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SA2 Volatility adjustment vs matching adjustment

W

Whitney10

Member
Hi

What are the differences between the volatility adjustment and the matching adjustment under SII?

Could anyone help me?

Thanks
 
"What are the differences between the volatility Adjustment (VA) and the Matching Adjustment (MA) under SII?

Could anyone help me?"


Both are an addition to the discount rate to mitigate impact of spread movements on the insurer's balance sheet from insurer’s who write products with long-term guarantees.

An MA is used where insurers have long-term predictable liabilities (such as annuities), and can hold matching assets to maturity. They are therefore not exposed to the risk of changing spreads on these assets (they are not exposed to the liquidity component of spread risk, although they are still exposed to default risk). By applying an adjustment to the rate used to discount the liabilities, they are reducing liabilities to match the fall in asset values due to the liquidity component of the spread. Ie they are allowed to take credit for the additional compensation that investors gain by holding an illiquid asset (the illiquidity premium).


A VA is used to reduce impact of large movements in spreads from unrealistic assessment of expected losses or unexpected credit risk. So as opposed to MA which is used for small and frequent changes in spread, the VA is intended to reduce impact from large and infrequent changes in spread due to market panic.


Whereas the MA will be applied to a ring fenced set of assets used to back a particular liability, ie an annuity portfolio. A VA can be applied to all business.


There are also differences in how these are calculated:


The MA is based on the assets of the insurer and is calculated as the spread over risk-free rates on the matching assets less an allowance for defaults and costs of downgrades (the fundamental spread which is determined by EIOPA for each asset class).


MA is therefore tailored to the firm’s asset-liability profile and will provide the best protection against artificial volatility on the balance sheet but also restricts the investment options and liability structures.


Whereas the VA is based on a representative portfolio calibrated at currency and country level (similar to the EIOPA risk free rate). It is calibrated at a % of the risk-adjusted spread of assets in this representative portfolio.


The VA gives more freedom with investments and less maintenance/justification required as to why the portfolio meets any criteria but basis risk exists between the calibration of the adjustment and the actual assets held by the insurer.

Does this help?
 
Hi, I have one additional question on MA and VA. Say, a company gains approval to use VA on all business but also gains approval to use MA. In this situation, would a company apply VA to all other business except annuities and MA to discount annuity cashflows? Or would the MA and VA be combined to discount annuity cashflows, as the mitigation purposes of both are different.
 
You can not combine both MA and VA together to discount liability cashflows.
You can find the regulations explicitly stating this in Article 77b paragraph 3 and Article 77d paragraph 5 of the recast SII directive.
 
Viki2010 said:
Hi, I have one additional question on MA and VA. Say, a company gains approval to use VA on all business but also gains approval to use MA. In this situation, would a company apply VA to all other business except annuities and MA to discount annuity cashflows? Or would the MA and VA be combined to discount annuity cashflows, as the mitigation purposes of both are different.
Click to expand...

A VA and MA cannot be applied together on the same line of business.

The VA is least likely to be used for annuities as a company would want to make use of the potential higher adjustment permitted via the MA. So the use of the VA for annuities will most likely arise if a company were refused permission by the regulator to use an MA.

Application of VA/MA is associated with products with long term guarantees. The Solvency II regulatory framework does not include a legal definition of "long-term guaranteeS".

Examples of non annuity traditional life insurance products include with profit contracts, unit-linked policies with guaranteed investment yield, etc.

Examples of these guarantees include those on interest, sum assured, surrender value.

 
Hi

Thanks for the reply. It was very useful.

If the VA is for large spread movements and the MA is for small spread movements, why the MA is higher than the VA?

Could the MA be applied the equity release mortgage and income protection?

Thanks
 
Hi

The VA is designed in order to protect insurance companies from large spread movements which might otherwise cause panic selling of certain asset types, which itself could cause further market falls.

The MA deals better with small spread movements than the VA does, but the MA will also be highly useful in situations when there are large spread movements.

