Keeping an eye on things
Brexit superhero Steve Baker MP was in fine form on the last (23 June 2021) Treascom meeting. The witness before the Committee was PRA chief executive Sam Woods. Steve began by asking (transcript here, Q69 ff)
‘Q69 Mr Baker: …can I go back to Harriett Baldwin’s question about matching adjustment? If I understood correctly … you said it is about capital being set against expected cash flows. Could you just tell me something about the risk profile of those expected cash flows?
Well obviously, but interesting that the question is now on the official list of priorities for the UK Endorsement Board to consider.
Their summary is interesting.
My emphasis. I discussed the ‘parliamentary debate’ issue here.
In our discussions with equity release actuaries, Dean and I have often come across some recurring arguments.
An example is what we might call the ‘hedging fallacy’ – the argument that we can’t apply B76 (or BS) to value equity release NNEGs because these option price formulas are derived under the assumption that the underlying variable, in this case, forward contracts on residential property, can be hedged. This assumption is obviously empirically invalid, so the argument goes, therefore we shouldn’t use B76/BS. And the argument (often) continues, we should then throw away B76/BS and use the discounted projection approach instead. And thankfully, the discounted projection approach delivers much lower NNEG values. So there is nothing to worry about – all that undervalued NNEG stuff is overhyped.
This argument is false, but it is false in a number of interesting ways.
From the Treasury Committee hearing, Wednesday 23 June 2021. Steve Baker (SB) questions deputy governor Sam Woods (SW).1
This one will run for a long time, and more later.
SB: Can I just go back to Harriet Baldwin’s question about MA? So I understand correctly, you said it’s about capital set against expected cashflows. But could you just tell me something about the risk profile of those expected cashflows?
SW: Yes, so the way the MA works, crudely, is that if insurance companies can prove to us, to a fairly high – well very high – standard, that they have achieved a fixity of cashflows coming in from the assets, which maps onto what they have got to pay on the other side on the liabilities, we then allow them to use a higher discount rate for their liabilities.
SW: What we do not allow them to take over into that higher discount rate is something called the fundamental spread, because the fundamental spread is meant to capture the risk that those bonds ‘go wrong’. Now there is a lot of work that went into calibrating the fundamental spread when S2 was set up.
SW: The point that I was making was that under the construct that we currently have, there is not an allowance for uncertainty around that going forward, and I think in the context of, if we were looking at broadening elegibility somewhat, if we were looking at de-bureaucratising somewhat, if we were reducing the capital strength and the risk margin, I think in the mix of all that it would make sense to look at that question and I think that there is probably a way of making that work better, which leaves the whole thing square.
SB: So obviously there are, you know, people concerned about MA, some of them experienced in the field of prudential regulation. So the rules that you apply are in public I take it.
SW: Yes
SB: But presumably the application of those rules to individual firms is a matter that is commercially in confidence?
SW: (Pause) Yes, although you know we give you of course the aggregate figures, and the firms themselves I think to various degrees disclose how their capital figures come together and it’s plain, basically, that firms in the annuity business and with heavy credit exposures will be heavy users of the MA.
SB: So I find myself listening to various figures, and they seem to be quite alarmed at the capital position that some firms might be in, because of the MA. What would your advice be to them if they wish to bottom out this argument? What argument would you want to listen to in order to try and bottom this out?
SW: Well I think they should consider the question of, I mean, their argument is essentially – and I am glad that people make that side of the argument because the insurers make the opposite and its good to be attacked on both sides. (laughter) No honestly I think it is a good thing, because I think there should be a debate about this given how important it is. I think the argument I would make to them is, if their contention is basically that you should only ever discount liabilities at the risk free rate, now that is a perfectly respectable world view. That is a world view that in my opinion would have two negative aspects.
SW: One is I do think that that would significantly increase the pricing of annuities, and I don’t know if you have looked around but the annuity you get for £100k is not particularly appetising. But there is just a trade off in there between the degree of risk that we choose to run and the amount of benefit that consumers can get, that’s inevitable. They have a corner solution view on that. So that is one obvious downside of what they suggest.
SW: But the other big downside is that the thing that the MA does which I think is genuinely very helpful and risk reducing is the incentive it provides for them to match. It is actually a very good thing as we go through something like last year with markets going all over the place, [that] insurers can actually ride that out because they have achieved that matching. That is a good thing.
SW: So I think that those are the counterpoints to them, but I think it’s a good thing that they push us around on it.
In the wake of the Archegos fiasco, Malcolm Hurlston and Mark Northway, the chairs of the UK Shareholder Association and Sharesoc respectively, wrote to the Governor of the Bank of England on April 14th to express concerns that this case raises for shareholders. We reproduce the core of their letter:
The situation which has unfolded at Archegos Capital Management recently raises serious concerns not only for private investors, many of whom own bank shares, but for any member of the public with a bank account and particularly those with savings in excess of the FSCS £85,000 threshold. We have learnt that Credit Suisse, one of six banks acting as counterparties to Archegos, may have lost $4.7 billion from the collapse.
Continue reading “Could an Archegos Event Happen in the UK?”
The highly regarded North American Actuarial Journal has just published our article of the same title. The article can be obtained here.
The story will be a familiar one to our regular readers.
Continue reading “Discounting the Discounted Projection Approach”
Our friend Guy Thomas has recently published an important article on the valuation of equity release mortgages: “Valuation of no-negative-equity guarantees with a lower reflecting barrier.” It is in a strong journal by UK actuarial standards: Annals of Actuarial Science. Our congratulations to him.
Continue reading “Guy Thomas Challenges the Market Consistent Approach”
Insurance ERM today has a fine table and an accompanying article showing how much life insurance companies are ‘benefiting’ (my scare quotes) from Matching Adjustment.
In summary, the total benefit of MA (created capital plus reduced capital requirement) is now £92bn, up 13% from 2019, and probably reflects the growing business in bulk annuities.
“In 2020, the biggest beneficiary was Legal & General (£28.4bn), followed by Aviva (£14.5bn) and Rothesay Life (£14.1bn)”
The data now allows us to update our own table on the capital coverage ratio ‘benefit’.
The blue line shows the capital coverage ratio with MA, the red line, the same ratio but without MA. The usual suspects are still lurking at the right hand side.
Dean and I have updated our work on the MC approach and have just issued a new Discussion Paper on the subject, ‘A Market Consistent Approach to the Valuation of No Negative Equity Guarantees and Equity Release Mortgages’.
To quote the abstract:
This paper provides a new market consistent approach to the valuation of No Negative Equity Guarantees and Equity Release Mortgages. The paper innovates in two respects. First, it provides a new treatment of net rental yields and deferment rates and a proof that the two are equal. Second, the paper provides a new approach to the estimation of the volatility inputs. The proposed approach to volatility produces a volatility term structure that is dependent on the age and gender of the borrower. Illustrative valuations are provided based on the Black ’76 put pricing formula and mortality projections based on the M5 Cairns-Blake-Dowd (CBD) mortality model. Results have interesting ramifications for industry practice and prudential regulation.
The word ‘interesting’ does a lot of the heavy lifting here.
We will be presenting the paper to David Blake’s Sixteenth International Longevity Risk and Capital Markets Solutions conference in Copenhagen in August.
Dean and I have had a fair bit of behind the scenes back and forth on equity release valuation, and especially on the PRA’s Equity Release Valuation Principles, which continue to be as misunderstood as ever. As someone once said, it can be extremely difficult to persuade people of something that they do not wish to be true, and especially so where their living depends on their not understanding it.
Here is the link to our new Discussion Paper on the subject.