Keeping an eye on things
The chart above shows estimated losses on the recent credit spread movements on the corporate bond exposure of a firm like Just Group. First of all, let me state I have nothing against Just, which I am using as an example. My target, as always, is the regulatory system that approved the capital position of such a firm in the first place.
The screen was not a pretty sight this morning.
There was an interesting article last week in the Actuarial Post about the impact of the crisis on life insurers. Unfortunately they got the main point wrong, arguing that the asset side would be hit by “declines in bond yields”.
See table below, sourced from Financial Times market data. The FTSE is down 11% since the start of the current market crisis (around the middle of February 2020), but it looks as though insurers have been disproportionately affected.
A thoughtful article in Lexology here.
See the great piece here by Jonathan Ford, on why pension fund investors continue to pump huge allocations at private equity, given that the returns, net of fees, are no better than the return on the stock market, and given the pricing opacity and illiquidity of private equity.
An intriguing answer, suggested to him by the hedge fund manager, Cliff Asness, is that “pricing opacity and illiquidity are not actually bugs in the private equity model, but features that investors willingly pay for”.
I just spotted a comment from ‘JKingdom3’ on our letter to the FT last month (Capital created by matching adjustment is entirely artificial, see Eumaeus “Our Reply to Rothesay“, 5 November 2019).
Kingdom wonders whether we have considered every angle, arguing that “In a world where firms seek to maximise their profit subject to the constraints they face, the “correct” assets required to meet this will be the assets corresponding to the least cost to the shareholder”. He contrasts investing
1. … $74.41 in the risk-free asset, hold no capital over ten years, and pay the policyholder $100 in ten years’ time with certainty; and
2. … $67.56 in the risky asset, and hold the minimum capital needed to meet the 99.5% requirement each year over the ten years.
He suggests that option 2 is a good deal for policyholders, and a better deal for investors. Correct or not?
I was in Amsterdam last week, inspecting volatility of canal prices (more later) but volatility was all over the place last week. On Monday, the PRA strenuously defended matching adjustment in Court with the idea that price movements are simply ‘short term’.
It may also assist the Court to know that the PRA is supportive of the principles underlying the MA, not only because (properly implemented) it more appropriately reflects the risks to which annuity providers are exposed but also because it enables firms to “look through” short term volatility in the market price of credit risk to which they (as buy-to-hold investors) are not exposed.
At the same time, our old friend golden.labrador@dogs.k9.gov mailed us to point out that if a firm had sold its bond portfolio at the height of the crisis (see chart above) when spreads had exploded, it would have been considerably worse off than if it had stuck to a buy and hold strategy, as matching adjustment allows you to do.
But where does this take us?
The High Court hearing I referred to last week took place over 22 and 25 November, part of the process for a Part VII transfer of a portfolio of liabilities from Equitable to Utmost Life & Pensions. Martin Moore QC spoke for the applicants on Friday, I spoke for myself (as an Equitable non-profit policyholder) on Monday morning.
This Friday I will be attending the Second Court Hearing on the Part VII proposal to transfer the long-term business of Equitable Life of Equitable Life Assurance Society, of which I am a policyholder, to Utmost Life and Pensions Limited.
I will be arguing that the Part VII transfer be blocked on the grounds that Utmost is financially much weaker than ELAS, because ULP’s balance sheet is propped up by £97m in non-existent capital created by an unsound practice called Matching adjustment.
If you are a regular reader you will be familiar with many of the arguments I will give, but the hearing is public so you may be interested in hearing them afresh, and seeing how the Court deals with them.
The hearing is on Friday 22 November 2019 at the Royal Courts of Justice, 7 Rolls Buildings, Fetter Lane, London, EC4A 1NL. Anyone is entitled to attend. The room location will be published on Thursday 21st.
A commenter comments.
If your theories are correct, it is Eumaeus who should be
able to make unlimited arbitrage profits if the matching adjustment is mis-pricing. Why have you not done this? The answer is that outside the university classroom, arbitrage is not possible for illiquid assets / liabilities.
Eumaeus replies
On the contrary, arbitrage is easy. (1) Borrow from pensioners at close to risk free through the buyout market, receive payment in safe assets (2) replace safe assets with higher yielding ones (3) persuade PRA that some or all of the spread on higher yielding assets is risk free (4) discount liabilities at the higher rate and create capital (5) when you have created enough capital, distribute some of it to owners.
I.e. Matching Adjustment is an effective a way of shorting the illiquid asset. You have bought the illiquid at market price, including the ‘illiquidity premium’, although it is difficult to prize away the illiquidity element from the market risky element. Then, by discounting your illiquid riskless pension liability at higher than risk free, you have beautifully captured that illiquidity spread. Arbitrage courtesy of PRA, thank you regulators!