Charlotte Gerken (executive director of Life Insurance at the PRA) spoke to the 18th Conference on Bulk Annuities last Thursday (29 April) on the supervision of UK annuity firms in the UK, and in particular on the matching adjustment (MA).
The issues she covered in the speech have been covered by Eumaeus over the last three years, but it is worth reminding our readers of them.
Different schools of thought?
Charlotte says “There are several schools of thought on whether illiquid liabilities should be discounted at a “risk-free” rate, or if it is appropriate in some cases to allow for some addition to the risk-free rate.”
Several schools of thought? Well not really. Regular readers of this blog know that I am fond of quoting Don Kohn, who has just retired from the Bank’s Financial Policy Committee.
While economists are famous for disagreeing with each other on virtually every other conceivable issue, when it comes to this one there is no professional disagreement: The only appropriate way to calculate the value of a very low-risk liability is to use a very low-risk discount rate.1
The only other school of thought, if ‘thought’ is the right word, is from the insurance industry. As a colleague said to me back in 2013 “The reason we have historically allowed it at the levels we have, is that the industry needs it to remain competitive.”
Markets not efficient?
She says “The MA performed its expected function in 2020, allowing insurers to look through the sharp spike in credit spreads.” (my emphasis) What is she saying here? If it is true, it necessarily follows that there is some cast-iron guaranteed way of making money by buying into dips in the credit market. As bond prices fall, buy more bonds, in the certainty that they will rise again. It follows that there is some sort of operational procedure that a hedge fund might use to make a guaranteed return on capital. Is the PRA really suggesting that? If course credit spreads, after widening considerably in the second quarter of 2020, have now drawn back to previous levels. Does that prove there is a cast-iron method of making profits by buying on dips? Nick Leeson famously tried that.
In the 1990s and 2000s there were indeed a few of the more rugged banks who would borrow at their own funding rate, usually close to risk free, then invest in high yielding bonds of varying quality and earn the spread. They justified it by their skill in seeing through credit ratings. The story did not end well as Charlotte (who started as a banking supervisor at the FSA) will surely know.
The whole proposition violates the so-called ‘weak form’ of the Efficient Market Hypothesis. As Professor John Cochrane commented here, “the central empirical prediction of the efficient markets hypothesis is precisely that nobody can reliably tell where markets are going – neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences.”
Benefits for shareholders?
Finally, she says “The MA is a significant benefit for firms, in bringing forward unrealised profits that are then available to be deployed to grow businesses, or to reward shareholders.” Which shareholders exactly? There are existing shareholders, who in the case of many life insurance firms are private equity companies or hedge funds. These certainly benefit by taking risky profits early. Then there are prospective shareholders, the ones that the existing shareholders hope to sell to when the firm is launched onto the wider market. These will not earn the excess return they are hoping for, because that return has already been earned by the existing shareholders, yet they still have the risk not just of the market going down, but rather of the market not performing as forecast.
It is analogous to a fund manager selling me a fund at the price he forecasts the fund to be in 5 years time, rather than the price it has now. Perhaps he is a good fund manager, and perhaps the fund will attain that price in the future. But if I buy at that price, I will make nothing, even if he is right. And if he is wrong, I will lose money, even though the price goes up, but less than expected.
Increasing use of MA
The chart in the appendix shows that MA portfolios have increased since the start of 2018 by 30%, to around £335bn.
Charlotte’s point is to demonstrate that the PRA is not being mean to the industry in applying some discipline to a regime that violates all commonly accepted economic principles, but that point is alarming in itself. She also hints that firms may be overdoing it a little. “… it is reasonable to ask whether the FS (Fundamental Spread) has gone too far in this direction. The impact of the long-term average spread floor makes the FS a predominantly backwards looking measure, insensitive to current market signals.” My emphasis.
The Fundamental Spread is an invention of the PRA, being that proportion of the market spread deemed to be due to credit risk. But its whole purpose is to be insensitive to ‘market signals’, and to “look through spikes in credit spreads”, so why is she saying that it should be sensitive to them? She adds “Under stress, firms will only see the FS increase under a ratings downgrade, thus completely setting aside any information contained in market spreads.” That is also strange. The whole point of the FS is to ‘look through’ the information contained in market spreads, on the assumption that the spreads contain no information at all, being a form of excess volatility.
In summary, Kremlin watchers like Eumaeus think that the PRA is covering itself. It has conceded internally for some time that the whole MA thing is completely bonkers, and was only ever tolerated to disguise the fact that a substantial portion of the UK life insurance industry is technically insolvent. I.e. a mask rather than a cushion.