow for shallow market adjustments including scarcity discounts and liquidity premiums
  • it may be appropriate to allow for credit risk adjustments (eg, to bank SWAP rates)
  • the scarcity discount for indexed stocks may be higher than nominal stocks due to limited supply
  • it may be appropriate to adjust for the liquidity of liabilities, and
  • forward rates should be used, if spot rates are used this should be justified.

9.5.35 In summary this supports the methodology framework for short-term rates, but has no guidance on what to do at durations longer than observed rates.

9.5.36 The Institute of Actuaries (UK) has recently commissioned some research into discount rates and this work should be completed soon. However this work will be unable to be considered in time for determining the Treasury’s methodology.

9.6  Other New Zealand Technical Papers

The Treasury

9.6.1 In August 2009 the Treasury prepared a paper Discount Rates for the Calculation of the Retirement Plan Liability of the Crown for the Government Superannuation Fund. This was the start of a process to bring the ACC and GSF risk-free rate assumptions onto a consistent basis. That paper was designed specifically to meet the 2009 financial reporting requirements under NZ IFRS. The Treasury’s intention at that time was to undertake a project to develop principles and a methodology to determine consistent risk-free rates to be used in the Government’s financial statements in 2010 and beyond. This paper and methodology is the outcome of the Treasury’s project identified last year.

The Commerce Commission's Approach to Estimating the Cost of Capital, June 2009

9.6.2 This paper uses a risk-free rate as the basis for building up a cost of capital and concludes that government stock is the appropriate starting point. It provides some useful discussion on proxies for the risk-free rate.

“112. In practice, the risk-free rate cannot be observed; it is usually proxied by the return on a very safe asset. When selecting the risk-free rate, the first step is to identify a suitable proxy. A related second issue involves choosing how to deal with the statistical properties — mean reversion and interest rate volatility — of certain proxies. Depending on the proxy chosen, the third step is to decide whether spot rates or yields to maturity should be used. The final step is to determine the appropriate maturity of the rate.”

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