Towers Watson survey shows industry split over asset eligibility.
UK insurers are developing more granular models to measure the risk of default in their assets, in an attempt to maximise the benefit of Solvency II's matching adjustment (MA).
An industry survey by consultancy Towers Watson demonstrated that there is a growing interest among annuity providers in particular for modelling default and spread risk separately in their internal models.
The survey also showed that disparate views remain about the list of admissible assets -- less than one year before the deadline for firms to submit a pre-application to use the MA.
The MA is one of the measures in the Solvency II framework to protect long-term insurance businesses, especially those offering guarantees. The adjustment is an allowance to the swap-based discount rate, designed to ensure that the values of closely-matched assets and liabilities move in tandem.
This allowance equals the part of the credit spread that is not attributable to the risk of default and downgrade or migration. In other words, it is calculated by subtracting a so-called fundamental spread from the credit spread.
But determining this fundamental spread – and how it moves in stressed markets – is not straightforward, in particular under the standard formula, which fails to isolate default and migration risk from spread risk.
In the face of this, some internal model firms are developing their models in a way that enables them to gauge the two risks separately. According to Towers Watson's survey nine out of 10 insurers are doing it with external ratings (see Figure 1).
The calculations of the fundamental spread can have a very sizeable impact on the MA benefit, said Tim Wilkins, market risk expert at Towers Watson. "If firms are allowed to assume that stressed spreads are driven for the most part by liquidity risk [as opposed to default risk], the fundamental spread will not move dramatically and the MA will negate much of the impact of the shock," he explains.
It remains to be seen to what extent the regulator would allow that. In a regulatory update published in August, the Prudential Regulation Authority (PRA) suggested that firms should take a more prudent approach, but fell short of providing details.
Regulatory uncertainty over other key aspects of the MA is also causing problems for firms. The survey demonstrated the industry is split on the eligibility of assets.
Asked about infrastructure loans and bonds, for instance, four insurers considered those to be eligible, while two others said they were not. In the case of equity-release mortgages, which account for a substantial share of the portfolio of some annuity providers, one firm answered yes, against three that said no and two that said they were not sure (see Figure 2).
This comes after the PRA ruled out publishing a closed list of assets deemed eligible. The regulator said it is up to firms to justify that a given security or loan complies with the criteria.
"Firms cannot generalise," Wilkins observes. "They need to go line-by-line and decide based on the cash-flows and the terms of the contract. It is quite an onerous process and everything is made more difficult because there are areas of uncertainty, including the extent to which pre-payment risk is acceptable."
A common view on diversification benefit is also yet to emerge. Eight firms responded that they plan to use excess returns in matching assets to cover losses in other parts of the business, while another seven said they did not expect to be allowed to do so. Wilkins said that firms are trying to avoid this issue by minimising as much as possible the amount of surplus assets in MA portfolios.
