SII effects on asset managementCFA UK31 October 2012

Servaas HoubenMaarten Koppenens

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Agenda

• The VaR framework▫ Return on capital in Solvency II

• The current landscape▫ Risk free rate in insurance▫ Spread components▫ Solvency II framework▫ Sovereign credit risk

• Opportunities for asset managers▫ Return on capital optimisation▫ Hedging and de-risking

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Mark to market value matters• Value at Risk

▫ Solvency II suggests 99.5% percentile▫ Over the last 5 years about 1,800 daily returns, 99.5% VaR is the 9th worst

daily return▫ Equity looks very risky indeed on this measure

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A comparison of VaR across asset types

Source: Bloomberg,

4

Assets of European insurance companies

Source: Bloomberg

5

The Big 5 dominate - regional asset size

Source: Bloomberg,

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Return on capital - Summary

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The return on capital for an individual asset class is calculated as the return above the minimum guarantee rate of 2.5% divided by the requiredcapital charge for that asset class.

Viewed in isolation, the RoC of an individual asset class is a straightforward indicator of its attractiveness. However, in the context of theportfolio, the RoC of the entire portfolio does not necessarily consist of the asset classes with the highest RoC, due to the effects of aggregatingthe return and the charge.

2 years duration bucket

4 years duration bucket

6 years duration bucket

8 years duration bucket

3% 12% 12% 17% 26% 28% 31%47% 50% 50% 59%

87%

CLOS (Cash SMEs) Equity Property Mortgages Cov AA Corp AA Brazil (BBB) CollateralisedFunding (US RMBS

AAA)

CollateralisedFunding (High Yield)

CollateralisedFunding (FI

Securities includingCLOs)

Corp BBB Corp A

0% 1% 4% 5% 12% 12% 15% 16% 17% 27% 30% 36% 39% 42% 59% 65% 83%

RMBS UK(Prime)

RMBS Dutch(Prime)

India (BBB) CLOS (CashSMEs)

Equity Property Corp AAA Korea (A) Mortgages Corp AA Cov AA Corp A Corp BBB Brazil (BBB) CollateralisedFunding (USRMBS AAA)

CollateralisedFunding (FISecuritiesincluding

CLOs)

CollateralisedFunding (High

Yield)

1% 1%9% 12% 12% 13% 17% 21% 21%

25% 28% 29%39%

Russia (BBB) Cov AAA India (BBB) Equity Property Korea (A) Mortgages Corp AAA Brazil (BBB) Corp AA Corp BBB Cov AA Corp A

8% 12% 12% 12% 14% 17%21% 22%

28% 29%37% 39%

Russia (BBB) Equity Property Cov AAA India (BBB) Mortgages Corp AAA Korea (A) Corp BBB Corp AA Corp A Cov AA

Risk free rate - 1

•Several options for risk free curve:▫Swap curve with credit adjustment▫Government curve▫Corporate bond curves▫Collateralised AAA curves

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Risk Free rate - 2Snapshot of market and Solvency II curves

Risk Management Hedging uses assets quoted on OISPricing (Guarantees) Funding for hedging based on OISProvisioning Solvency II based on LIBOR & UFR

– One-off surplus (based on current market environment)– Hedging efficiency and provisioning risk due to LIBOR-OIS basis

EUR 24 August 2012

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

1 11 21 31Term (Years)

EUR / 24 August 2012 / Spot / Annual

Market LIBORMarket OISSolvency II Risk Free

Source: Bloomberg

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Spread components•Spread = yield corporate bonds – risk free yield ▫Credit risk factors:Expected defaultSpread wideningDowngrade/transition

▫Non credit risk factors:TaxRegulatoryLiquidity

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Solvency II & Basel III spread assessment• Solvency II favours EEA government debt over other forms of sovereign debt

• Basel III does not make this EEA/non EEA distinction

• Issues regarding the standard formula:

