matching adjustment volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of...

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06/11/2014 1 Matching adjustment Volatility adjustment Paul Fulcher Ross Evans November 2014 Components of the risk-free rate OIS swaps not sufficiently DLT Reference rate Libor swaps not sovereigns Libor risk via CRA Credit Risk Adjustment Smoothed over time Volatility adjustment Matching adjustment To counter pro- cyclicality Industry portfolio Own portfolio For illiquid liabilities and buy-to-hold assets UFR after VA UFR before MA Ultimate forward rate Extrapolation past Last Liquid Point To counter pro-cyclicality and illiquid markets AND OR OR 2

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Page 1: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

06/11/2014

1

Matching adjustment Volatility adjustmentPaul FulcherRoss Evans

November 2014

Components of the risk-free rate

OIS swaps not

sufficiently DLT

Reference rate

Libor swapsnot sovereigns

Libor risk via CRA

Credit Risk Adjustment

Smoothed over time

Volatility adjustment

Matching adjustmentTo counter pro-

cyclicality

Industry portfolio Own portfolio

For illiquid liabilities

and buy-to-hold

assetsUFR after VA

UFR before MA Ultimate forward rate

Extrapolation past

Last Liquid Point

To counter

pro-cyclicality and

illiquid markets

AND

OROR

2

Page 2: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

06/11/2014

2

Matching adjustment

3

Rules

Principles

Volatility adjustment

4

Page 3: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

06/11/2014

3

Matching adjustment

Matching adjustment 101

6

Expected defaults

Expected loss on downgrade

Residual element of

spread

Sp

read

ab

ove

ris

k-fr

ee

“Fundamental spread”

Matching adjustment

Increase inspread

Increase inMA

Mar

ket

mo

ve

Default risk premium

Page 4: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

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4

Fundamental spread vs. Solvency I

7

 ‐

 0.20

 0.40

 0.60

 0.80

 1.00

 1.20

 1.40

 1.60

 1.80

 2.00

AAA/Aaa AA/Aa A/A BBB/Baa

1d.p %

Credit RatingEIOPA 5‐10 yrs EIOPA 10‐15 yrs

Yie

ld d

edu

ctio

n %

2013 stress test exercise

Fundamental spread vs. Solvency I

8

 ‐

 0.20

 0.40

 0.60

 0.80

 1.00

 1.20

 1.40

 1.60

 1.80

 2.00

AAA/Aaa AA/Aa A/A BBB/Baa

1d.p %

Credit RatingEIOPA 5‐10 yrs EIOPA 10‐15 yrs

2011 LTGA

Yie

ld d

edu

ctio

n %

Page 5: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

06/11/2014

5

9

Sizing up the impacts

31/12/2013(£m)

Solvency I ICA Solvency II with MA

BEL 17.38 16.82 16.78

MADs 0.61 - -

Risk margin - - 0.97

Technical provisions 17.99 16.82 17.75

Solvency margin 0.70 - -

Credit risk SCR - 1.39 1.81

Longevity SCR - 1.24 1.23

Diversification - (0.55) (0.61)

Total capital 0.70 2.08 2.43

Total assets 23.00 23.00 23.00

Own funds 4.31 4.10 2.82

Solvency ratio 123% 122% 113%

10

Assets

BEL

RM

SCR

Own Funds

vs. Solvency I

vs. ICA

vs. Solvency I

vs. ICA

vs. Solvency I

vs. ICA

Page 6: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

06/11/2014

6

Applying to use the matching adjustment

11

Timeline

12

2014 2015 2016

Q4 Q1 Q2 Q3 Q4 Q1

Further updates from the PRA?

MA pre-application process (feedback by 31 March)

Formal application window opens (1 April)

Solvency II go-live

Notify PRA on pre-application submission (30 November)

Pre-application submission (1 December to 6 January)

6 month review of application

Page 7: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

06/11/2014

7

If Spiderman was the regulator …

13

Getting caught in the web

14

Page 8: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

06/11/2014

8

What needs to be in the application

15

Eligible assets

Eligible liabilities

Portfolio management

Liquidity plan

Portfolio management

16

Page 9: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

06/11/2014

9

Dingbat 1

17

Dingbats 2 and 3

18

Page 10: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

06/11/2014

10

Dingbat 4

19

Other issues – Dingbat 5

20

Page 11: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

06/11/2014

11

Risk margin impacts

21

31/12/2013(£m)

Solvency IIwithout MA

Solvency II with MA

Solvency IIwith MA

(credit in risk margin)

BEL 18.26 16.78 16.78

Risk margin 1.16 0.97 1.92

Technical provisions 19.43 17.75 18.71

∆ Technical provisions (1.68) 0.96

Total capital 3.45 2.43 2.43

∆ Capital (1.02) -

Asset eligibility

22

Equity release mortgages

Sale and leaseback

Bonds with market standard redemption clauses

Prepayable loans

Callable bonds

Non £-denominated bonds

Page 12: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

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12

Solution 0 Trial applications

23

Solution 1Assign against SCR or Risk Margin

24

EligibleAssets

BEL

RM

SCR

Own FundsIneligible

Assets

IFRS Tech Prov

Page 13: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

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13

Solution 2Provision for ineligibility risk with default risk

25

Asset ineligible cash flows SPV

Ring-fenced fund

Bond with fixed rate

cash flows + Default risk

Solution 3aHedge ineligibility risk internally

26

Asset ineligible cash flows

Group companye.g. SHF

Ring-fenced fund

Asset eligiblecash flows

1

2

3

4

Page 14: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

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14

Solution 3bHedge ineligibility risk externally

27

Asset ineligible cash flows

External partye.g. Bank or Reinsurer

Ring-fenced fund

Asset eligiblecash flows

1

2

3

4

Solution 4Do something else!

