Sept 2021

[1495_sc]

Q1. iii)

Credit risk SCR

As risk free interest rate has dropped, credit spread would widen. Hence, value of corporate bonds would reduce and credit risk SCR will reduce.

However, examiner's report states that corporate bonds will be valued more because of fall in interest rate. This also makes sense but can you help in understanding what's wrong with my understanding?

Also, when we consider financial risks like interest rate risk, why have we just talked about assets and not the impact on BEL? EIOPA rate will be based on risk free rate hence the valuation rate will change and affect BEL. Is it because we don't know for sure if EIOPA has responded to the pandemic and adjusted the prescribed risk free yield curve?

In general, for all SCR stresses, the direction would be based on

- whether it increases BEL (like increase in mortality assumption)
-whether it reduces assets (like fall in equity)

Whether each stress increases or reduces SCR is not known unless assessed in the context of the question. Is my understanding ok?

 

[Lindsay Smitherman]

Q1. iii)

Credit risk SCR

As risk free interest rate has dropped, credit spread would widen. Hence, value of corporate bonds would reduce and credit risk SCR will reduce.

However, examiner's report states that corporate bonds will be valued more because of fall in interest rate. This also makes sense but can you help in understanding what's wrong with my understanding?

Yield on corporate bonds = risk-free rate + credit spread
If the risk-free rate falls, the credit spread doesn't (necessarily) change
What is more likely is simply that the yield on corporate bond falls too
So if we have a corporate bond with a yield of 4% whilst risk-free rates are 2%, then if risk-free rates fall to 1% we would (all else being equal) expect the corporate bond yield to fall to 3%
Hence the value (price) of the corporate bond would increase

[In fact, if interest rates fell, the credit spread could even reduce: lower interest rates could mean a more positive economic outlook and therefore lower default risk ... but that would be a second-order, tangential idea.]

 

[Lindsay Smitherman]

Also, when we consider financial risks like interest rate risk, why have we just talked about assets and not the impact on BEL? EIOPA rate will be based on risk free rate hence the valuation rate will change and affect BEL. Is it because we don't know for sure if EIOPA has responded to the pandemic and adjusted the prescribed risk free yield curve?

Try to be very careful not to confuse two types of question that can be asked on the SCR:
(1) the calculation of the SCR risk components (which is what part (ii) of this question is covering)
(2) the impact on the SCR calculation of certain events happening (which is what part (iii) is covering)

In part (ii), the effect of the interest rate stress on the BEL is mentioned (as well as on the assets) - as is appropriate for that type of question.

For part (iii) we are now looking at 'what is the impact on the size of the SCR if interest rates have fallen'.

So basically we are considering, what is the impact on the following calculation if interest rates change:
SCR = {base assets - base BEL} minus {stressed assets - stressed BEL}

You can see that there are offsets within that calculation. Discount rate changes for the BEL will impact on both the base BEL and stressed BEL and so there will be some offsetting there (albeit not exactly). Perhaps more importantly, changes in interest rates will impact both the value of fixed-interest assets backing the annuity and term assurance business and the BEL for those products, again broadly offsetting within the calculation (again this is not precise, as there is some mismatch). [Similarly, changes in the value of equities will impact both the equities in unit funds and the unit part of the BEL, cancelling out within the above calculation.]

Given these offsets, we can see that for this question part (iii), the main impact is going to be on the value of assets in excess of BEL, particularly the own funds. Hence for the changes in the economic environment that have occurred (equity, property and interest rate movements) the solution focusses on the impact of the changes in the value of those assets in excess of BEL. So, for example, in relation to the interest rate change, we would principally be considering the impact on the 25% of fixed-interest bonds that we are told are held within those excess assets.

There is some mention within the solution of the impact of having a lower discount rate, noting that there is a secondary effect (it is mentioned in relation to mortality / longevity risk). But there are not enough marks available here for it to be worth going into the second-order aspects in much detail, as there are a lot of other more material things to cover.

Hope that makes sense?

 

[Lindsay Smitherman]

In general, for all SCR stresses, the direction would be based on
- whether it increases BEL (like increase in mortality assumption)
-whether it reduces assets (like fall in equity)

Better to consider the impact on {assets - BEL} because a stress that increases BEL might actually be advantageous overall if it increases assets by more. For example, in part (ii) here the stress of interest rates increasing is actually the correct (adverse) direction, even though it would reduce the BEL. Such a stress would reduce the value of assets more than the BEL, because we are told that the fixed-interest assets backing the annuities are of a longer term than the liabilities, plus there is the impact of the fall in value of the fixed-interest assets within own funds etc.

Whether each stress increases or reduces SCR is not known unless assessed in the context of the question. Is my understanding ok?

Yes - a good rule to use!