how asset share change following increased yields on government bonds

[Flamy]

Hi, this comes from September 2009 Q2 (i) (c).

ASSET says asset share will fall following the increased yields on government fixed interest bonds.

I am struggling to understand this, as the part of asset share that is impacted - income from government bonds, is not affected I thought, as they are fixed interests. The prices of gilts will fall, but the asset share is not marked to market, is it?

Unless the impact of reduced income from corporate bonds and equities are considered here, I don't see the direct impact to asset share out of gilts. Help please!

Thank you.

 

[margaret.emery]

Hi,

I don't have ASSET for this year, so I have looked up the question & the examiner's report:

Actual Question (relevant bits):

Q 2(ii) Explain how the following would impact the change in Peak 1 regulatory
surplus over the year, considering each in isolation:

...
(c) Increased yields on government fixed interest bonds.
...

Answer from examiner's report:

(c) Increased fixed interest yields:

- Higher expected fixed interest yields are likely to increase the valuation rate of interest. To the extent that fixed interest yields are hypothecated to these policies, this will reduce the regulatory reserves.
- Higher yields will reduce the market value of fixed interest bonds held
- The extent to which surplus is impacted depends on the degree of mismatching of assets to liabilities.

This sounds reasonable, i.e. Question asks about impact on surplus, answer says that both assets and reserves will fall, so the impact on surplus depends on which falls the most.

Your second query, was "The prices of gilts will fall, but the asset share is not marked to market, is it?"

Can you clarify which part of the question we are thinking about here.

Part (ii) refers to Peak 1, so no asset share, just a prospective actuarial method to get the reserves. Assets are 'admissible assets', so as per Chapter 12 section 3 'Quoted Investments should be valued at bid price'.

Part (iii) refers to Peak 2, so yes, we have an asset share. Assets again are as per Chapter 12 section 3 'Quoted Investments should be valued at bid price'. The value of our assets have clearly dropped, so when we calculate the asset share using actual investment return, it will also have fallen.

Hope this helps.

 

[dok87]

ASSET says asset share will fall following the increased yields on government fixed interest bonds.

I am struggling to understand this, as the part of asset share that is impacted - income from government bonds, is not affected I thought, as they are fixed interests. The prices of gilts will fall, but the asset share is not marked to market, is it?

Impact of market and credit risks on asset shares is better seen visualizing how an ICA or RCM stress works. For example in an equity stress of say 20%, the equity proportion of asset share will also be stressed by 20% (consistency). This is saying the assets backing that part of asset shares will effectively be bringing in significant capital loss.

Translating this to yields, the gilt-backed proportion of the asset share is stressed down by the same percentage as the fall in assets (due to risen git yields).

This explanation can be translated to unstressed scenario. If falling yields leads to negative total return (capital + gains) then all things being equal crediting the negative returns will reduce asset shares, assuming the asset share roll-up is done on unsmoothed returns.

Hope it helps!

 

[misterh]

The market value of assets does fall (yields up, price down) but this is exactly offset by the fall in WPBR (ie the AS). The change in market values are thus irrelevant - it is the change in FPRL that is important (yields up, cost of guarantees down). Note that the market value of the working capital f.i. assets will drop however.

 

[dok87]

Misterh, just a subtle point on the below;

The market value of assets does fall (yields up, price down) but this is exactly offset by the fall in WPBR (ie the AS). The change in market values are thus irrelevant

Asset share movement will only broadly cancel-out asset movement if the mix of assets backing asset shares is not significantly different from the mix of actual asset holding. For instance a notional mix, typically a long-term strategic asset mix may be assumed to back asset shares and if this materially differs from the actual holding (e.g. due to tactical switch in the actual holding) the impact of the mismatch on working capital could be significant, aside impact of FPRL.

So overall it depends on extent of mismatch and for how long.

 

[SABeauty]

Why does the WPBR drop if you are using a retrospective approach?

Yields have increased so by the definition if asset share:

"The asset share is the retrospective accumulation of past premiums, less expenses and the cost of cover, at the actual rate of return on the assets. The accumulation could be done for a single contract or a group of contracts. It is also referred to as the earned asset share or the retrospective earned asset share."

Has the actual rate of return not increased? So why does WPBR drop?

 

[dok87]

SABeauty, I split your query as follows:

Has the actual rate of return not increased? So why does WPBR drop?

Gilt yields have risen so market values fall. Presumably its fixed interest gilts so level income (coupons) are coming in.

Total return on gilts is Income + Capital Gains. The fall in market value is a capital loss that can (most likely) outweigh the income (coupons) so total return is negative.

Why does the WPBR drop if you are using a retrospective approach?

Assets were valued following the rise in gilt yields so asset shares will be restated as at the date of the asset valuation, bringing in the latest returns over the intervening period. So the retrospective accumulation as at the last valuation will be rolled with negative total return to the latest valuation date. This is just like a downward shock on asset share.

Hope it helps!

 

[Flamy]

Thanks guys for all the comments, I do appreciate it and dont have further question on this. SAbeauty, hope you are happy about your answer too!

So I gathered from the comments:

1) Investment return in the asset share calculation is made up of capital gains (bid price) and income, if the return is not smoothed.

2) Movement in assets and asset share, e.g. due to fall in gilts prices, may not cancel out each other, depending on the matching.

Thank you