28

Sell ineligible assets

Transitionals

Don’t use MA … use the VA instead

Page 15: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

06/11/2014

15

Volatility adjustment

Components of the risk-free rate

OIS swaps not

sufficiently DLT

Reference rate

Libor swapsnot sovereigns

Libor risk via CRA

Credit Risk Adjustment

Smoothed over time

Volatility adjustment

Matching adjustmentTo counter pro-

cyclicality

Industry portfolio Own portfolio

For illiquid liabilities

and buy-to-hold

assetsUFR after VA

UFR before MA Ultimate forward rate

Extrapolation past

Last Liquid Point

To counter

pro-cyclicality and

illiquid markets

AND

OROR

30

Page 16: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

06/11/2014

16

What we say to dogs … ... and what they hear

31

What Solvency II says …… and what different people hear

32

Page 17: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

06/11/2014

17

Evolution of “risk-free” hedging debate

Physical

matching

assets

Hedge

overlay

Not

material

Gilts

Swaps

Gilts

Gilts

Swaps +

spreadlocks

/ gilt TRS

Swaps

Swaps

Choice of “risk-free”

33

Gilts + reverse

spreadlock /

cash (Libor) + swaps

Credit risk adjustment

0

20

40

60

80

100

12/2000 12/2003 12/2006 12/2009 12/2012

50%(3m GBP LIBOR - 3m SONIA swaps)

1y average

Cap and Floor

34

bps

Page 18: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

06/11/2014

18

Volatility vs. Matching adjustment

35

Volatility adjustment Bond-Yield Matching adjustment

• Less generous

• Less restrictive

• Basis risk

• No SCR offset

Investment implications

• Shorter-dated credit

• Long-dated “risk-free”

overlays

65% Residual (Liquidity...) 100% • More generous

• Highly restrictive

• No basis risk

• Reduced SCR – but

Risk Margin?

Investment implications

• Long-dated closely-

matched credit

65% Default risk premium 100%

Downgrade risk

Expected defaults

Risk-free rate

Volatility Adjustment – reference portfolios

GBP

UK DE FR AT NL 0 1 2 3 >3

0% 25% 50% 75% 100%

Eurozone

IT DE FR NL ES AT Others 0 1 2 3 >3

36

Page 19: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

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19

Bit of obligatory maths ….

risk-free rate = reference-rate + credit risk-adjustment + volatility adjustment

risk-free rate = Libor swap rate + credit risk-adjustment + 65% * w_govt * risk-corrected spreads on gilts + 65% * w_corp * risk-corrected spreads on corporates

The risk-correction is essentially fixed so:

risk-free rate = (1- 65% * (w_corp+w_govt) )* (Libor swap rate + credit risk-adjustment) + 65% * w_govt * yields on gilts + 65% * w_corp * yields on corps

credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor)

Using the weights for GBP in the LTGA, we find

risk-free rate = 47.6% * Libor swap rate + 19.8% * gilt yield + 32.6% * corporate yields + 23.8% * 1y average of Libor-Sonia (max variation 12bps)

37

Hedging with just gilts or swaps

y = 0.5151xR² = 0.3705

-40

-30

-20

-10

0

10

20

30

40

-40 -20 0 20 40

change in RFR ASW

change in ASW

Gov bond ASW

Linear (Gov bond ASW)

38

0

20

40

60

80

100

120

0% 20% 40% 60% 80% 100%

yearly 99.5% VaR

[bps]

portfolio allocation

Gilts

Gilts vs. swaps

Page 20: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

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20

Adding corporate bonds into the mix

y = 0.3599xR² = 0.9439

-40

-30

-20

-10

0

10

20

30

40

-100 -50 0 50 100

change in RFR ASW

change in ASW

Corp bond ASW

Linear (Corp bondASW)

39

0

20

40

60

80

100

120

0% 20% 40% 60% 80% 100%

yearly 99.5% VaR

[bps]

portfolio allocation

Corps

20% Gov and 32% Corp

Adding sub-sovereigns into the mix

y = 0.3599xR² = 0.9439

-40

-30

-20

-10

0

10

20

30

40

-100 -50 0 50 100

change in RFR ASW

change in ASW

Corp bond ASW

Linear (Corp bondASW)

40

0

20

40

60

80

100

120

0% 20% 40% 60% 80% 100%

yearly 99.5% VaR

[bps]

portfolio allocation

Corps

SubSov

Page 21: Matching adjustment Volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights

06/11/2014

21

Evolution of “risk-free” hedging debate

Physical

matching

assets

Hedge

overlay

Not

material

Gilts

Swaps

Gilts

Gilts

Swaps +

spreadlocks

/ gilt TRS

Swaps

Gilts + reverse

spreadlock /

cash (Libor) + swaps

Swaps

Swaps

+ VA - CRA

Blend of gilts,

supras and

swaps + cash

Blend of swaps

+ gilts/supra

TRS

Choice of “risk-free”

41

The thorny issue of approval

42

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22

43

Expressions of individual views by members of the Institute and Faculty of Actuaries and its staff are encouraged.

The views expressed in this presentation are those of the presenters.

Questions Comments

Thank you!