Category: Ifoa

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The spirit is willing, and also the letter

Kevin’s piece earlier this week raised the issue of the Institute of Actuaries ‘putting things right’.

In that spirit, we publish our letter to the Institute sent in August, concerning the governance over the voodoo ERM valuation project that it sponsored with the ABI.

The whole point is that the IFoA/ARC must demonstrate its quality assurance, as opposed to asking that interested outside parties take their word for it when they tell us that the assurance process was done correctly but won’t give out any concrete details. After all, if the quality assurance is good, then there is no good reason to withhold the evidence that leads to that conclusion. Otherwise, the IFoA/ARC leave themselves open to the criticism that there is no actual assurance, no transparency and no accountability.

We are not holding our breath.

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Market Consistent or Real World?

Although we have often criticised it, the Discounted Projection aka ‘Real World’ Approach used by the equity release industry to value their NNEGs and ERMs has two significant things going for it. The first is fantastic marketing. Who could be against a ‘real world’ approach, especially when the alternative is a Market Consistent or ‘Risk Neutral’ approach? Everyone knows that most people are not risk-neutral. ‘Real world’ or ‘risk neutral? It’s a no-brainer.

The other thing that the DP/’Real World’ approach has going for it is that it produces much lower valuations. Hosty et alia (2007) hit the nail right on the head:

7.3.3 Market consistent or real world?

On our proxy market consistent approach we have derived a cost for the NNEG which would render the product non-profitable, whilst real world modelling has produced a significantly lower cost.

The importance of commercial considerations as a reason for preferring this approach was confirmed by Tom Kenny at the 28 February 2019 Staple Inn launch event for the Tunaru report. Mr Kenny was the chair of the event, and is Director of Actuarial & Underwriting, Retirement Lending at Just Group plc in his day job: “clearly if we move down a purely market consistent route … it’s going to be extremely expensive,” he said.

 Darn right it’s going to be expensive.

Continue reading “Market Consistent or Real World?”

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Hey Presto! The Disappearing Risk Trick

Explain why the Matching Adjustment is a fundamental principle of actuarial science

Dean wrote in his last posting that the exam question posed by Craig Turnbull’s thoughtful piece on Matching Adjustment was whether the MA, whose purpose is to provide a measure of long-term credit default risk, actually delivers a ‘good measure’ of this risk.

Turnbull sets out a deceptively simple looking problem. Suppose we hold a well-diversified portfolio of MA-eligible 10-year zero-coupon non-financial corporate bonds. All the bonds have a BBB public credit rating and a yield to maturity of 2.5%. The 10-year risk-free yield is 1.0% and so the bond credit spread is 1.5%. The problem is to work out this bond’s capital requirement.

He continues:

Continue reading “Hey Presto! The Disappearing Risk Trick”

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The dreaded illiquidity premium

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.

Continue reading “The dreaded illiquidity premium”

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May go on for longer than Brexit

ARC ERM Launch Event 28th February 2019

Craske: ” I don’t think anybody at the moment is suggesting a wholesale change in the way anybody does their modelling. We are not there yet.”

Mee: “I guess this is the first stage of the research and I think you [Tunaru] propose some interesting further work“.

Kenny: ” I would say what hasn’t come out of the paper is what the difference between those two approaches [Risk Neutral and Real World] is, and that’s something the working party wants to look at, to say .. what is the difference between the two approaches, and then have that policy debate”

Craske “the paper comes out with some relatively low volatilities that we are not used to seeing, and I think there needs to be more work done around that, around the sort of, single house price, dilapidation, old people living in there. That hasn’t really been factored in at all … this paper’s really good to get this discussion out, and I do urge you all to keep an open mind when you look at it, because we don’t always – sometimes we’ve got a very narrow way of thinking, but I do think that there’s more to go, and this may go on for longer than the Brexit discussions.”

What are they telling us?