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To Be or Not to Be, L&G’s £10 Billion Question

L&G have been much in the news recently, so too has our own Dean Buckner, with star appearances in the Financial Times, the Times and the Daily Mail (see also here) and all in two days.

The fur continues to fly over L&G’s planned June 4th dividend, but the attention is shifting subtly from the dividend itself to the underlying valuation methodology and the central issue is (one again) the Matching Adjustment.

There is also the issue of the firm’s ‘virus spread’ losses or, more precisely, Dean’s estimate that these could be up to £10.3 billion. Dean has stirred up a right hornets’ nest this time.

Here is my take.

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Definitely a cushion

More to follow but  see below for a partial transcript of the Treasury Committee hearing yesterday, with Harriett Baldwin quizzing Jon Cunliffe and others about the effect of Covid on life insurers.

Does Sir Jon agree with Sir John Vickers “when he says that, er, the Matching Adjustment is more of a  mask than a cushion“?

A lot of waffle from Sir Jon. He says that ‘market liquidity risks’ are not suffered if assets are held to maturity, which is correct, then says “if you were to price the assets that insurance companies hold on their balance sheets at market prices, you would be picking up how liquid the assets were, whether you could sell them in stress etc”,  which is clearly false, but at least confirms that he thinks it is a cushion.

Baldwin complains that she is out of time, and Stride (Chair) closes with the remark that he senses “a slight frustration there, and you might have valued a little more time to probe”

I think on that basis we might write to the panel after this session, and if we do if I can ask the members of the panel to respond very promptly to any letter we might send on the issue of insurance and stress testing.

Clearly more to follow. Stay tuned.

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Are Britain’s banks strong enough for coronavirus?

Howard Mustoe’s article on banking strength is here.  Quite long, but worth it (of course!).  It quotes Durham University Professor Kevin Dowd and former Bank of England regulator Dean Buckner saying the most appropriate capital measure is a market value one, which is based on banks’ share prices.

This is calculated by multiplying the number of shares in issue by the current share price. They prefer this measure because share prices are an up-to-date reflection of what investors think a company is worth, whereas the banks’ reported figures are not.

True, although other miserable people say to focus on book value.

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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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Can UK Banks Pass the COVID-19 Stress Test?

Source: Positive Money

Eumaeus is pleased to release our report Can UK Banks Pass the COVID-19 Stress Test? on the dire state of the UK banking system.

In his final remarks as Governor, Mark Carney reiterated the same upbeat message that he has always given, that the UK banking system is superstrong:

Some watching will recall the financial crisis a little more than a decade ago. Then, the financial system was the core of the problem. Now, it can be part of the solution.

Over the past decade, the UK financial system has been transformed. We didn’t build this strength for its own sake.

This is prudence with a purpose.

Resilience with a reason.

Deputy governor Sam Woods said much the same to the Treasury Committee on Wednesday April 15th:

We go into this with a well capitalised banking sector.

We don’t think so. Our report explains why.

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Hegel on an Off Day: Kevin’s Response to CP 2 20

Last week Eumaeus posted Dean’s response to the PRA’s Consultation Paper CP 2 20.

Here is mine.

My first impression about CP 2/20 is one of overwhelming bafflement. The PRA has a statutory duty to consult when proposing new rules, but there is also an implied obligation to consult clearly and intelligibly.

It is one thing for the Regulatory ‘Will’ to be inscrutable, but it is quite another when that Will becomes inscrutable to the point of unintelligible. CP 2/20 reads as if it could have been written by Hegel on an off day.”

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