Hi, Can you please help to understand the following- equity market risk and lapse risk are positively correlated, ie stock market falls and increased lapses tend to happen together. My understanding of equity market risk was that it increases in case the value of the underlying equities increases and decreases in case the value of the equities decreases. Thus, a fall in the stock market will lead to a reduction in the equity market risk and an increase in the lapses (and lapse risk) which would mean they are negatively correlated Thanks
You are getting two different things confused here. If equity markets fall, then looking forwards the company now has less exposure to equity market risk than it had before so it needs to hold less capital to support equity risk than it did before. But what we are talking about here are the correlations between the events themselves, ie the equity market fall and the higher lapses. When equity markets fall, that tends to lead to higher lapses (people getting nervous about market volatility and/or needing the cash). Hence the two events of (1) equity markets falling and (2) lapses increasing are said to be positively correlated. In other words, there is a fairly high chance that they would both happen at the same time.
Hi Thank you for your answer, I am still confused how the equity markets falling will increase the equity risk for the company? Isn't the correlation being considered for the risks used for SCR calculations in the question or is the sub-part moving towards looking at the risks as a standalone different from SCR calculations? Thanks
Again, you are confusing two distinct things - and I definitely didn't say that equity markets falling will increase the level of equity risk for the company (in fact, I actually indicated the opposite). Equity markets falling (in the near future) would be bad for the company, therefore that is what would be used for the stress test in the SCR calculation. If equity markets have actually fallen, then looking forwards the company now has less equity exposure (in absolute terms) than it had before that event happened. So it is less exposed to the risk of an(other) equity market fall than it was previously - but equity markets falling again would still be bad for the company.
Hi Thank you for your reply, I understand that a fall in equity would be bad for the company, I am trying to understand how equity market risk and lapse risk are positively correlated.. as we are saying that a fall in the markets will not increase the equity risk.. then how will the positive correlation work? In the question it is mentioned an increase in equity risk will increase the lapse risk- and then states like a fall in the stock market implying that the increase in equity risk is due to this? Thank you again for helping out with this.
No - it isn't saying that an increase in equity risk is due to the equity market fall. (As I have stated above, the opposite is likely to be the case.) The equity market fall is the example of the event that would be categorised as equity risk. Equity risk stress event = stock market fall; lapse risk stress event = higher lapses. Would place a fairly high probability on these two things (stock market fall & higher lapses) happening at the same time for UL business, so they are positively correlated.
but in the question it is mentioned that equity market risk and lapse risk are positively correlated ; I am trying to say here is: fall in stock market, reduces the equity market risk which would mean lapse risk should also reduce from the positive correlation relation (as given) .. which is not the case I understand that stock market fall and higher lapses are positively correlated but I do not understand how equity risk and lapse risk are positively correlated too when seen with the example of an equity market fall Thank you for your help
'Equity market risk' refers to the equity market risk stress that is worst for the company (because that is what is going to be used to determine the capital requirements, as per the rest of the question) - which is an equity market fall. 'Lapse risk' refers to the lapse risk stress that is worst for the company - which is an increase in lapse rates. Those two events (equity market fall and increase in lapse rates) are positively correlated for the company selling UL business. Hence those two risk components of the capital requirement calculations (equity market risk and lapse risk components) are positively correlated for that company. I don't think I can say this any other way. You seem to be getting confused between the impact of events actually happening (which is not what this question is asking about) and the risk stresses that are used to calculate capital requirements (which the question is all about) and I'm afraid that we can't help any further if you are unable to appreciate or accept this distinction.
