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Easily the worst media explanation of LDI yet

See BBC News at Ten, 12 October 2022, for easily the worst media explanation of LDI yet. The fun starts 7:10.

Presenter “So let’s turn to our business editor, Simon Jack, who’s the expert on all these things.

Jack:

8:00 “Investors want more interest to justify the extra risk”. Not really. A gilt is risk free because the nominal payment (coupon and principal) is risk free. What investors are demanding is compensation for the extra inflation implied by the market.

8:05 “The cost of borrowing shot up”. Gilts are an asset, not a liability, and don’t involve borrowing. Of course, arbitrage implies the cost of long-dated borrowing will go up commensurately, so perhaps we could forgive him.

8:20 “Some pension managers have used them as security to get ready cash now”. Argh. Pension schemes have bought them using borrowed money, using them as security for the borrowing. No cash, apart from the haircut (‘margin’).

8:25 “To be able to pay out on those pension promises” Argh again. The scheme assets, typically risk bonds or equities, enable the payout. And again, there is no cash apart from the margin (and margin doesn’t have to be cash, necessarily).

Jack’s Wikipedia entry says “Before entering journalism, Jack worked for a decade as a corporate and investment banker in London, New York City and Bermuda. He has said that he neither liked the work, nor showed much ability at it.” Fair enough.

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More Trouble at t’ Equity Release Mill

Last week’s (4 October 2022) Daily Telegraph had a nice article by Charlotte Gifford on the impact of higher loan rates and a possible house price fall on the equity release sector:

Equity release market in trouble as rates rise and house prices wobble

‘It will all come crashing down’, warns economics professor

It’s worth a read.

In essence, higher rates and a possible house price fall are not good news for the sector. Says the econ professor “if the Bank Rate hits 6pc and house prices fall by 15pc, then the loss to the lender is … 28 percent of the loan. If house prices fall even more, by 40pc, then the loss would be … 41percent of the overall loan.”

But then again, the ER people are still pretty upbeat, so perhaps it will all go away.

We noticed a couple of flies in the ointment, however.

Continue reading “More Trouble at t’ Equity Release Mill”

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il ritorno d’ulisse

 

Apologies again for the absence. Eumaeus (and Ulysses) were far away from their homeland for many weeks, and missed the market hell of the past few weeks. More on that later.

Meanwhile, the chart above shows the total return on 10 year gilts against total return on the FTSE, which I have been following for a long time, and which I last discussed in January 2021 here.

Continue reading “il ritorno d’ulisse”

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When less equals more (capital)

Source: WTW, Analysis of Proposed Solvency II Reforms, 21 July 2022

The Association of British Insurers came out yesterday with a firm statement on the proposals to increase the capital that insurers ‘hold’, arguing, based on analysis by Willis Towers Watson that the proposals would in fact on average lower the capital ‘held’.

This results conflicts somewhat with UK government claims that the proposals would free up capital to support investment in wind farms and other worthy things.

Figure 4.1 from Willis is copied above. It had Eumaeus scratching his head for a long while, even with help from his dogs. The block colour represents the range in which ‘all’ the sample of 16 firms sit, except for the maximum and minimum outlier values, so the block colour does not in fact represent ‘all’ firms, but never mind.

But the results are intriguing. Under the PRA scenario A, for example, the average reduction in  own funds (Solvency II ‘capital’) leads to an average reduction in capital of about 5%. But that is for all firms. For all annuity providers – who are the main customers for MA – the average reduction is 20%. And worse, there is an outlier firm that loses 30% of its capital. Yikes!

Admittedly, scenario A is severe, and the PRA always signalled this, but none of the other scenarios look particularly encouraging given the purpose of the government proposals. For the proposals were to free up capital for long term infrastructure projects, which could only come from firms with long term liabilities, i.e. annuity providers. But it is annuity providers who are most severely affected under all the scenarios!

It’s all a mess and will lead to more friction between the government and the Bank of England.

That is not to say the reforms are a bad thing. Far from it: in Eumaeus’ view they do not go nearly far enough. But the mess is an indication of the broken nature of life insurance, and of the failure of regulation to deal with the problems in a timely way in the aftermath of the Great Financial Crisis.

Those who sow the wind etc etc.

[UPDATE] The Eumaeus response to HMT is here.