The MA is generally higher/better to use than the VA, where possible to do so, because:
- it is based on actual assets held rather than a reference portfolio
- it is based on the full liquidity spread (the VA is targeted to about two-thirds of the liquidity spread - although note that this is not covered explicitly in the Core Reading so you should not be expected to know it)

See the following thread re equity release mortgages and the MA:
https://www.acted.co.uk/forums/index.php?threads/chapter-15-page-25.13775/#post-51223

Income protection insurance products do not have sufficiently predictable liabilities: the income will only be payable when someone becomes sick, and the duration is uncertain as it will depend on the length of sickness/disability. They therefore cannot be cashflow matched by holding assets to maturity, and therefore they would not meet the eligibility requirements for an MA.

Hope that helps. :)
 
Would reviewable or impaired life or index linked annuities be approved for MA?
 
Hi

Index-linked annuities: yes in theory, if the liability cashflows can be matched closely enough using index-linked bonds (that are linked to the same index) - but this can be difficult to achieve in practice as there are fewer issues of index-linked bonds than of conventional bonds. Also, index-linked bonds tend to be government issues rather than corporates and therefore would not be expected to have material spread - so there would not be any material MA to be achieved.

Reviewable annuities: I would imagine not, because the liabilities are not sufficiently "predictable" due to the annuity amount being reviewable.

Hope that makes sense?
 
Lindsay Smitherman said:
Hi

Index-linked annuities: yes in theory, if the liability cashflows can be matched closely enough using index-linked bonds (that are linked to the same index) - but this can be difficult to achieve in practice as there are fewer issues of index-linked bonds than of conventional bonds. Also, index-linked bonds tend to be government issues rather than corporates and therefore would not be expected to have material spread - so there would not be any material MA to be achieved.

Reviewable annuities: I would imagine not, because the liabilities are not sufficiently "predictable" due to the annuity amount being reviewable.

Hope that makes sense?
Click to expand...
I quite like this answer. The 'like' button wouldn't do my 'like' justice.
 
Lindsay Smitherman said:
Hi

Index-linked annuities: yes in theory, if the liability cashflows can be matched closely enough using index-linked bonds (that are linked to the same index) - but this can be difficult to achieve in practice as there are fewer issues of index-linked bonds than of conventional bonds. Also, index-linked bonds tend to be government issues rather than corporates and therefore would not be expected to have material spread - so there would not be any material MA to be achieved.

Reviewable annuities: I would imagine not, because the liabilities are not sufficiently "predictable" due to the annuity amount being reviewable.

Hope that makes sense?
Click to expand...

Thank you. It makes sense!
 
Are the MA and VA only really useful for conventional without profits business, i.e. would they be useful for WP and unit linked business?

UL: BEL = unit fund BEL + non unit fund BEL

Unit fund BEL = unit price x number of units --> No discounting so MA, VA are Non applicable
Non unit fund BEL = PV (expenses + benefits in excess of unit fund - charges) --> involves discounting so MA, VA possibly applicable if allowed?

WP BEL = PV (expected total future benefits (i.e. both those that are currently guaranteed and discretionary future benefits) + expenses - premiums) --> involves discounting so MA, VA possibly applicable if allowed?
 
MLC said:
Are the MA and VA only really useful for conventional without profits business, i.e. would they be useful for WP and unit linked business?

UL: BEL = unit fund BEL + non unit fund BEL

Unit fund BEL = unit price x number of units --> No discounting so MA, VA are Non applicable
Non unit fund BEL = PV (expenses + benefits in excess of unit fund - charges) --> involves discounting so MA, VA possibly applicable if allowed?

WP BEL = PV (expected total future benefits (i.e. both those that are currently guaranteed and discretionary future benefits) + expenses - premiums) --> involves discounting so MA, VA possibly applicable if allowed?
Click to expand...

