Matching adjustment April 2017 Q1

[smSA2]

I have some queries on question 1 of April 2017 exam paper. I will appreciate if someone can correct my understanding below:

1(i) The solution in the examiner report states that risk of defaults on corporate bond will be subject to the Counterparty default risk module. This is incorrect as corporate bonds are not subject to this risk module.

“Risk of defaults on corporate bonds held (or reinsurer default).
Counterparty default risk module”.

Is this an error in the solution?

(iv) I don’t follow the solution when it says “…the company is only exposed to credit spread movements on the liabilities which reduces the magnitude of the stress”.

My understanding is that the direct impact on the standard formula SCR is in calculation of the spread risk sub-module. Under the spread risk sub-module, a stress is applied to assets which results in a lower value of assets. This means the yield on assets would go up under the stress, which could result in a higher matching adjustment provided that increase in the yield on assets is assumed to be higher than any increase in the fundamental spread. A higher matching adjustment would result in a lower value of technical provisions and hence, higher net assets under the stress. Spread risk capital requirements would be lower as change in net assets would be lower compared to if matching adjustment is not applied.

There may not be any impact on other sub-modules in the market risk module as matching adjustment is not stressed but some second order impact is possible due to a higher rate used to discount liabilities.

(v) The question asks how the company can identify appropriate assets and the factors it will need consider for the matching adjustment. The solution in the examiner report does not seem to be tailored to the question and focuses too much on modelling of liabilities / matching adjustment which is not asked. Projection of asset and liability cashflows is relevant for matching adjustment calculation but for identification of assets it should be a minor point in the answer.

I would expect the answer to cover following points:

· First step will be to identify which assets can be attributed to immediate annuities as they are written in the same fund as the deferred annuities. This will depend upon a number of factors.

· Not all assets attributed to immediate annuities will be eligible e.g. equity or property. The company will need to review terms and conditions or prospectuses of the assets to assess their eligibility.

· Some assets may not be eligible for the matching adjustment in their own right but when grouped with other assets they can produce fixed cash flows e.g. a foreign currency bond hedged with an FX swap.

· Assets may need to be restructured or securitised to make the eligible for the matching adjustment e.g. equity release mortgage.

· The company will need to consider the PRA’s interpretation of the matching adjustment eligibility requirement set out in Solvency II.

· Project asset and liability cashflows under different scenarios / sensitivities to assess which assets can be included in the matching adjustment portfolio.

Am I missing anything or misinterpreting the question?

 

[Lindsay Smitherman]

Hi - taking each point in turn:

1(i) The solution in the examiner report states that risk of defaults on corporate bond will be subject to the Counterparty default risk module. This is incorrect as corporate bonds are not subject to this risk module.

“Risk of defaults on corporate bonds held (or reinsurer default).
Counterparty default risk module”.

Is this an error in the solution?

Calling this an 'error' is perhaps a bit strong. This is a good example of how the SA2 Examiners do not expect students to know factual information which goes beyond what is stated in the Core Reading (unless it is something that could reasonably be intuited from the principles and other information stated there).

You personally may know that the corporate default risk module in practice only (broadly) covers defaults on things like deposits, derivatives, reinsurers, with the rest covered in the spread risk sub-module. But the Core Reading does not state this - so students would not be expected to know it.

Therefore the Examiners will be relaxed about answers; it would be unfair to penalise students who might reasonably expect corporate bond defaults to be classified as 'counterparty defaults' - when there is nothing in the Core Reading to say otherwise. I am sure that those who (correctly) classified this as part of the spread sub-module instead would have received the mark also. (And I see that the other example given in the ER for counterparty default is in relation to reinsurance, which is fine.)

 

[Lindsay Smitherman]

(iv) I don’t follow the solution when it says “…the company is only exposed to credit spread movements on the liabilities which reduces the magnitude of the stress”.

My understanding is that the direct impact on the standard formula SCR is in calculation of the spread risk sub-module. Under the spread risk sub-module, a stress is applied to assets which results in a lower value of assets. This means the yield on assets would go up under the stress, which could result in a higher matching adjustment provided that increase in the yield on assets is assumed to be higher than any increase in the fundamental spread. A higher matching adjustment would result in a lower value of technical provisions and hence, higher net assets under the stress. Spread risk capital requirements would be lower as change in net assets would be lower compared to if matching adjustment is not applied.

