Ch-14, Pg 22 last core reading

Hi folks,

The last core reading says that it is possible to construct an arrangement which allows credit to be taken in SII b/sheet for future profits which are not allowed otherwise eg, those arising beyond CB. I am not sure what this Para means?

Further it goes on to explain how securitisation could be used to allow to meet MA when they otherwise wouldn’t eg equity release assets. Can you please explain how is this done in a equity release product where cash flows are not certain?

Thanks ,

Jishnu Bhatia

 

Hi,
1. I don’t have a copy of the notes and so I’ll leave this to someone closer to it. Notwithstanding, the section quoted would appear to be a case of regulatory arbitrage. It’s not a particularly great example and that may be part of the problem; for eg future profits are recognised on the SII balance sheet and SII sets out critieria for contract boundaries.

2. Simplistically, the securitisation seeks to carve out the ERM cash flows into a senior and junior note. The senior note is structured so as to meet the MA eligibility criteria (ie generates fixed cash flows, is free from prepayment and morbitity risk etc) and is owned by the MA portfolio. The residual / junior note is held by the non MA portfolio or an external counterparty. This note will contain the ‘undesirable’ / variability features that are MA ineligible.

Hope that helps.

 

Hi Mugono,

Regarding the second point above, could you please explain how the Cashflows are fixed for an ERM product given their are surrenders in this product. And even for a lifetime mortgage product we don’t know how long the person is going to survive?

 

Hi
Ref 2, one way to think about it is consider the following equation of value:

ERM receivable = senior note + junior note

The senior note is constrained by the MA eligibility criteria. So the structurer will need to set such parameters as the (fixed) tenor, coupon rate etc. In practice the tenor may be set by considering the expected life expectancy of the customer and the coupon may be set by considering the desired credit rating etc.

The junior note can be thought of as the balancing item to get you back to the value of the ERM receivable. This note will be exposed to such risks as morbidity and prepayment risks, ie the risks that make ERMs in unrestructured form MA ineligible. This is where the risks you highlight will likely sit; ie the crystallisation of these risks will burn through the value of the junior note first. The risk to the senior note will manifest via the fundamental spread.

This is a complex area but I hope the above is useful.

A final point on surrenders:

An insurance contract that allows surrenders does not automatically make it MA ineligible. Broadly speaking, surrenders are allowed provided its ‘cost neutral’. The precise wording can be found in the Directive.

Similarly, assets that contain the option for the issuer to redeem an asset does not automatically make it MA ineligible. Again, the precise wording can be found in the Directive.