matching adjustment volatility adjustment€¦ · credit risk-adjustment = 50% * 1y average of...
TRANSCRIPT
06/11/2014
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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
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Matching adjustment
3
Rules
Principles
Volatility adjustment
4
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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
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Fundamental spread vs. Solvency I
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‐
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
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‐
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 %
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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%
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Assets
BEL
RM
SCR
Own Funds
vs. Solvency I
vs. ICA
vs. Solvency I
vs. ICA
vs. Solvency I
vs. ICA
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Applying to use the matching adjustment
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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
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If Spiderman was the regulator …
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Getting caught in the web
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What needs to be in the application
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Eligible assets
Eligible liabilities
Portfolio management
Liquidity plan
Portfolio management
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Dingbat 1
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Dingbats 2 and 3
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Dingbat 4
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Other issues – Dingbat 5
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Risk margin impacts
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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
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Equity release mortgages
Sale and leaseback
Bonds with market standard redemption clauses
Prepayable loans
Callable bonds
Non £-denominated bonds
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Solution 0 Trial applications
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Solution 1Assign against SCR or Risk Margin
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EligibleAssets
BEL
RM
SCR
Own FundsIneligible
Assets
IFRS Tech Prov
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Solution 2Provision for ineligibility risk with default risk
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Asset ineligible cash flows SPV
Ring-fenced fund
Bond with fixed rate
cash flows + Default risk
Solution 3aHedge ineligibility risk internally
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Asset ineligible cash flows
Group companye.g. SHF
Ring-fenced fund
Asset eligiblecash flows
1
2
3
4
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Solution 3bHedge ineligibility risk externally
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Asset ineligible cash flows
External partye.g. Bank or Reinsurer
Ring-fenced fund
Asset eligiblecash flows
1
2
3
4
Solution 4Do something else!
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Sell ineligible assets
Transitionals
Don’t use MA … use the VA instead
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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
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What we say to dogs … ... and what they hear
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What Solvency II says …… and what different people hear
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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”
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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
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Volatility vs. Matching adjustment
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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
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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)
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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)
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0
20
40
60
80
100
120
0% 20% 40% 60% 80% 100%
yearly 99.5% VaR
[bps]
portfolio allocation
Gilts
Gilts vs. swaps
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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)
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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
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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”
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The thorny issue of approval
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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!