We wrote here about the PRA insurance stress test that cannot fail. A friend of Eumaeus wrote in to say that the tests involve assets being downgraded, hence the assets will get a higher fundamental spread. “You should probably clarify this”.
Our friend is correct, and our apologies for getting this part wrong. Option 1 on p.7 specifies that for assets other than government or central bank, firms should assume that there is a 2 notch downgrade. So our hypothetical AAA portfolio (CQS 0) is downgraded to CQS 2, or A, with a pre-stress shift of 150 basis points.
Page 9 specifies a post-stress shift in the fundamental spread of 30bp, not 10bp as we supposed. Therefore the MA will increase by 150-30 = 120bp. But this is still a significant fall in the liabilities, and our point remains. We wrote
Almost all the impact of the stress on capital would be offset by the increase in fake capital produced by the Matching Adjustment cushion, so net capital would be barely affected. Consequently, the Matching Adjustment virtually guarantees that the life industry will pass the stress test without breaking into a sweat.
Such a ‘stress’ test is like an exam that is almost impossible to fail. What is the point?
Quite.