Matching adjustment Volatility adjustment

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Matching adjustment Volatility adjustment Paul Fulcher Ross Evans November 2014 Components of the risk-free rate Reference rate Libor swaps not sovereigns Credit Risk Adjustment Smoothed over time OR

1 Matching adjustment Volatility adjustment Paul Fulcher Ross Evans November 2014 Components of the risk-free rate Reference rate Libor swaps not sovereigns Credit Risk Adjustment Smoothed over time OR Volatility adjustment To counter procyclicality Industry portfolio UFR after VA OIS swaps not sufficiently DLT AND Ultimate forward rate Extrapolation past Last Liquid Point To counter pro-cyclicality and illiquid markets Libor risk via CRA OR UFR before MA Matching adjustment Own portfolio For illiquid liabilities and buy-to-hold assets 2 1

2 Matching adjustment Principles Rules 3 Volatility adjustment 4 2

3 Matching adjustment Matching adjustment 101 Market move Increase in spread Increase in MA Spread above risk-free Residual element of spread Default risk premium Expected loss on downgrade Expected defaults Matching adjustment Fundamental spread 6 3

4 Fundamental spread vs. Solvency I stress test exercise Yield deduction 1d.p % % AAA/Aaa AA/Aa A/A BBB/Baa Credit Rating EIOPA 5 10 yrs EIOPA yrs 7 Fundamental spread vs. Solvency I LTGA Yield deduction 1d.p % % AAA/Aaa AA/Aa A/A BBB/Baa Credit Rating EIOPA 5 10 yrs EIOPA yrs 8 4

5 Sizing up the impacts 31/12/2013 ( m) Solvency I ICA Solvency II with MA BEL MADs Risk margin Technical provisions Solvency margin Credit risk SCR Longevity SCR Diversification - (0.55) (0.61) Total capital Total assets Own funds Solvency ratio 123% 122% 113% 9 Own Funds SCR RM vs. Solvency I vs. ICA Assets vs. Solvency I vs. ICA BEL vs. Solvency I vs. ICA 10 5

6 Applying to use the matching adjustment 11 Timeline Q4 Q1 Q2 Q3 Q4 Q1 Further updates from the PRA? Notify PRA on pre-application submission (30 November) Pre-application submission (1 December to 6 January) MA pre-application process (feedback by 31 March) Formal application window opens (1 April) 6 month review of application Solvency II go-live 12 6

7 If Spiderman was the regulator 13 Getting caught in the web 14 7

8 What needs to be in the application Eligible assets Eligible liabilities Portfolio management Liquidity plan 15 Portfolio management 16 8

9 Dingbat 1 17 Dingbats 2 and

10 Dingbat 4 19 Other issues Dingbat

11 Risk margin impacts 31/12/2013 ( m) Solvency II without MA Solvency II with MA Solvency II with MA (credit in risk margin) BEL Risk margin Technical provisions Technical provisions (1.68) 0.96 Total capital Capital (1.02) - 21 Asset eligibility Equity release mortgages Sale and leaseback Bonds with market standard redemption clauses Prepayable loans Callable bonds Non -denominated bonds 22 11

12 Solution 0 Trial applications 23 Solution 1 Assign against SCR or Risk Margin Ineligible Assets Own Funds SCR RM Eligible Assets BEL IFRS Tech Prov 24 12

13 Solution 2 Provision for ineligibility risk with default risk Asset ineligible cash flows SPV Ring-fenced fund Bond with fixed rate cash flows + Default risk 25 Solution 3a Hedge ineligibility risk internally Asset ineligible cash flows 2 Group company e.g. SHF 1 3 Ring-fenced fund 4 Asset eligible cash flows 26 13

14 Solution 3b Hedge ineligibility risk externally Asset ineligible cash flows 2 External party e.g. Bank or Reinsurer 1 3 Ring-fenced fund 4 Asset eligible cash flows 27 Solution 4 Do something else! Sell ineligible assets Transitionals Don t use MA use the VA instead 28 14

