Category: matching adjustment

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Stress tests apply not only to banks

Sir John Vickers kindly mentioned us last week (6 June 2019) in his keynote address to the 19th Annual International Conference on Policy Challenges for the Financial Sector in Washington. Most of the speech is about bank stress tests – he has long insisted that market-based measures should play a greater role in regulatory assessment than is current practice – but he mentions the insurance stress tests towards the end, citing the PRA’s current consultation on its stress test for insurers.

For the valuation of pension scheme liabilities, firms should assume that the discount rate would change by the level of any change in the risk-free rate plus 50% of the change in spread on AA rated corporate bonds. Under the proposed stress the risk-free rate decreases by 100bps and 50% of the spread on AA rated corporate bonds is an increase of 85bps. Therefore, both elements combined result in a 15bps fall at all tenors to the discount rate.1

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From the postbag – the illiquidity premium

Two items today. A friend of Eumaeus from Ireland writes to say they are disappointed that we did not cover the Jeffery and Smith paper (Equity Release Mortgages: Irish & UK Experience) as extensively as we might have done. Another friend wrote to express a puzzle about the Matching Adjustment principle.  The principle suggests that we can construct a synthetic non-sovereign bond rate that is risk free, but which has a higher return than a (risk free) gilt, which we can use to discount the future liability. But if the gilt and the synthetic bond are certain to pay the same amount at maturity, how can their returns differ?

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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:

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The experience of the 1930s – more from the postbag

Source: Giseck/Longstaff/Schaefer

A friend of Eumaeus comments on my post yesterday, where I said “I have argued many times in the past that we should look at the default experience of the 1930s (or the 1880s or whenever) in assessing the true default risk of long term credit exposure.” He objects that the PRA have done exactly that, citing Supervisory Statement 8/18:

When using transition data, the PRA expects firms to … compare their modelled 1 in 200 transition matrix and matrices at other extreme percentiles against key historical transition events, notably the 1930s Great Depression (and 1932 and 1933 experience in particular). This should include considering how the matrices themselves compare as well as relevant outputs…

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An unavoidable leap of extra-statistical faith

Craig Turnbull (Investment Director at Aberdeen Standard Investments, author of A History of British Actuarial Thought) offers an intriguing critique of the Matching Adjustment here. ‘To the extent that the profession wishes to defend the MA as a matter of actuarial principle’, he says, alluding to the IFoA president’s recent defence of it, ‘we must provide a clear explanation of the apparent logical contradiction at the core of its treatment of credit risk capital: that the capital required to support the risk of adverse asset outcomes can be (partly) created by assuming those same assets perform well.’ (Our emphasis).

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Return of the Matching Adjusters

By DB and KD

Since we published our objections to the Matching Adjustment, and particularly since the FT article about the magic money tree, Eumaeus has been faced with a barrage of criticism. Are we being funded by right-wing think tanks such as the Adam Smith Institute? (No we aren’t) Shouldn’t the Guardian investigate Kevin’s links to pro-Brexit groups? (No point. ‘Unearthed’ already did and they didn’t, er, unearth anything that was not already in the public domain. Took them a year to find out less than they could have found had they asked politely.) Are we trying to bring about the zombie apocalypse of the insurance industry by mass insolvency? Give us a break. We are however trying to expose bad practice, and there seems to be a bit of that around.

There are three objections to consider.

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Minority of one?

Jonathan Ford’s article last week (Investors should beware the insurance magic money tree) predictably attracted a lot of comment. A few observers, noting Martin Taylor’s famous comment that the “actuarial convention” by which the composition of an insurer’s assets determines the size of its liabilities was “one of the weirdest emanations of the human mind”, suggested that poor Martin was out of kilter with the rest of the Bank, or the PRA.

Far from it.

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Matching adjustment open to abuse

FT letters today.

 It is unfortunate that John Taylor (Letters, April 18) elevates “one of the weirdest emanations of the human mind”, the matching adjustment, to the status of a “fundamental actuarial principle”.

Matching adjustment allows life companies to buttress their balance sheets by creating tens of billions in fake capital, and makes companies appear to be in much better financial shape than they are. There are companies whose capital would be wiped out but for matching adjustment.

It is also naïve to think that matching adjustment is not open to abuse merely because it is consistent with rules that the companies lobbied for. For life companies, matching adjustment provides the ultimate way to game the capital rules — in some cases, with no capital. The Prudential Regulation Authority should put a stop to it.

Dean Buckner

Kevin Dowd

The Eumaeus Project and Durham University, UK