Keeping an eye on things
Craig Turnbull (Author, A History of British Actuarial Thought with day job as Investment Director at Aberdeen Standard Investments) has just published this piece on the valuation of equity release mortgages.
Continue reading “On the Actuarial Treatment of Equity Release Mortgages”
‘Golden Retriever’ @k9.dog asks ‘What makes you conclude that corporate credit risk increased during 2018?’, presumably referring to my report of John Vickers speech the other day.
Well “average bond spread increased by c.41bps in 2018” should be a clue, taken from the Just Group 2018 regulatory report. May not be correct, but other insurers reported the same thing. Indeed, total spread widening in 2018 caused a fall in asset values of around £7bn – according to another source. Fortunately MA was there to mop up the losses, so there weren’t really any losses at all.
Another actuary, referring to this post reported proudly that he had managed to listen to 18 minutes 50 seconds of the Wii Shop Channel. Look mate, the whole purpose of that music was to act as a deterrent, and to encourage actuaries to mend their ways. Not an endurance competition. There is some more above (2 hour loop).
Have a good weekend everyone.
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
The main argument for the illiquidity premium is that it cannot be arbitraged out, as I discussed here.
So let’s set up a company where we borrow long dated liabilities at risk free, and invest the proceeds in long-dated illiquid assets. Persuade shareholders/PRA etc that there is an illiquidity premium because ‘it can’t be arbitraged out’.
Create a pile of equity by discounting liabilities at risk free + premium, pay yourself a lot of dividends or sell the company, and retire to the beach.
Congratulations! You have just arbitraged out the illiquidity premium!
The presentation yesterday went well, although there was the usual puzzlement about whether expectations about house price growth enter into the calculation of the forward price.
The best trick I can think of, although this doesn’t always work, doesn’t require any mathematics, just logic.
As notified earlier, our talk ‘New Developments in Equity Release Valuation’ will be at Centre for Commercial Law Studies, 67-69 Lincoln’s Inn Fields, London WC2A 3JB, 10 June 2019 (today) at 5:00 – 6:30pm
Here is the notice published by the Centre. No registration required.
DB
I watched the end of the ARC ERM Launch Event 28th February 2019 again, and added to our partial transcript to reflect a penetrating observation by Malcolm Kemp at 1:46:30.
Continue reading “Matching adjustment – under any other name”
One of our regular (and valued) commenters asks
Are there any constraints under which you would accept that discounting of long-term liabilities at more than risk-free could be societally justifiable?
It depends on circumstances.
Jeffery and Smith (Equity Release Mortgages: Irish & UK Experience, p.30) discuss the apparent paradox that when we use a ‘real world’ model to project a forward price, then calculate the expected value of put and call options at different strikes, the internal rate of return of those options is considerably different from that obtained using the Black formula. See their table which I have copied below. Put options even have negative discount rates.
Taking the case of the put options, how can we rationalise these negative discount rates? Why would an investor even consider an asset that is expected to lose money, let alone one as risky as a put option which has a chance of expiring worthless, losing everything?
They continue.
The answer is that few rational investors hold a portfolio 100% in a put option. Rather, a put option is a form of insurance held in connection with other assets. An investor in shares can, sometimes with a modest outlay, acquire a put option that substantially mitigates losses in a market crash. The willingness to accept a negative expected return on the put option reflects the reduction of risk to the portfolio as a whole. This is the same reason that buyers of household or motor insurance would not expect (or hope) to make a profit on that insurance.
Are they right? Does the ‘willingness to accept a negative expected return’ really reflect the need to reduce the risk?