– No capital requirement EEA government/CDS exposure

– No inclusion in default risk module

– Preferential treatment of government bonds

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Solvency II sovereign categorisation

Issued in domestic currency

Issued in non-domestic currency

EEA government bonds None Level 2 text: Article 156.3 –high charge

Non-EEA government bonds

Level 2 text: Article 163 SR7.4 – low charge

Level 2 text: Article 156.3 –high charge

Differentiation EEA governments 1

Yield as per 1 Jan 2006

2

2.5

3

3.5

4

4.5

- 5 10 15 20 25 30

Term in years

Yiel

d: G

er, F

ra, G

re, B

ri

Germany France Greece Britain

12

Source: Bloomberg

Differentiation EEA governments 2Yield as per 14 Feb 2012

0

0.5

1

1.5

2

2.5

3

3.5

4

- 5 10 15 20 25 30

Term in years

Yiel

d: G

er, F

ra, B

ri

0

50

100

150

200

250

300

350

400

450

Yiel

d G

reec

e

Germany France Britain Greece

13

Source: Bloomberg

Differentiation EEA governments 3CDS development

-

50

100

150

200

250

31/01/2006 15/06/2007 27/10/2008 11/03/2010 24/07/2011date

CD

S pr

emiu

m G

er, F

ra, B

ri

-

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

CD

S pr

emiu

m G

re

Germany France Britain Greece

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Source: Bloomberg

Conflicts of interest government yield curve

• Government can avoid default• In case of default local regulator is under pressure to write down liabilities

in line with the loss in value of local government bonds

Policyholder security

Pressures government to reduce liabilities

National interest, stability, political motives

Insurance company

Regulator

Government

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Default definition – what’s in a name?• Dominic Republic 2005:

▫ Recovery rate on defaulted bonds 95%▫ Rating agencies’ verdict: default

• Zimbabwe 2006:▫ Annual inflation rate: 1,216% p/a▫ Rating agencies’ verdict: no default

• Angola 1996:▫ Annual inflation rate: 4,416% p/a▫ Rating agencies’ verdict: no default

Default and re-scheduling

1800-24 1825-49 1850-74 1875-99 1900-24 1925-49 1950-74 1975-2006

Africa NA NA 1 1 1 0 1 21

Asia NA NA NA NA 1 2 4 7

Europe 13 9 7 5 2 12 0 7

Latin America NA 15 10 22 13 18 11 36

Default and re-scheduling

1800-24 1825-49 1850-74 1875-99 1900-24 1925-49 1950-74 1975-2006

Africa NA NA 1 1 1 0 1 21

Asia NA NA NA NA 1 2 4 7

Europe 13 9 7 5 2 12 0 7

Latin America NA 15 10 22 13 18 11 36

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Reinhardt & Rogoff

Limitations rating agency data

• Lack of historical data: are the Probability of Default and Recovery Rate robust?

• Changing data set over time: historical average not reflecting future risks

• Lack of transparency: how to compare different 1-year PDs?

• Difference local and foreign defaults• No historical 1 year PD for

investment grade (BBB and higher)• Lowest rating is “mixed” bag

0%10%20%30%40%50%60%70%80%90%

100%

1983 1990 1995 2000 2005 2010

Moody's distribution sovereign issuer ratings

Aaa Aa A Baa Ba B Caa-C

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Moody’s

Matching Premium – Draft Level 2 Text

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Methodology

Matching Premium Spread

= IRR on Asset portfolio - Fundamental Spread - IRR on liability cashflows (discounted using Solvency II risk free rate.)

Fundamental Spread

= MAX (Minimum Fundamental Spread, Expected Default)

Expected Default

= Probability of Default x LGD + Marked to Market due to a rating downgrade

Minimum fundamental spread

= 75% of Long Term Average Spread

Qualifying Liability

• No future premium allowed.

• Underwriting risk covers only longevity, expense and revision risks

• No option for surrender or only a surrender option where the surrender value does not exceed the value of the assets.

