Matching adjustment

Discussion in 'SA2' started by yogesh167, Aug 30, 2019.

  1. yogesh167

    yogesh167 Ton up Member

    Hello

    if company holds corporate bonds, we can take credit for illiquidity premium as MA while discounting under SII.

    Is MA adjustment affected depending on credit rating of corporate bonds?

    Similarly, can we take credit for illiquidity prem if we hold govt bonds?

    Thanks in advance
     
  2. mugono

    mugono Ton up Member

    I’m surprised this is not in the notes...

    MA is added to the risk free rate prescribed in the rules.

    Conceptually, the MA can be thought of as the difference between the (implied) spread on the ‘bonds and other assets with similar cash flow characteristics’ less the fundamental spread (FS). The FS will vary, amongst other things, by credit rating.

    Government bonds that are included in a firm’s MAP will contribute towards the calculated MA benefit as any other asset in the MAP.
     
    Last edited: Aug 30, 2019
  3. Em Francis

    Em Francis ActEd Tutor Staff Member

    Thanks for this Mugono

    The fundamental spread is described in the notes (Section 2.1 of chapter 11).
    Thanks
    Em
     
  4. yogesh167

    yogesh167 Ton up Member

    What do you mean by MAP here?
     
  5. Aladinsane

    Aladinsane Active Member

    Worth pointing out that the spread on the bond will depend on its credit rating (lower rating, higher spread). The FS being dependent on credit rating seems like a secondary consideration.

    Also MAP = Matching Adjustment Portfolio, i.e. the ring-fenced fund of assets and liabilities, where the assets are used to determine the MA and the MA is applied to those liabilities.

    Govt bonds can be used to get an MA, but firms probably won't waste their time bothering to get an MA using govt bonds because the spread will be so low. They'll want to use more liquid assets with a higher spread, e.g. corps.
     
  6. mugono

    mugono Ton up Member

    Good challenge :).

    It may indeed be the case that an investor would look at the rating on a bond to determine what to bid for it (which will generate an implied spread).

    For insurance firms, the matching adjustment is an amount in excess of the risk free rate that the insurer can earn in a 'risk free manner'. The fundamental spread (cost of downgrade + cost of default, floored by the long-term average spread) represents risk that the insurer should retain.

    The FS is entirely relevant in getting to an appropirate amount of matching adjustment that eligible liabilities can recognise up front. Remember: MA is a liability (not asset) adjustment.

    Finally, Uk firms do include government bonds within their matching adjustment portfolios (MAP). The typical maturities on corporate bonds is a lot shorter than governments. And so firms seeking to match their assets and liabilities may have no or limited choice but to purchase such "lousy" yielding assets :). Although in practice, the search for yield may drive insurers into other asset classes, e.g. infrastructure (equity release mortgages, commercial real estate etc).

    Hope that helps.
     
    Em Francis likes this.

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