Hi, In September 2015 Q1 (iv), the solution says that if the insurer invests in corporate bonds as opposed to Government bonds to match the annuities, they can use the corporate bond yield as their investment return assumption, with a deduction for credit risk as the insurer is still exposed to that risk. No deduction required for illiquidity risk as insurer isn't exposed when in a matched position. I think this is referred to in the notes when it says that where best estimates are used for investment returns under the EV calc, a reduction should be included to allow for credit risk. I'm a bit confused about why this is done as opposed to allowing for risk through the RDR? If the associated liabilities weren't annuities, would there also be a deduction for illiquidity risk here, since the insurer is exposed to this risk? Is it only in the EV calc that such a deduction would be used? Thanks in advance
In embedded value calculations, we are concerned with projecting future profits and so with a risk-neutral valuation, the investment return is equal to the risk free rate (RFR) and then a liquidity premium (LP) may be added. Or you could say that it is equal to the rate on corporate bonds minus the part of the spread (ie spread over RFR) that is related to credit risk. Either way, you end up with the same thing, this being RFR + LP. You are effectively removing the credit risk part from the corporate bond spread of the investment return assumption and increasing value of profits through the LP. In Solvency 2 projections, we are concerned with discounting liabilities and so we would instead add the LP to the discount rate (ie the Solvency II matching adjustment), and so reduce the value of the liabilities. Unlikely as, with the matching adjustment under Solvency 2, it will be difficult to justify including a liquidity premium where the company is exposed to the risk that they will need to sell assets to meet their liabilities, ie they will be exposed to liquidity risk. It tends to be just annuity-like contracts that meet the criteria for the matching adjustment. However, with EV calculations, the company is not constrained by regulation so the criteria is less stringent. As discussed above, the LP (ie matching adjustment) is applied to the liabilities under Solvency II is based on the same concept. There is also a similar concept under IFRS 17 in the construction of the discount rate. Hope this helps.
Thanks Em! In the notes it says that even if a risk-neutral market-consistent approach isn't used, investment returns may be set as the best estimate returns with a deduction for credit risk and discounting would be done at the RDR. Does the deduction here also reflect an illiquidity premium? We are deducting the credit risk as we can't take credit for that in the EV calc since we are exposed to the risk of default? Thanks for the help
It would depend on the assets this is based on. If corporate bonds, then we assume there is a spread of default and illiquidity over the risk free rate. And so, if a deduction is being made for the default risk, then this leaves the illiquidity premium and so the company is taking account of this extra return in their projection. Yes, it is assumed that an investor is always exposed to default risk but in some circumstances, ie when our liabilities are not exposed to early payment, we are not exposed to liquidity risk and therefore the investor can justify benefiting from this extra return. The fact that it is not market consistent means that the investment return is not necessarily the same as the discount rate (ie RDR).
