The Staple Inn event, Andrew Rendell, 1:03:14
I think where it gets more complicated is when you look at the fact that the insurers have long term liabilities – they have long term illiquid liabilities, and they are matching them with illiquid assets, so there is a synergy there when you bring those two sides together. So we just look at the Matching Adjustment concept. What’s that saying is that if you have a corporate bond, is the economic worth to the insurer the same as it is to everybody else, arguably it isn’t, and the reason for that being that a typical market participant will put a discount to the price that they would be prepared to pay for it, because that corporate bond has risks around liquidity, and it has risks around price volatility over the duration of the asset.
The insurer says ‘well I don’t care about that, because I’m going to hold my asset to maturity, and therefore I don’t need that discount, so the corporate bond is worth more to me than it is to a typical participant. So that’s what the Matching Adjustment does, that recognises that is expressed through an adjustment to the liability rather than an adjustment to the assets, but in a sense that’s what is going on.
In a sense, yes, and the Rendell’s argument is a classic one that you hear all the time from actuaries. Formally:
(Premiss) An insurer will value an illiquid asset more than a market participant
(Conclusion) An insurer should value an illiquid asset more than a market participant
Not a complex argument, but there are two problems. First, the move from ‘is’ to ‘should’, which as any logician will tell you, is formally invalid. Second, the identity of ‘the insurer’. Which of the various actors in the drama – existing shareholders, prospective shareholders, management, auditor, pensioners – is he, or she?
The first question answers the second. If the ‘should’ is the ‘should’ of accounting rules (as opposed to an ethical or legal ‘should’), then the insurer is the management of the insurance firm and its auditors. The existing shareholders technically own the firm, and the pensioners are a form of creditor who are important stakeholders, but neither have the expertise to value its books, so they entrust that task to the management, who have the primary responsibility of compiling financial statements, supported by the auditors, who in effect say ‘it’s OK’.
Hence, if ‘the insurer’ is management (or its own accounting function) supported by auditors, then the ‘should’ is the ‘should’ of accounting standards. Accounting standards such as IFRS say that that accountant should value assets and liabilities at the price “at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions ” etc.
But then the argument above is invalid. Doubtless management will or wants to value the illiquid asset at more than the price at which an orderly transaction would take place. But that gives them no license to do so, at least if the ‘should’ is dictated by accounting rules.
Rendell’s argument therefore fails. Perhaps he means something else by the term ‘the insurer’, but perhaps he should say.
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