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Use of volatility adjustment for WP or UL business

M

Max Clinton

Member
Hi, I have a question on the use of volatility adjustment for WP or UL business.

So the purpose of the VA is to reduce the risk of forced sales of assets (bonds) in the event of extreme bond movements. It does this by increasing the risk free rate used to discount liabilities, thus reducing the value of liabilities to offset the fall in asset values.

So would the VA be able to be used for UL/WP business where these were (say) invested solely in equities not bonds? This would be beneficial as we could project forward unit fund / asset shares at a higher risk free rate which would increase value of proportional charges (UL) / reduce chance of guarantees biting and so reduce cost of guarantees (WP). So in both cases this could reduce the SII BEL, but would this be allowed?

Thanks,

Max
 
Hi, I have a question on the use of volatility adjustment for WP or UL business.

So the purpose of the VA is to reduce the risk of forced sales of assets (bonds) in the event of extreme bond movements. It does this by increasing the risk free rate used to discount liabilities, thus reducing the value of liabilities to offset the fall in asset values.

So would the VA be able to be used for UL/WP business where these were (say) invested solely in equities not bonds? This would be beneficial as we could project forward unit fund / asset shares at a higher risk free rate which would increase value of proportional charges (UL) / reduce chance of guarantees biting and so reduce cost of guarantees (WP). So in both cases this could reduce the SII BEL, but would this be allowed?

Thanks,

Max

In the UK, you are not allowed to use VA for UL.

You can for WP but your portfolio must mee certain requirements and requires PRA approval in the UK. I am not sure of the precise details but presumably requires a certain amount of bonds and a reaonable mix.

In terms of WP CoG calculations, the EIOPA rules aren't that specific and I have seen interpretations saying that you either should or shouldn't increase the rate asset shares are projected at but in both cases you can increase the discount rate use for dicsounting the guarentee payoffs.
 
Studier has provided a good answer within the UK context.

Solvency 2 leaves it up to individual member states to decide whether firms in their jurisdiction require supervisory approval to apply a VA.

Some countries, eg UK took up this option whilst other countries, eg France did not.

The implication for French insurers is that they can apply a VA to all liabilities.
 
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Hi Max - just to the add to the (very good) answers you have had already:
  • One of the PRA requirements is effectively that the business on which a VA is approved has to have sufficiently 'predictable' liability cashflow (this relates to meeting the liquidity management part of the approval process). In the UK, I understand that VAs are most likely to be applied for on an annuity portfolio which has not met the MA criteria or (as indicated above) WP business (where there is sufficient underpinning guaranteed benefit to meet the predictability requirement).
  • However, the SA2 Core Reading doesn't go into this amount of detail and also, as indicated above, different approaches are taken in different EU countries. You therefore don't need to be concerned with this level of detail for the exam and could simply consider a VA to be a 'maybe' whatever the type of business (unless an MA is already in use on that business, of course).
  • Remember that the VA is based on a representative portfolio of assets - it doesn't matter what assets the company is actually holding: the risk-free rates that the company can use, including the VA, are absolutely set by EIOPA.
Hope that helps.
 
Thanks mugono and Lindsay for your added explanations :)!
 
Regarding volatility adjustment's application- The purpose is to reduce forced sale of assets in the event of extreme bond spread movements. As extreme bond spread movements here relate to future, are we saying that volatility adjustment is applied for inforce block of business (hence in current time period) anticipating extreme future spread movement? If there is no such extreme movement of bond in reality + insurer already has applied VA , would this mean that the insurer has understated BEL as risk free rate is higher after addition of VA?

Or, is VA applied only when insurer actually faces such an extreme situation- say during the pandemic?

Please confirm.
 
If an insurer is eligible for using the VA, they use a different set of risk-free rates from EIOPA = rates that have the VA added into them. So they would be using the VA all the time.

Under 'normal' market conditions, the VA will be small. As soon as there are spread movements in the market, the VA will change: big increase in spreads -> fairly big increase in VA (it's not an exact 1 for 1 relationship).

So the VA reflects actual market movements that have happened, not what might happen in the future.
 
Alright. Similar to how EIOPA publishes risk free yield curve on a monthly basis, they would be publishing VA and MA fundamental spread also every month and in case of extreme market events, the insurer would adjust their VA accordingly by changing the discounting rate. In this manner, the risk of forced sale of assets of insurer is lower.