I'd like to know the answer to this question too. I feel like you won't be able to get WP or UL annuities into the MAP unless the funds were invested in bonds, but then the bonds would have to be chosen to match the annuity payments. This would mean that they wouldn't generate any extra return to increase the annuity payments anyway, so they might be WP and UL by name but conventional in nature. Look forward to a reply from Emma/Lindsay.
 
MLC said:
Are the MA and VA only really useful for conventional without profits business, i.e. would they be useful for WP and unit linked business?

UL: BEL = unit fund BEL + non unit fund BEL

Unit fund BEL = unit price x number of units --> No discounting so MA, VA are Non applicable
Non unit fund BEL = PV (expenses + benefits in excess of unit fund - charges) --> involves discounting so MA, VA possibly applicable if allowed?

WP BEL = PV (expected total future benefits (i.e. both those that are currently guaranteed and discretionary future benefits) + expenses - premiums) --> involves discounting so MA, VA possibly applicable if allowed?
Click to expand...
Aladinsane said:
I'd like to know the answer to this question too. I feel like you won't be able to get WP or UL annuities into the MAP unless the funds were invested in bonds, but then the bonds would have to be chosen to match the annuity payments. This would mean that they wouldn't generate any extra return to increase the annuity payments anyway, so they might be WP and UL by name but conventional in nature. Look forward to a reply from Emma/Lindsay.
Click to expand...

The MA eligibility criteria are set out in the Solvency 2 Directive. The criteria themselves focus on the features of an insurance contract and does not identify specific products. My suggestion would be to be focus on the liability features themselves (eg no regular premiums, only certain underwriting risks are permissible (eg excludes morbidity risk); and no policyholder optionality other than the option to surrender in specific circumstances).

A contract that satisfies the eligibility criteria will be able to apply a MA when discounting a stream of future cash flows.

In practice you’d need to assess the product features for MA eligibility on a case by case basis; so I’m therefore reluctant to be definitive about what types of product are ‘in or out’.

However, I can say that the example you’ve given of WP BEL, which includes future premiums would breach the eligibility criteria ref no future premiums. The MA could not therefore be applied to products with that feature.

In relation to the volatility adjustment; the Directive includes a member state option to require insurers to obtain regulatory approval prior to its use.

The UK for eg took up this option and included approval conditions that UK firms need to meet. The ability for firms to apply a VA to unit linked contracts (specifically, the non unit part of BEL) is prohibited.

By contrast, the French has no such approval criteria and can apply the VA without prior approval. Consequently, I would expect that French insurers apply VA to all business (including the non unit part of their UL BEL).

Hope that helps. Happy to discuss.
 
Simplistically, credit spread on corporate bond = default risk premium + illiquidity premium

The phrase you have quoted refers to the risk of the second of these components changing (with increasing, ie spread widening, likely being the downside risk)
 
Lindsay Smitherman said:
Simplistically, credit spread on corporate bond = default risk premium + illiquidity premium

The phrase you have quoted refers to the risk of the second of these components changing (with increasing, ie spread widening, likely being the downside risk)
Click to expand...
So when the spread increases, the liquidity risk goes up because now, the asset price falls and it’s enough to pay liabilities and the insurer needs to look for other sources of cash flow to pay? However, if the insurer has matched liabilities with fixed term bonds, the widened spread (due to illiquidity) doesn’t have any impact on the liability payments since the bond issuer is obliged to pay what was agreed at the outset. Obviously, default risk is there.

Is this understanding correct?
 
This sounds a little confused and you seem to have the driver the wrong way round. Reduction in liquidity of corporate bonds (or greater liquidity risk in the market) -> increase in illiquidity premium.

However, if the bond cashflows are closely matched to liability cashflows, the insurer knows that it will hold the bonds to maturity. So it doesn't actually have any liquidity risk itself because it isn't going to have to sell the bonds at any point (liquidity risk in this context basically means the risk of being unable to sell the bonds or having to sell them at very depressed market prices).
 
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