April 2017 Q1(i)

[Mbotha]

If a credit spread widens then, as the previous poster states, the market value of such assets will fall.

Hi Lindsay

I'm trying to understand the reason why widening spreads is listed as a risk in the examiner's report. Isn't it only a risk if the company doesn't intend to hold the bonds to maturity? I would assume that the company does intend to do so if it's assets and liabilities are well-matched.

Thanks!

 

[Lindsay Smitherman]

Good question!

Yes: if the company is going to hold the bonds to maturity then the company is not concerned about potential losses arising on sale of the bonds before that point in time.

However, widening of bond spreads will result in asset values falling - and the liabilities may not fall by the same amount. In fact, the liabilities can only be reduced to the extent that the spread widening is due to liquidity changes (rather than being due to changes in the credit risk element of the spread) and only if there is an effective matching/volatility adjustment approved and in place - which would not necessarily be the case (and in fact later in the question it makes clearer that the company doesn't use a matching adjustment).

So even though it may not be exposed to cashflow risk (if holding to maturity), the company is still exposed to the risk of having a significantly worsened solvency position - which could be an issue.

Hope that helps.

 

[ActuaryLad]

Hi Mbotha

Another way of looking at this might be to decompose what the spread on fixed income securities might represent. An element of the spread represents liquidity risk, and another element represents credit risk (which consider the default recovery rate and probability of default).

If credit spreads have widened due to credit risk then this suggests that the probability of default may have increased or that the default recovery rate may have decreased. Both of these items would reduce the projected probability adjusted asset cashflows, and therefore could increase the insurer's cashflow mismatching risk, and its ability to pay liabilities as they fall due.

Thanks and best wishes
Amit

 

[Mbotha]

Thanks so much. This helps a lot.

I have another question on Q1(ii).
The examiner's report states "reduce the risk in the fund and so reduce the SCR" as a solution:

• "Take out reinsurance" - this would have no impact on the BEL (as reinsurance premiums and recoveries are not taken account of in the calculation) but assets would be increased by reinsurance recoveries. High-level, I understand that the SCR for the life underwriting module would also be impacted since some of the mortality risk is shared with the reinsurer but I'm struggling with the details:
  • SCR = unstressed NAV - stressed NAV = (base assets - base BEL) - (stressed assets - stressed BEL)
  • Since reinsurance doesn't impact the BEL, where does the impact come through?
• "Invest in higher-rated corporate bonds" - this would reduce the SCR for the counterparty default module - is that right?
  
• "Reduce investment in risky assets"
  • This would reduce the SCR for the counterparty default module - is that right?
  • SCR for the market module: this may reduce if the stressed are less severe for the lower risk assets (SCR for property may be lower than that for equities). Is that right?
  • No impact on the SCR for the life underwriting module (?)

What I'm trying to understand is how these measures impact each of the modelled cashflows in various components (BEL, assets, SCR).

 

[Lindsay Smitherman]

Hi - I will give it a go!

• "Take out reinsurance" - this would have no impact on the BEL (as reinsurance premiums and recoveries are not taken account of in the calculation) but assets would be increased by reinsurance recoveries. High-level, I understand that the SCR for the life underwriting module would also be impacted since some of the mortality risk is shared with the reinsurer but I'm struggling with the details:
  • SCR = unstressed NAV - stressed NAV = (base assets - base BEL) - (stressed assets - stressed BEL)
  • Since reinsurance doesn't impact the BEL, where does the impact come through?

Stressed assets would be higher, because you would expect higher reinsurance recoveries if there are higher claims incurred.

• "Invest in higher-rated corporate bonds" - this would reduce the SCR for the counterparty default module - is that right

Yes - and the credit spread component of market risk.

• "Reduce investment in risky assets"
  • This would reduce the SCR for the counterparty default module - is that right?
  • SCR for the market module: this may reduce if the stressed are less severe for the lower risk assets (SCR for property may be lower than that for equities). Is that right?
  • No impact on the SCR for the life underwriting module (?)

Yes to the first question if the reduced investment in risky assets means fewer corporate bonds - but also see above re credit spread risk too (part of market risk). If it means a reduced investment in equities instead, say, then this would impact the market risk component.

Yes: the market risk stresses for equities tend to be higher than for property (and will be lower still for bonds and cash).

One potential impact that I could think of for life underwriting risk is if the assets involved are equity release mortgages, where the value will depend on mortality/longevity and also potentially on persistency.

Hope that makes sense?

 

[Mbotha]

Thanks, Lindsay!!

So does the spread component of market risk relate to both liquidity spread and credit spread? The reason I'm a bit confused is because the SCR diagram in ch12 refers to "spread" but the core reading detail below specifically refers to "credit spread" only (no mention of liquidity).

On a side note - part (v) of this question also says that the company needs to take into account any restrictions imposed by the PRA on the type of assets that can be included. Is this referring to the tiering limits?

 

[Viki2010]

Page 11 of ch 12 explains that the spread= illiguidity premium + credit risk premium

 

[Lindsay Smitherman]

Page 11 of ch 12 explains that the spread= illiguidity premium + credit risk premium

Yes - the term "credit spread" simply means the difference in yield between a credit-risky bond and a risk-free bond, and it will therefore reflect both the higher default risk and the (likely) lower liquidity of such bonds.

On a side note - part (v) of this question also says that the company needs to take into account any restrictions imposed by the PRA on the type of assets that can be included. Is this referring to the tiering limits?

This part of the question is about selecting appropriate assets to back the business for which a matching adjustment is being sought. The PRA places restrictions on the types of assets which can be used for this purpose, eg they have to be "bond-like" (see page 10 of Chapter 12).

 

[Mbotha]

Thank you, Lindsay and Viki2010.