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Two New Books by EUMAEUS

Two New Books by EUMAEUS

Eumaeus is pleased to announce the publication of two new books published by KSP Books. Regular readers will be familiar with draft versions of both these.

The first is The Eumaeus Guide to Equity Release Valuation: Restating the Case for a Market Consistent Approach, 2nd edition. The second is Can UK Banks Pass the Covid-19 Stress Test? Both were published on June 29th.

We thank Bilal Kargi of KSP Books for publishing these.

More publications are in the works and we will report on them as they come out.

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Brownian Blancmange

Whilst we were, er, snoozing, our friends Andrew Smith and Oliver Bentley came out with a doozy of an article in The Actuary (of all places!): ‘Taking Shape,’ The Actuary, January/February 2022, pp. 31-33. As they explain:

Brownian motion has many uses in actuarial work, but stochastic models based upon it can be complex and difficult to replicate. By their nature, Monte Carlo scenarios start from a common point but end in random places. We show how to construct paths that are similar to Brownian motion, using a deterministic method that is simple and easily replicated, and which has end points that a user can choose. Applications include the assessment of Value at Risk for dynamically hedged portfolios.

The deterministic method they propose is their Brownian Blancmange fractal ‘random’ walk and we won’t try to explain that here. Read the paper: it is only 3 pages long.

Among other uses, it allows the user to simulate a fractal (i.e., non-random) series whose frequency and starting and ending points are set by the user. Moreover, if the position being simulated is, say, an option, the user can also set the implied or predicted volatility (think of the vol parameter fed into the option price or trading strategy at inception) and the realised volatility (the volatility of the synthetic option or delta hedge).

Obvious applications are to dynamic VaR, stress testing and hedging analyses. On the latter, one particular sentence jumps out at us: ‘When implied and realised volatilities coincide, the hedge should, in theory, work perfectly with sufficiently frequent trading.’

As it happens, we had found the same result in our recent work on option pricing, and it of central importance. A lot more later on that.

An Excel workbook illustrating all eight fractals and the VBA code necessary to generate them can be found at github.com/AndrewDSmith8/Fractals-and-Hedging.

Our congratulations to Andrew and Oliver on a fine piece of work.

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Inflation Returns with a Vengeance

To those who have been watching the broad money supply for the last couple of years or so, it was blindingly obvious that inflation would take off after a decent ‘long and variable’ lag. Well, UK CPI inflation is now 7% and even the Bank of England now admits it could soon hit 10%.

The return of inflation has come as a surprise to many analysts. These include, most notably, especially even the Mystic Moggs at the Bank.

In August 2020, the Bank stated (see p. ii) that

In the MPC’s central [inflation] projection, conditioned on prevailing market yields, CPI inflation is expected to be around 2% in two years’ time. 

 A year later, the Bank stated

3.4: … The MPC expects CPI inflation to rise temporarily to around 4% in the near term, before falling back towards 2%. … Inflation starts to decline in 2022, and returns to the 2% target in late 2023(Chart 3.2).

Those are some specular forecasting failures, even by the Bank’s standards.

To be fair, the Bank is not alone. The Fed has made much the same set of mistakes: first they said there would be no inflation, then they said it would be temporary, then they were looking for it in all the wrong places, and now the dovest of Fed doves are turning into inflation hawks.  See this piece by Steve Hanke and me in the latest National Review: “The Fed Looks for Inflation in All the Wrong Places.”

[DB adds: Andrew Bailey is appearing on Parliament TV this afternoon, so don’t forget to tune in]

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Die Scheisse Trifft den Lüfter

There is an interesting piece by David Walker in Insurance Asset Risk on May 5th about German life insurers: ‘German regulator “intensively supervising” 20 life firms.’

The phrase “intensively supervising” got our attention. To elaborate:

Mark Branson, president of BaFin, has revealed about 20 German life insurers are currently under “intensive supervision”, all suffering “legacy issues from earlier guarantee promises”. About 30 pension funds are also being watched closely.

Looks like a lot of German life insurers and pension funds have been using Equitable Life as a how-to manual.

One also has to wonder why BaFin took so long to wake up to this issue – it can’t be that they were too busy harassing FT journalists investigating the Wirecard scandal, because that blew up over a year ago.