15 Volatility adjustment Components of the risk-free rate Reference rate Libor swaps not sovereigns Credit Risk Adjustment Smoothed over time OR Volatility adjustment To counter procyclicality Industry portfolio UFR after VA OIS swaps not sufficiently DLT AND Ultimate forward rate Extrapolation past Last Liquid Point To counter pro-cyclicality and illiquid markets Libor risk via CRA OR UFR before MA Matching adjustment Own portfolio For illiquid liabilities and buy-to-hold assets 30 15

16 What we say to dogs... and what they hear 31 What Solvency II says and what different people hear 32 16

17 Evolution of risk-free hedging debate Choice of risk-free Not material Gilts Swaps Physical matching assets Gilts Gilts Gilts + reverse spreadlock / cash (Libor) + swaps Hedge overlay Swaps Swaps + spreadlocks / gilt TRS Swaps 33 Credit risk adjustment bps %(3m GBP LIBOR - 3m SONIA swaps) 1y average 60 Cap and Floor / / / / /

18 Volatility vs. Matching adjustment Volatility adjustment Bond-Yield Matching adjustment Less generous 65% Residual (Liquidity...) 100% More generous Less restrictive Basis risk No SCR offset Investment implications Shorter-dated credit Long-dated risk-free overlays 65% Default risk premium 100% Downgrade risk Expected defaults Risk-free rate Highly restrictive No basis risk Reduced SCR but Risk Margin? Investment implications Long-dated closelymatched credit 35 Volatility Adjustment reference portfolios 0% 25% 50% 75% 100% Eurozone IT DE FR NL ES AT Others >3 GBP UK DE FR AT NL >

19 Bit of obligatory maths. risk-free rate = reference-rate + credit risk-adjustment + volatility adjustment risk-free rate = Libor swap rate + credit risk-adjustment + 65% * w_govt * risk-corrected spreads on gilts + 65% * w_corp * risk-corrected spreads on corporates The risk-correction is essentially fixed so: risk-free rate = (1-65% * (w_corp+w_govt) )* (Libor swap rate + credit risk-adjustment) + 65% * w_govt * yields on gilts + 65% * w_corp * yields on corps credit risk-adjustment = 50% * 1y average of Libor-Sonia, with a max variation of 25bps (35bps cap - 10bps floor) Using the weights for GBP in the LTGA, we find risk-free rate = 47.6% * Libor swap rate % * gilt yield % * corporate yields % * 1y average of Libor-Sonia (max variation 12bps) 37 Hedging with just gilts or swaps y = x R² = change in RFR ASW yearly 99.5% VaR [bps] Gilts 20 Gilts vs. swaps change in ASW Gov bond ASW Linear (Gov bond ASW) 20 portfolio allocation 0 0% 20% 40% 60% 80% 100% 38 19

20 Adding corporate bonds into the mix y = x R² = change in RFR ASW yearly 99.5% VaR [bps] Corps 20 20% Gov and 32% Corp change in ASW Corp bond ASW Linear (Corp bond ASW) portfolio allocation 0 0% 20% 40% 60% 80% 100% 39 Adding sub-sovereigns into the mix y = x R² = change in RFR ASW change in ASW yearly 99.5% VaR [bps] Corps SubSov Corp bond ASW Linear (Corp bond ASW) portfolio allocation 0 0% 20% 40% 60% 80% 100% 40 20

Evolution of risk-free hedging debate Choice of risk-free Not material Gilts Swaps Swaps + VA - CRA Physical matching assets Gilts Gilts Gilts + reverse spreadlock / cash

21 Evolution of risk-free hedging debate Choice of risk-free Not material Gilts Swaps Swaps + VA - CRA Physical matching assets Gilts Gilts Gilts + reverse spreadlock / cash (Libor) + swaps Blend of gilts, supras and swaps + cash Hedge overlay Swaps Swaps + spreadlocks / gilt TRS Swaps Blend of swaps + gilts/supra TRS 41 The thorny issue of approval 42 21

22 Thank you! Questions Comments Expressions of individual views by members of the Institute and Faculty of Actuaries and its staff are encouraged. The views expressed in this presentation are those of the presenters

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