Hello, Following up for April 2017 Q1 iv) what is the impact of matching adjustment on standard formula SCR? Whenever we talk about SCR impact, mainly three aspects to consider. (Please confirm if my thought process about SCR impact aspects is correct) 1. impact on assets 2. impact on BEL 3. which risk module of SCR should be considered (to identify the impact of stress applied post change in assets/BEL) Here, it is easy to follow that BEL will reduce as matching adjustment increases the discount rate for BEL. Now, as matching adjustment = spread on underlying portfolio - EIOPA fundamental spread = (illiquidity risk+default risk)- EIOPA spread which is ~ illiquidity risk as EIOPA spread is also a default risk premium Why are we considering this as credit spread risk module? Practically speaking, after applying MA, the level of matching between assets and liabilities will be very high and assets will be held till maturity. Hence, liquidity risk reduces. Is this why we are considering credit spread (which is mainly due to liquidity risk and default risk from corporate bond vs govt bond)? Please help in connecting the dots and understanding better. Thank you in advance!
The relevant SCR sub-module is the 'spread risk' module. This reflects the impact of a significant increase in spread on (corporate) bonds that are held by the insurer. If there is no MA in place and the spread on the bonds widens then asset values will fall (reflecting both higher default risk and lower liquidity) but liability values will be unchanged (they are still just discounted at the risk-free rate, which is not affected by the stress). Therefore a 'spread risk' SCR component has to be held. If there is an MA in place, the MA will increase under the stressed conditions to the extent to which the spread increase is attributable to reduced liquidity rather than greater default risk. So asset values will fall under the stress (as before) but liability values will also now be reduced due to the higher MA. This basically reflects that the lower liquidity aspect is not relevant for that insurer, because the bonds will be held to maturity since the company must be well cashflow matched (in order to get MA approval). So the 'spread risk' SCR component is lower when there is an MA in place than it would be without the MA. (However, there will still be some 'spread risk' element even with an MA in place, to the extent to which the spread widening reflects an increase in default risk.)
You might find the following thread also of interest: https://www.acted.co.uk/forums/index.php?threads/matching-adjustment-april-2017-q1.15738/#post-68919
Thank you. This is helpful. Can you just elaborate on why will MA increase under stressed conditions? I can rationalize on following basis- In stressed condition, value of assets will reduce due to adverse market movement (assuming 'stress' here is market stress factor). Hence, if MA is in place, insurers need to hold additional asset to retain their matched position. Will this correspondingly increase the spread on matching assets (if more corporate bonds are held for matching)? Please let me know if I am thinking in the right direction or any other explanation for this. Thank you!
I think you are over-complicating this. Very basically: The MA represents the illiquidity premium part of the credit spread. If the credit spread widens (as it does under this particular SCR stress that we are talking about), then this must either be because the illiquidity premium has increased, or the default risk premium has increased, or both. If the illiquidity premium has increased, so too should the MA.
