Matching adjustment and Illiquidity premium

Discussion in 'SA2' started by actman, Mar 16, 2019.

  1. actman

    actman Member

    Hi all,

    I understand that matching adjustment and illiquidity premium are all used to allow for a higher discount rate and therefore lower reserve/BEL as a result.

    My question is can you take credit for both? If yes, under what circumstances?

    I would really appreciate if someone could shed some light on this. Thanks heaps!
     
  2. Mateusz

    Mateusz Active Member

    Hi,

    I'd say that "illiquidity premium" is a general term, while the matching adjustment is what this concept is called under SII. So these are not really two separate things.

    For example, SII is very prescriptive regarding WHEN and HOW you're allowed to apply the MA. You need to demonstrate that certain eligibility criteria are satisfied and, if so, the calculation steps are pretty much laid out in the Directive. First, project the asset cash flows (from an eligible pool of assets) which closely match the best-estimate liabilities, work out the gross redemption yield and then deduct the portion of this yield which corresponds to the risks of default and credit downgrade. What is left in excess of the RFR is a spread we call the MA. In the de-risking process, you'd rely on default probabilities and other relevant assumptions published by EIOPA.

    However, allowance for illiquidity premium can be also made for other reporting purposes (e.g. under IFRS) and here there would normally be more freedom regarding the calculation methodology. Conceptually, you'd do something broadly similar to the MA calculation, but the approach (and the result) would not necessarily be the same.

    In summary, under SII you can take credit for the MA but NOT for both the MA and illiquidity premium, as you wrote in your question. An alternative uplift to the basic risk-free rates in the SII world is something called the volatility adjustment (VA). However, even here you can either apply the MA (if you're allowed to) or the VA (if you you're not able to apply the MA and you demonstrate that certain conditions are met).

    Regards,
    Mateusz
     
    Last edited: Mar 17, 2019
    actman likes this.
  3. mugono

    mugono Ton up Member

    Great answer Mateusz.

    To add, a number of insurers under SII still apply an illiquidity premium to their ICAS balance sheet for the purpose of calculating the transitional measure of technical provisions (TMTP)
     
    actman likes this.
  4. actman

    actman Member

    Thank you very much!
     

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