There may not be any impact on other sub-modules in the market risk module as matching adjustment is not stressed but some second order impact is possible due to a higher rate used to discount liabilities.

Yes, your understanding is correct. The line that you highlight is trying to say that the company is only exposed to spread movements that relate to defaults. We are effectively splitting out the overall change in yield into changes due to liquidity spread widening (which should increase the matching adjustment) and changes due to default risk spread widening (which wouldn't because, as you say, this would also cause the fundamental spread to increase). Therefore, if the matching adjustment increases under the stress, the magnitude of the overall spread widening stress impact on the balance sheet is lessened.

 

[Lindsay Smitherman]

(v) The question asks how the company can identify appropriate assets and the factors it will need consider for the matching adjustment. The solution in the examiner report does not seem to be tailored to the question and focuses too much on modelling of liabilities / matching adjustment which is not asked. Projection of asset and liability cashflows is relevant for matching adjustment calculation but for identification of assets it should be a minor point in the answer.

Am I missing anything or misinterpreting the question?

The question is actually worded as:

The company is therefore now undertaking an exercise to identify appropriate assets to match the immediate annuities for this balance sheet.
(v) Describe how it will identify appropriate assets and the factors that it will need to consider when doing so.

So it is asking how would we identify appropriate assets (starting from the existing portfolio, which also backs the company's deferred annuities) to match the immediate annuities. To do this, we need to perform a cashflow matching exercise, picking those assets from which the expected cashflows (coupons, redemption amounts) most closely match the expected liability cashflows. Hence a reasonable proportion of the solution describes the cashflow matching investigation that will be performed.

I can't see anything in the solution to part (v) that talks about modelling or calculating the matching adjustment - that comes later in the question. The solution does, however, include a couple of points on choosing assets with the highest liquidity spreads if the company wishes to maximise its matching adjustment. This seems fair given that the purpose of the exercise (as stated earlier in the question) is to apply for an MA.

The solution also includes a couple of points about ensuring that the assets selected are eligible for the MA under the PRA's rules, and indicates that any example would be acceptable. You have given several examples; it is unlikely that all of these would have scored (although the ER indicates 1 half mark being able for an example).

The Core Reading states only that 'The addition of this ‘matching adjustment’ must be approved by the regulator and there are strict requirements in relation to the eligibility of the assets and liabilities.' It does not go into specific examples or details of what those eligibility requirements are, and so the Examiners would again be careful not to require students to know factual details that go beyond what is indicated by the Core Reading.

Your points suggest more detailed knowledge from experience of working in this area? I have found that the SA2 Examiners are careful to try to avoid giving an undue advantage to someone working in a particular area, aiming to ensure that the questions are equally accessible to those who are answering only on the basis of the Core Reading. You would probably appreciate that in relation to questions on areas where you have no experience, but others do.

Hope that helps to clarify things in relation to the ER for this question.

 

[smSA2]

Thanks Lindsey. I am now clear on 1(i) and (iv). I understand your point that examiners are not keen on giving credit for points that go beyond the application of core reading but I am still confused on (v) as why describing some practical aspects would not have scored marks.

The points that I have stated above in (v) are coming more from reading around the subject and from application of the core reading to information given in the question. For example, identifying which assets can be attributed to immediate annuities as they are written in the same fund as the deferred annuities comes from general application of the core reading.

A number of points in the examiners’ report seem to go beyond the core reading, such as:
· matching will be based on duration, currency, nature and any indexation
· deductions for expected defaults or credit risk may be done by credit rating

I consider following two points on matching adjustment in the core reading are particularly relevant for this question:
· matching assets held to maturity to back predictable liabilities
· strict eligibility criteria for assets and liabilities

The answer addresses the first of these points in detail and the second one is mentioned only briefly that any restrictions imposed by the PRA on assets should be considered.

If we were to expand on the second point, we can say that the company will need to consider characteristics of assets to see if they meet the eligibility criteria including any guidance provided by the PRA. I would expect to see some general discussion in the answer on how this exercise can be done for example reviewing contractual terms of the underlying assets, does the current systems that keep information on assets allows them to asses these features or they need data from an external provider, any validation on this data that may need to be done, etc.