Let me know if there is anything else. Thank you so much!
 
Regarding internal model tests for getting approval, can you help me with simplification of profit and loss attribution test?

Does this mean identifying all sources of profits and losses? How is it related to categorization of risk chosen?
 
Alright. Similar to how EIOPA publishes risk free yield curve on a monthly basis, they would be publishing VA and MA fundamental spread also every month and in case of extreme market events, the insurer would adjust their VA accordingly by changing the discounting rate. In this manner, the risk of forced sale of assets of insurer is lower.

Let me know if there is anything else. Thank you so much!
Yes that's right - except the insurer doesn't 'adjust their VA' as such - they just keep using the rates provided by EIOPA, which would then (under such circumstances) have a larger VA included within them.
 
Regarding internal model tests for getting approval, can you help me with simplification of profit and loss attribution test?

Does this mean identifying all sources of profits and losses? How is it related to categorization of risk chosen?
Yes it's basically like doing an analysis of surplus. The company should be showing how the various factors that generate risk and uncertainty within their business (eg mortality differing from expected) have contributed to actual profits / losses over the period. If an event happened to cause a significant loss during the year, and they had not been reflecting that risk anywhere within their internal model, questions might be asked!
 
Sept 2021-

Q1, part ii)
Examiner's report for interest rate up and credit spread up mentions that

'not offset by any change in VA'

I did not understand the reference completely. Are we saying that if interest rate increases and credit spread increases, given the insurer applies volatility adjustment, EIOPA will publish the higher risk free + VA. This will reduce BEL (at a discount rate which will be higher than increase in risk free rate due to higher VA) but asset will still fall more than BEL in both cases (as asset duration is higher).

Is this correct?

Also, why have we referred to free assets when the question mentions 'own funds, risk margin and other liabilities'? As I understand, for 50% eq, 25% FI bonds and 25% property, some of it would belong to free assets but not entirely.
 
Can someone please clarify today if possible?
Sept 2021-

Q1, part ii)
Examiner's report for interest rate up and credit spread up mentions that

'not offset by any change in VA'

I did not understand the reference completely. Are we saying that if interest rate increases and credit spread increases, given the insurer applies volatility adjustment, EIOPA will publish the higher risk free + VA. This will reduce BEL (at a discount rate which will be higher than increase in risk free rate due to higher VA) but asset will still fall more than BEL in both cases (as asset duration is higher).

Is this correct?

Also, why have we referred to free assets when the question mentions 'own funds, risk margin and other liabilities'? As I understand, for 50% eq, 25% FI bonds and 25% property, some of it would belong to free assets but not entirely.

In my understanding, the meaning of not offset by any change in VA is just to apply a stress. Because if we apply the VA, the the stresses won't be applied.
 
In the standard formula if the credit spread widened it is assumed to be entirely due to higher default risk, and because the VA is an adjustment for liquidity risk then it will not have an offsetting impact.
 
Hi
In September 2020, the examiner's report mentions that
  • If the volatility adjustment has been applied for this will offset an element of the corporate credit impact, but not the majority of it.

    according to the above post, VA should not have offset the credit spread widening stress. Can you please help understand the discrepancy?

    Thanks
 
I think you are confusing different concepts.

The post above is about the rules that apply when determining the SCR using a standard formula approach. Under that approach, no credit can be taken in the SCR calculation for an increased VA under the credit spread widening stress. (This isn't the case if an internal model is used: the VA can be 'dynamic'.)

The question is asking about what would happen to the company's balance sheet under a given scenario. The point you have quoted is basically saying that if the company uses a VA when discounting its liabilities, and the spread widening is partly due to liquidity risk, then the VA would increase under that situation and so the technical provisions would reduce.
 
Thank you for your reply

Can you please confirm, in September 2020, we are considering the impact of a certain event/stress on the SCR whereas in the thread we are looking at the stress which would be applied for calculating SCR in the first place?
 
Look again at the question wording. Sept 2020 Q3(i) (which I presume you are referring to) is asking about the impacts of the scenario event on the company's estate, defined as assets minus technical provisions, as well as on its required capital (equivalent to SCR). So it isn't just about impact on SCR, it's also about impact on (assets and) TP.
 
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