Matching Adjustment

Discussion in 'SA2' started by vikky, Aug 15, 2017.

  1. vikky

    vikky Ton up Member

    IF a company would recalculate its Coverage ratio( Own Funds/SCR) without any dependence on MA, what effect would this have on OF?
    My understanding is that the liabilities would go up as we have a lower discounting rate with MA removed. However am not sure if this would have any effect on the asset valuation side?
  2. Lindsay Smitherman

    Lindsay Smitherman ActEd Tutor Staff Member

    Using an MA increases the discount rate used for that part of the business for which the MA is approved. Hence its use will reduce the technical provisions relative to not using one.

    The valuation of assets is at fair value, which would be market value where this is available - and the MA is not relevant.

    [There is another thread discussing whether the MA could potentially relevant for the valuation of reinsurance recoveries, but you don't need to worry about this.]
  3. Viki2010

    Viki2010 Senior Member

    Hi Lindsay, the VA does not include an explicit subtraction of a fundamental spread. Would the credit risk still remain with the insurer as it is the case when MA is applied?
  4. Lindsay Smitherman

    Lindsay Smitherman ActEd Tutor Staff Member

    Yes it would. Consider simplistically:

    Yield on credit-risky bond = risk-free interest rate + illiquidity premium + allowance for default risk (= fundamental spread)

    The discount rate including MA is determined by deducting the fundamental spread from the actual asset yield, which gives risk-free rate + illiquidity premium. The VA is an addition to the risk-free rate to allow for illiquidity. So they represent the same thing.
  5. dimitris13

    dimitris13 Ton up Member

    hi there,
    I have three quick qs.
    1. is MA=Bond Spread - FS?
    2. According to Eiopa i see that FS=max(PD+CoD;35%LTAS).
    However the following sentence from the latest Technical documentation for int rates mentions
    "In general, the MA should be calculated on the basis of the amount FS – PD = max(CoD, 35%·LTAS – PD)"
    does this mean that MA=Bond Spread-(FS-PD)?

    On the other hand CMP notes mention the following: discounting = rf+Spread-FS= rf+(ILP+CRP)-FS= rf++ILP.

    3. So how MA is related to ILP?
    I know , and has also been mentioned above that VA is related with liquidity too but somehow (at least mathematically MA is also related to illiquidity)
  6. mugono

    mugono Ton up Member

    Good questions:
    1 & 2. The official definition of the fundamental spread is set out in the Solvency 2 text, which as you say is based on the higher of PD + COD; or a % of the LTAS. The % is different for corporate and government bonds.

    Most people (including myself :)) are ‘lazy’ and only refer to PD + COD when speaking / thinking about the dynamics of the fundamental spread. This probably wouldn’t occur if / were the LTAS element of the calculation to be the biting component.

    The conceptual and legal definition of the FS is: FS=max(PD+CoD; x%LTAS)

    My understanding is that the additional text in the technical documentation you quote: "In general, the MA should be calculated on the basis of the amount FS – PD = max(CoD, 35%·LTAS – PD)" was added to correct for an inconsistency that exists within the approach used to calculate the PD and COD in a manner that didn’t breach legally binding text!

    The COD is based on the assumption that a bond, following downgrade, would be replaced with an equivalent bond at the original (ie pre downgrade) credit rating.

    This assumption then gets ignored for the purpose of calculating the PD. And consequently causes an inconsistency between the two components.

    If memories serves correctly, the industry highlighted this issue owing to concerns that the FS effectively baked in a double count. The stated approach (ie to deduct the PD) was judged to be acceptable on both legal and technical grounds as a way to remove this double count (PD risk still remains).

    3. MA and VA are conceptually harvesting the same thing: an illiquidity premium. The calculation approach differs for various (non technical) reasons.
    dimitris13 and Em Francis like this.

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