Category: matching adjustment

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Regulation masking condition of insurers

Source: FT

A great piece from Ford of the FT this morning.  Insurers don’t have to mark down the virus losses on their bond portfolios on the assumption that the spreads will narrow back down again. Analysis from Dean Buckner, a former insurance regulator at the UK watchdog, has estimated that six large UK insurers collectively ran up £28bn of mark-to-market losses on their bond holdings as of the beginning of June, etc.

But the worry is that “a large number of bonds subsequently default or get downgraded to junk. That would force the insurer to crystallise a sudden and potentially much more substantial loss. ”

Quite.  The comments as always are instructive. Buckner is accused of being a ‘mark to market fundamentalist’. Correct. If you value the balance sheet above its market price, you are defrauding prospective shareholders who might want to buy. If you value the balance sheet below its market price, you are defrauding existing shareholders who might want to sell. You should not be defrauding shareholders, who bear the brunt of the risk. Therefore value the balance sheet at best estimate of its market price.

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Liquidity vs default risk

The core assumption of Matching Adjustment is that default risk changes very slowly over time, which is why the average spread over a 30 years period is one of the inputs into the Fundamental Spread (=credit risk spread) calculation. It follows that sharp movements in bond spreads cannot be the result of changes in default risk, hence cannot correspond to any change in the credit risk spread. The change must therefore be in the Matching Adjustment (=liquidity) spread.

How could we test this assumption?

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Another Gem from the PRA

Capillamentum? Haudquaquam conieci esse! – A wig? I never would have guessed!  PRA meeting, believed to be not later than 79 AD

“It seems an unaccountable thing how one soothsayer can refrain from laughing when he sees another,” remarked Cicero in De Natura Deorum, I. 71. His point is that while the profession demands a certain gravitas in front of the ordinary public, its members have a jolly good laugh in private, because they all know they are frauds.

Which point takes us to this stunningly absurd speech by Charlotte Gerken (PRA director of life insurance). It is written by an impressive collection of individuals and expressed with utmost dignity, yet we imagine that they must have had a few giggles when they gathered in the halls of the PRA to write this impressive piece of tosh.

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Two for one

Not one but two articles on Matching Adjustment in mainstream media today.

The Times:

L&G ‘sitting on £10bn of bond losses’ Pressure grows on insurer to abandon dividend

Legal & General is sitting on estimated bond market losses of as much as £10 billion, according to a shareholder group which is urging the insurer to postpone its planned dividend. The UK Shareholders Association argues that the outlook for financial markets is much too uncertain to justify L&G making its £754 million payout promised for next month. Dean Buckner, its policy director and a former Prudential Regulation Authority official, said L&G would be sitting on huge paper losses because of the slide in many bond prices since the start of the year.

Slightly misquotes me. I actually said that mark to market losses could be high as £10bn, but without knowing the breakdown by rating and sector it would be difficult to say.

In the Financial Times:

Investors should beware the insurance magic money machine

Ford gives one of the best layperson explanations of the Matching adjustment that I have seen yet.  He supposes a company with £100 of risk free assets and thus £100 of liabilities swaps them for £100 of higher yielding risky assets.

The matching adjustment kicks in when it shifts some of that money into higher-yielding assets. In theory this should change things: higher yields carry more investment risk. So to continue protecting the annuitants, the insurer needs more loss-bearing capital than its present zilch.

But here’s where our convention really earns its corn. Using matching adjustment, our insurer can discount its liabilities at a higher rate, reflecting the extra return it hopes to make from those higher-yielding assets. This reduces its liabilities to, say, £90. So without anyone contributing a penny, or the company retaining any earnings, hey presto, its equity “buffer” has risen from £0 to the more substantial level of £10.

No less helpful is what happens when market turmoil strikes and spreads balloon. Then our insurer gets to discount its liabilities at even higher rates, creating more artificial capital and thus compensating for falling asset prices.

Then we are back to masks versus cushions again.

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Coronavirus to cost insurers more than $200bn

By Oliver Ralph, FT today.

Just over half of the $203bn estimated loss relates to claims, with insurers expecting to pay out for events cancellation, business interruption and trade credit cover. Another $96bn comes from investment losses, where turmoil in financial markets has hit the assets insurers hold to fund claims. “This is a loss of a magnitude that none of us have seen in our lifetime,” said John Neal, Lloyd’s chief executive.

But that is general insurance.

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If stress tests are on pause, then so too should be insurance company dividends

The Times, today.

Sir John Vickers, the architect of the financial regime put in place after the 2008 crisis, has expressed concern about the Bank of England’s decision to abandon stress tests for insurers and said that Legal & General’s imminent dividend of more than £750 million should be blocked. Sir John, former chairman of the Independent Banking Commission, said: “If stress tests are on pause, then so too should be insurance company dividends, notably L&G’s, until the future is clearer.”  The Bank’s decision on Thursday not to publish its 2019 stress test of insurers was a mistake, he said, and came at a time when companies’ balance sheets and their ability to withstand the shock of the pandemic should be under scrutiny.

https://www.thetimes.co.uk/article/abandoning-stress-tests-for-insurers-is-a-mistake-txt2kjx92

More to come.

[Edit] See also, my emphasis:

Sir John criticised an accounting rule that enabled insurers to flatter their capital positions. This is the so-called matching adjustment rule, which allows insurers to use a higher discount rate to value their liabilities when their assets yield more. “The fall in yields and widening of spreads will have eroded insurers’ capital levels but accounting methods partly obscure this,” he said. “The matching adjustment to capital may be more of a mask than a cushion.”
The PRA and L&G declined to comment.

 

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Liquidity again

Sam Woods was questioned by the Treasury Committee on Wednesday. Transcript below, starting 16:50.

A few odd things. Woods says there have been defaults and downgrades, but soon after claims that ‘blowouts in bond spreads’ are driven by liquidity. He mentions the Matching Adjustment as the ‘piece of machinery that is operating quietly in the background’, and Baldwin asks whether without it there would be actual insolvencies. Woods first says that there wouldn’t, or he thinks there wouldn’t, then says that without it there would be ‘a major problem’.

Why don’t they just state the accounting numbers as they are, i.e. some firms with no net assets at all, or negative assets, adding that this doesn’t make the firms insolvent, because it’s merely a liquidity effect and the spreads will narrow back again? Why falsify the accounting?

More later, I expect.

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Letter from Sam Woods to insurers on distribution of profits

Here.

When UK insurers’ boards are considering any distributions to shareholders or making decisions on variable remuneration, we expect them to pay close attention to the need to protect policyholders and maintain safety and soundness, and in so doing to ensure that their firm can play its full part in supporting the real economy throughout the economic disruption arising from Covid-19.

[…]

In the current situation of high uncertainty, it is therefore critical that insurers manage their financial resources prudently in order both to ensure that they are able to meet the commitments they have made to policyholders in a way that is consistent with the expectations of the Financial Conduct Authority, and to enable them to continue to invest in the economy.

But that is odd though. The whole purpose of the Solvency II regime is to provide the necessary safety and soundness through model-based, PRA-approved capital management. A 100% coverage ratio corresponds to a 1 in 200 probability of default, and to my knowledge, no firm is allowed to operate under the soft limit of 130% capital coverage, which corresponds (by my mathematics) to a probability of lower than 1 in 2,000 years.

So why the worry, Sam?