Assumptions

Our analysis assumes:

• Long Term Average Spread by rating and term can be derived from the iBoxx GBP Corporate Bond Index spread history.

• Fundamental Spread is equal to 75% of Long Term Average Spread.

• Assets are invested in the same index constituents by rating and term as the relevant iBoxx indices.

Qualifying Assets

• Ring fenced from other insurance portfolio

• Same currency as liability.

• Cashflow matched to liability cashflows.

• Cashflows of the assets are fixed cannot be changed by the issuer or any third parties. (Except for Inflation linked instruments matching inflation linked liability)

• Investment grade bonds only

• Limited to a maximum investment of 30% in BBB bonds

• Limited to a maximum investment of 15% in BBB for bonds which are purchased after 31-Dec-2012

Matching Adjustment – Draft Long Term Guarantee Assessment

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Matching Adjustment (previously known as Matching Premium) is split into “Classical Matching Adjustment” and “Extended Matching Adjustment”.

Classical Matching Adjustment (Article 77c)Same as the draft level 2 text “Matching Premium” approach.• No future premium • Underwriting risk covers only longevity, expense and revision risks• No option for surrender or only a surrender option where the surrender value does not exceed the value of the assets.

Extended Matching Adjustment (Article 77e)The insurance company can apply a portion of the matching adjustment to the portfolio which remains matched under stressed situations.

• Allows future premium • Underwriting risk covers only longevity, expense, revision, lapse and disability recovery risks.Key Impact – this widens the scope for applying matching premium to insurance liabilities other than UK and Spanish annuities. Insurance liabilities which previously were discounted using the risk free curve may be eligible for discounting at a higher yield than risk free yield.

Assessment for Cashflow MismatchThere will be a breach if one of these 2 conditions is not met for liability cashflows < last liquid point:a) sum of cashflows < sum of liability cashflows per bucket (monthly, quarterly, semi annually or annually)b) company unable to provide evidence that any mismatch shall not jeopardize the timely payment of benefits

Admissible assets • The limit on BBB rated bonds is 33.33%, excluding member state government bonds.• Make-whole clauses on callable bonds are eligible. • Cashflows of a single asset cannot be split into admissible & inadmissible parts.

Fundamental Spread• Some preliminary fundamental spread was presented for GBP and EUR corporates grouped by ratings, sectors and duration bands.

SCR Treatment• Under the SCR module, the increase in spread assumed in the spread SCR module can be passed on the discounting of liability as well.• This means that the liability value may be reduced under the matching adjustment treatment leading to a lower spread SCR when holding credit.

Transitional Measure• It appears that if the matching adjustment treatment is elected then the transitional measure would no longer apply.

Proposed Scenarios for the Quantitative Assessment

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I - Adapted relevant risk-free interest rate term structure

No adaptation

Standard adaptation

50% of standard adaptation

200% of standard adaptation

Standard adaptation only for liabilities w/ duration > 7 yrs

II - Extrapolation

QIS5 with LLP of 20 yrs for EUR

LLP 20yrs for EUR, 40 yr convergence

LLP 20yrs for EUR, 10 yr convergence

III - Article 77c Matching adjustment

No Matching Adjustment

Matching Adjustment

IV - Article 77e Matching adjustment

No Matching Adjustment

Matching Adjustment using standard adaptation for lapse risk

Matching Adjustment using alternative adaptation for lapse risk

V - Transitional Measures

No transitional measure

Transitional measure applied to all existing business

Transitional measure applied to paid in premiums only

VI - Scenarios

Reference date 31 December 2011

Reference date 30 June 2012

Reference date 31 December 2010

Reference date 31 December 2004

Prolonged low interest rate environment for 7 years

Matching Premium vs Liquidity Premium (1)

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Historic Comparison of iBoxx EUR Corporate A 10Y Matching Premium vs QIS 5 Liquidity Premium

1. Low spread environment generates a negative matching premium when the spread falls below the fundamental spread.

3. Post 2007 Matching Premium exceeds QIS 5 Liquidity Premium due to spread widening.

2. Pre 2007 -Matching Premium is below the QIS 5 Liquidity Premium.

QIS 5 Liquidity PremiumQIS5 Liquidity Premium (currency)

= 50% x MAX (iBoxx Corporate Spread (currency)- 40bps, 0)

• Varies by currency

• Independent of assets held

• Is fixed for the first 30 years of maturity and then set to 0.