If a candidate lists these points in his/her response, would this not score marks?

I am just trying to get clarity on why these points on some practical aspects which usually would be expected in a response to exam questions are not considered here.

 

[Lindsay Smitherman]

Hi

Picking up on some of your specific points:

• The exams are based on the Core Reading, so whilst additional reading around the subject is great to improve your understanding, you would not be expected in the exam to know factual information which is not included in the Core Reading.

• That is not the same as saying that application beyond the Core Reading is not expected - in fact, it is what SA subjects are mainly about, ie understanding the inherent principles and being able to apply them. So most of the points that you find in the ERs (for all papers and questions) will not be stated in the Core Reading. However, you would not be expected to know detailed factual information which is not included there. So here, for example, students would not be expected to know the details of what the 'strict requirements for the eligibility of the assets and liabilities' actually are. We have included some of the basics in the course materials, as for example we feel that knowing that the assets need to be 'bond-like' can help very much with understanding the MA and its application - and seems reasonable for students to appreciate. However, I personally am not convinced that knowing that assessing eligibility might require information from an external party is something that someone not working in this area (and who therefore doesn't know what the eligibility requirements actually are in detail) should be expected to know - so maybe the Examiners would feel the same way? But I can only guess at this.

A number of points in the examiners’ report seem to go beyond the core reading, such as:
· matching will be based on duration, currency, nature and any indexation
· deductions for expected defaults or credit risk may be done by credit rating

The first point is not 'factual information that goes beyond the CR' - it is part of the basic principles of investment that are covered in earlier subjects and which would be assumed knowledge at SA level. If we are being asked to choose assets that match specific liabilities (which is what the question is doing), consideration of these items seems a very fair point for students to mention.

Similarly, understanding that expected defaults would vary by credit rating would also be assumed understanding at this level, based on earlier subjects. (There is also actually mention of this concept in the Core Reading that is included in Chapter 22 on managing credit risk.)

The answer addresses the first of these points in detail and the second one is mentioned only briefly that any restrictions imposed by the PRA on assets should be considered.

I would guess that the former (about choosing assets that match the liabilities) is covered in more detail because (a) this is what the question has explicitly asked for and (b) this is the area where it is more reasonable for students (without specialist knowledge) to be able to write in more detail.

As I mentioned above, the second point is also covered by allowing one example to be given (as well as by the point that you mention) - the Examiners must have decided not to want students to drill down too far into giving different examples. (It is generally the case that breadth of ideas is preferred.)

If we were to expand on the second point, we can say that the company will need to consider characteristics of assets to see if they meet the eligibility criteria including any guidance provided by the PRA. I would expect to see some general discussion in the answer on how this exercise can be done for example reviewing contractual terms of the underlying assets, does the current systems that keep information on assets allows them to asses these features or they need data from an external provider, any validation on this data that may need to be done, etc.

As I mentioned above, I can't say for sure what the Examiners' thinking is here, but FWIW my personal opinion is:
- your first point (ie considering characteristics of assets to see if they meet the eligibility criteria including any guidance provided) would be given that first mark as indicated in the ER
- the point about reviewing contractual terms of the assets sounds too similar to the previous point and so doesn't seem like it would be given any extra credit (it doesn't feel like it is adding enough value to the basic point that we have to consider whether the assets meet the PRA's eligibility criteria)
- the other points seem to me personally to be wandering a little bit away from what could reasonably be expected to be known or understood by a non-expert student

I appreciate that this might feel a bit frustrating, but there aren't 'rules' about what would and would not be expected to gain a mark. I can't say for sure whether points like this (which do not appear in the ER) would gain additional half marks, but as a rule of thumb I would caution against drilling down too far into any one area just in case they don't.

I would also recommend not getting too hung up on the specifics of whether individual points are or are not explicitly covered in the ERs. We could end up spending a lot of time dissecting the details otherwise, and it is very unlikely to be worth it!

What is more important is being able to generate a good wide range of different ideas, ensuring that you are addressing exactly what has been asked for, and showing sound understanding of the Core Reading principles and how they apply in the given scenarios.

