April 2013 Examiners' report

[smSA2]

I am confused after reading the solution contained in examiners’ report to question 1 (vi). The points mentioned in examiners’ report are all valid but the answer does not appear to me to be tailored to the specific question. Also it is unclear to me, why the examiners’ report says that the company may move out of corporate bonds as my understanding is that the issue here is of gilt-swap basis risk.

The examiners’ report is supposed to contain all points for which marks were awarded. If I mention the following points, as these are not in the examiners’ report, am I right in assuming that these would not have scored marks in the exam?
• Sell gilts portfolio and invest in interest rate swaps.
• Shorten the duration of gilts portfolio by selling long dated gilts in order to reduce volatility and enter in to a series of forward starting swaps to get the required duration.
• Using spreadlocks, the insurer can lock in current spread between a swap and an underlying government bond yield.

Other actions
• Model the gilt-swap basis risk and hold capital against this risk. The action it needs to take will also depend on whether it is using standard formula or an internal model.
• Matching adjustment may reduce this spread risk (provided that the insurer’s assets and liabilities qualify for matching adjustment). In addition, matching adjustment would allow the insurer to discount the liability at a higher rate so it needs to carefully assess whether it needs to sell its gilts portfolio at all.

 

[smSA2]

Q1 (iii), (iv)

Addition, can any one please let me know whether following points would have scored any marks as these are not stated in the examiners' report:
Question 1 (iii) the solution covers the relevant information but it does not address the issue that even to meet on-going solvency requirement on Pillar 1 basis excess capital may be required. For example, Pillar 1 requirement includes RCR which contains a series of prescribed stress tests to certain assets. The market value of those assets may move with market which may increase RCR and therefore it would be imprudent if the company do not hold capital in excess of Pillar 1 requirement.

Question 1 (iv)
• The risk measure (VaR, TVaR or run-off) to be used. (The solution in examiners’ report only mentions VaR)
• A 1 year VaR approach may not be suitable for modelling certain types of risks for example mortality which are better modelled by run-off approach. The company will need to consider how it would translate any risks modelled using a run-off approach in to 1 year VaR (using any conversion formula).
• Whether the company needs to use an external ESG or it has in-house modelling capability?

 

[Mark Willder]

I am confused after reading the solution contained in examiners’ report to question 1 (vi). The points mentioned in examiners’ report are all valid but the answer does not appear to me to be tailored to the specific question. Also it is unclear to me, why the examiners’ report says that the company may move out of corporate bonds as my understanding is that the issue here is of gilt-swap basis risk.

In part (v) we concluded that the new rules would lead to a lower valuation interest rate and hence higher reserves (mainly because the insurer must now use the return from swaps, and so cannot take credit for the higher returns it is currently getting on its corporate bonds). So the report covers actions that can be taken following the worsening solvency position.

I agree that there is a gilt-swap basis risk, so you would get credit for saying that entering into swaps would be useful. However, the fall in valuation interest rates is much more important and so there are more marks for addressing this.

The company may move out of corporate bonds to ease its credit risk. Under the new rules in the question the insurer gets no credit for the higher returns from these bonds, but would need to reserve for their credit risk.

The examiners’ report is supposed to contain all points for which marks were awarded. If I mention the following points, as these are not in the examiners’ report, am I right in assuming that these would not have scored marks in the exam?
• Sell gilts portfolio and invest in interest rate swaps.
• Shorten the duration of gilts portfolio by selling long dated gilts in order to reduce volatility and enter in to a series of forward starting swaps to get the required duration.
• Using spreadlocks, the insurer can lock in current spread between a swap and an underlying government bond yield.

You'd get credit for the first point, but not the other two. There are only 4 marks on offer, so you need to give a good spread of ideas without going into lots of detail on swaps.

One way of seeing this is that the points given in the report are all things covered in the course, whereas your points go beyond the coverage of SA2.

Other actions
• Model the gilt-swap basis risk and hold capital against this risk. The action it needs to take will also depend on whether it is using standard formula or an internal model.
• Matching adjustment may reduce this spread risk (provided that the insurer’s assets and liabilities qualify for matching adjustment). In addition, matching adjustment would allow the insurer to discount the liability at a higher rate so it needs to carefully assess whether it needs to sell its gilts portfolio at all.

Yes, you're first point on modelling would score. Its always good in any question to say that you'd model the consequences to help you make a decision.

The question has mentioned that "one suggestion" was to use unadjusted swap rates. There have been many other suggestions (including the matching adjustment), but the question wants you to talk about their one suggestion.

Addition, can any one please let me know whether following points would have scored any marks as these are not stated in the examiners' report:
Question 1 (iii) the solution covers the relevant information but it does not address the issue that even to meet on-going solvency requirement on Pillar 1 basis excess capital may be required. For example, Pillar 1 requirement includes RCR which contains a series of prescribed stress tests to certain assets. The market value of those assets may move with market which may increase RCR and therefore it would be imprudent if the company do not hold capital in excess of Pillar 1 requirement.

The solution is very much written around the Core Reading in Chapter 18, so inevitably these are the points that score marks.

You're right though, so I'd have been happy to give you a mark for this in the exam.

Question 1 (iv)
• The risk measure (VaR, TVaR or run-off) to be used. (The solution in examiners’ report only mentions VaR)
• A 1 year VaR approach may not be suitable for modelling certain types of risks for example mortality which are better modelled by run-off approach. The company will need to consider how it would translate any risks modelled using a run-off approach in to 1 year VaR (using any conversion formula).
• Whether the company needs to use an external ESG or it has in-house modelling capability?

Again you're right, but I doubt there would be credit for these ideas.

You've got some very good ideas here and show great understanding, so I know it must be frustrating that they don't all score. However, the examiners are looking for a good spread of ideas - they're looking for good overall awareness rather than specialist knowledgein particular areas.

The examiners have to make a subjective judgement of what should be in and out of the marking schedule. They will draw heavily on what's in the Core Reading. However, many good ideas from other subjects (eg ST5, 6 and 9) and beyond will be beyond the course and will not score.

My advice for the exam would be to start with the big simple ideas and get a wide spread of these. Then, only if there's time, add more complex detail.

Best wishes

Mark