• Floored at 0

Matching PremiumMatching Premium (rating, term, currency)

= 100% x [iBoxx Corporate Spread (rating, term, currency)- Fundamental Spread (rating, term, currency)]

• Varies by currency and rating

• Dependent of assets held

• Varies by maturity term.

• Can be negative.

• Matching Premium for BBB corporate is capped at the AA or A level.

Matching Premium vs Liquidity Premium (2)

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iBoxx EUR AAA 10Y Corporate iBoxx EUR AA 10Y Corporate

iBoxx EUR A 10Y Corporate iBoxx EUR BBB 10Y Corporate

Temporary spike in spread due to GE downgrade from AAA to AA

Matching Premium for BBB bonds is effectively floored at the AA level regardless of the spread on the BBB bonds.

QIS 5 Liquidity Premium is fixed and independent of the rating of the bonds invested.

Historic Comparison of iBoxx EUR Corporate 10Y Matching Premium vs QIS 5 Liquidity Premium by rating

Sample Matching Premium Calculation – iBoxx Corporate Index

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Based on our understanding of the likely proposal for Matching Premium, we have provided an estimate of the matching premium by rating and maturity term.

Long Term Average Spread = Average Z Spread on iBoxx Indices.

Note that there is no history prior to the inception of iBoxx indices back in 1999.

Fundamental Spread =

75% x Long Term Average Spread

iBoxx Corporate Spread =

Z Spread to Swap Curve

Matching Premium Estimate=

iBoxx Corporate Spread – Fundamental Spread Matching Premium for

BBB bonds is effectively floored at the AA level . Hence the overlapping line for BBB and AA corporates.

About usServaas Houben heads the risk scenario generation team at Prudential, London.

He studied econometrics in the Netherlands and worked in life insurance for the

first four years of his career. Following this, he worked in Dublin and London.

Besides actuarial, Servaas completed the CFA and FRM qualifications, and

regularly writes on his blog, for CFA digest and Dutch actuarial magazines.• Email: servaashouben@gmail.com• Blog: http://actuaryabroad.wordpress.com• Tel: +44 (0) 207 548 2774

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Maarten Koppenens joined UBS in April 2010 and is responsible for Dutch

insurance solutions focusing on accounting and regulatory frameworks, liability

management and optimalisation of asset allocation. Prior to joining UBS, Maarten

worked at Swiss Re as a marketing actuary focusing on de-risking of insurance

liabilities. Besides being a qualified actuary, Maarten holds a degree in

econometrics and an MBA.• Email: maarten.koppenens@ubs.com • +44 (0) 207 567 4357

References & contact details• Churm & Panigirtzoglou, Decomposing credit spreads, Bank of England working paper no 253

• Kahneman, Thinking fast and slow, 3 November 2011

• Moody’s, Corporate Default and Recovery Rates, 1983-2010, February 28, 2011

• Moody’s, Narrowing the gap – a clarification of Moody's approach to local versus foreign

currency government bond ratings, February 2010

• Moody’s, Sovereign Default and Recovery Rates, 1983-2010, May 10, 2011

• Reinhart & Rogoff, This time is different: A Panoramic View of Eight Centuries of Financial

Crises, April 16, 2008

• Remolona, Scatigna, Wu, A ratings-based approach to measuring sovereign credit risk,

International Journal of Finance and Economics volume 13 (2008)

• S&P, Sovereign Defaults And Rating Transition Data, 2010 Update, 23 Feb 2011

• Webber – bank of England, Decomposing corporate bond spreads, 2007Q4

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