 

[smSA2]

Thanks. My point about requiring data from an external provider is not that they will provide eligibility assessment for the insurer but an insurer’s existing system may not have sufficient information on all assets to make an assessment. For example, they may need to source data from Bloomberg or an asset manager on specific assets to enable them to make the eligibility assessment.

 

[Lindsay Smitherman]

Yes, thanks, that is how I interpreted your point - ie needing more info on the assets from a specialist (not assessing eligibility). I guess I am just feeling that you would need to know about the specific detail of the eligibility requirements in order to think that help from someone like that would be needed. If the eligibility requirements relating to assets were just 'it has to be a bond' then there wouldn't be any obvious need for someone external to look at the asset to tell you that. So you would have to know that the actual requirements are more complex than that.

But that's just my personal view of course!

 

[Tong_Tong]

Yes, thanks, that is how I interpreted your point - ie needing more info on the assets from a specialist (not assessing eligibility). I guess I am just feeling that you would need to know about the specific detail of the eligibility requirements in order to think that help from someone like that would be needed. If the eligibility requirements relating to assets were just 'it has to be a bond' then there wouldn't be any obvious need for someone external to look at the asset to tell you that. So you would have to know that the actual requirements are more complex than that.

But that's just my personal view of course!

Hello,

I am trying to get my head around (iv). My understanding is the following:

1. The credit spread will include both the fundamental(risk of default) and illiquidy spread.
2. If the credit spread widens, under stress scenario, then both the fundamental and illiquidity spread will increase.
3. The fundamental spread widening will reduce the value of the assets but will have not impact on the discount rate rate used for Technical provision (TP).
4. With the inclusion of Matching Adjustment (MA), widening of credit spread will also include MA widening which is used to discount TP.

As a result inclusion of MA will lower the capital requirements of credit spread widening?

So if there is no (MA) a credit widening stress will mostly reduce the asset side. With MA it will impact both asset and liability...hence the overall impact is lower therefore SCR requirement is lower with MA

Thanks,

 

[mugono]

Hello,

I am trying to get my head around (iv). My understanding is the following:

1. The credit spread will include both the fundamental(risk of default) and illiquidy spread.
2. If the credit spread widens, under stress scenario, then both the fundamental and illiquidity spread will increase.
3. The fundamental spread widening will reduce the value of the assets but will have not impact on the discount rate rate used for Technical provision (TP).
4. With the inclusion of Matching Adjustment (MA), widening of credit spread will also include MA widening which is used to discount TP.

As a result inclusion of MA will lower the capital requirements of credit spread widening?

So if there is no (MA) a credit widening stress will mostly reduce the asset side. With MA it will impact both asset and liability...hence the overall impact is lower therefore SCR requirement is lower with MA

Thanks,

Responses in turn.
1. credit spread = retained risk + illiquidity premium. The retained risk is generally equated to downgrade and default risk.
2. that is conceptually what you may expect to happen. It's certainly what I'd expect to see for internal model firms. The Fundemental Spread under the Solvency II Standard Formula is insensitive to spread widening iirc (I haven't checked the calibration). The consequence is that any spread widening will be attributed to illiquidity. [This may or may not be too detailed - refer to the core reading.]
3. Credit spread widening will affect the value of the assets. Solvency II allows insurers to take some credit for the widening of credit spreads (the illiquidity spread component) via the discount rate: i.e. as a volatility adjustment or matching adjustment.
4. Yes.

Yes - the inclusion of MA will lower the capital requirements. The dynamic nature of the MA in stress and the inclusion of the MA in base both serve to reduce the credit risk SCR.

 

[Tong_Tong]

Thanks for your response. My understanding is that Fundemental spread is effectively the retained credit risk...So if we were to widen the credit spread, I would expect the retained risk/fundemental spread to increase?

 

[mugono]

Thanks for your response. My understanding is that Fundemental spread is effectively the retained credit risk...So if we were to widen the credit spread, I would expect the retained risk/fundemental spread to increase?

Yes, it would not be unreasonable to expect some of the credit widening to be due to the market changing (increasing) its expectation around the level of retained risk when spreads widen.

Also see the second response above.