Category: replies

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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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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

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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.

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Now there are three

Dean Buckner and Kevin Dowd, 1 March 2019

Professor Tunaru opens his NNEG report with an oft-cited quote from George Box: “All models are wrong but some are useful.” The Box aphorism is an apt one, but Professor Box went on to state

Since all models are wrong the scientist must be alert to what is importantly wrong. It is inappropriate to be concerned about mice when there are tigers abroad. (Box, 1976, p. 792)

For us the most interesting of the terms of reference in the ABI-IFoA aka astrology project on NNEG valuation was (to quote the project’s request for tender) to “consider whether there are any “halfway house” solutions between real world and risk-neutral approaches … .”

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Questions for tonight

As most of our readers already known there is an event tonight at Staple Inn Hall to deliver the results of Professor Tunaru’s research project on Equity Release Mortgages.

Kevin and Dean won’t be able to attend. However we have published Part I and Part II of our own commentary on the research paper. In addition, for anyone attending who would like to ask, here are the questions we would like to have asked, if we had been able to attend.

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An ingenious objection

Ingenious objections are always interesting, particularly when they are wrong. An actuary has objected to my post here, where I considered a put written at 90 on a price series which goes 95,96,95 etc. The point of the post was to show that the standard formula works perfectly well for such a distribution. The objector objects that if the series really does oscillate between 95 and 96, the price will clearly never reach 90, so the standard pricing formula must be wrong. The true price of the put must be zero.

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Jam tomorrow

There certainly was a ‘lively debate’ at the LSE on Monday evening. The house was packed, with guests including our friends at the Treasury, the PRA, and a number of analysts. Kevin will be writing some more about this, meanwhile here are the slides. Note that we covered them in a slightly different order. I discussed slides 16-19 (and mostly slide 16) on the ‘upper bound principle’ after Kevin’s main presentation.

The upper bound continues to be misunderstood, as I commented in our reply to the Institute yesterday. It does not depend in any way on arbitrage arguments, complete markets, geometric Brownian motion or any of that stuff.

Simply, jam today worth more than jam tomorrow, and should be valued as such by accountants such as KPMG. Yes?