The UK's Q4 2023 banking crisis.

[King Penda]

Anyway the fuel discount has ended that heaps more pressure on those that are skint but luckily it’s getting warmer. 8 million will get the cost of living payment towards the end of the month . So expect Amazon to be busy has opec have or are cutting production we could easily see fuel head back towards £2 a litter (derv)

[sancho panza]

29 minutes ago, Chewing Grass said:

@sancho panza half of those buildings are on the estate owned by the local council that they bought of MPC Property for IIRC nearly £200 Million.

https://www.warringtonguardian.co.uk/news/23401022.council-boss-celebrates-companys-expansion-birchwood/

And @spygirl I'm not surpised with regard to CRE being funded less by banks.I've also seen enough of local councils buying up empty shops to know that the taxpayer has already been lined up to take the hit on a fair bit.I didn't know councils were buying up warehousing but then thinking about I do remember some council that was levered up to the gills with it

Here it is

https://www.theguardian.com/society/2020/jul/13/english-councils-rely-heavily-commercial-investments

 

 

I'd agree,I think ground zero for UK banks will be the BTL portfolio's and some of the FTBer high LTV loans.I'm prepping a post on 2007 favourite Mortgage Express

[Loki]

7 minutes ago, sancho panza said:

And @spygirl I'm not surpised with regard to CRE being funded less by banks.I've also seen enough of local councils buying up empty shops to know that the taxpayer has already been lined up to take the hit on a fair bit.I didn't know councils were buying up warehousing but then thinking about I do remember some council that was levered up to the gills with it

Here it is

https://www.theguardian.com/society/2020/jul/13/english-councils-rely-heavily-commercial-investments

 

 

I'd agree,I think ground zero for UK banks will be the BTL portfolio's and some of the FTBer high LTV loans.I'm prepping a post on 2007 favourite Mortgage Express

They still had enough down the back of the sofa to tear down the ~35 year old existing centre and build this

https://www.willmottdixon.co.uk/projects/spelthorne-leisure-centre

Blah blah climate renewables etc

[sancho panza]

Mortgage expresss was a big lender into the GFC bubble 2008.The BTLer I know who's surveying their options in terms of bankruptcy has 12 or 13 of their mortgages with them.All legacy mortgages from that period,all IO.Currently,likely 100% LTV or more likely higher still

The BTLer informed me that when they spoke with ME,they appear to use the Zoopla valuation which they thought was liekly over valuing the portfolio.

ME,were part of Bradford & Bingley,which was taken over by UK Asset Resolution and then sold as below.

The UK govt in a rare moment of goodtiming,managed to palm it off at the covid peak.

https://www.bbg.co.uk/about-us

Our history

On 29th October 2021 ownership of Bradford & Bingley transferred to Davidson Kempner Capital Management LP, a global institutional investment management firm. Bradford & Bingley also became a private limited company and is now named Bradford & Bingley Limited. Mortgage Express continues to be a subsidiary of Bradford & Bingley.

Prior to 29th October 2021 Bradford & Bingley was directly owned by UK Asset Resolution Limited, a holding company itself directly owned by HM Treasury, which acquired Bradford & Bingley in October 2010.

In 2008 Bradford & Bingley was nationalised, and its savings book and branch network was transferred to Santander. If you were previously a Bradford & Bingley Savings customer, please visit the Santander website.

 

These appear to be the results for Mortgage Express for the year to Mar 31 2022.It looks like the loan book was moved onto B&B's books prior to sale to DKCM.

However there are some interesting things to note.My writing is in italics

 

 

Mortgage Express results to 31/3/22

The servicing of the loans is now B&Bs  business as the loans were consolidated into it.

What's interesting here is the pre sael no laons were categorsied as stage 1 due to the lack of data/onerous costs etc.

 

Here's the really interesting bit on page 25 of 36.Nearly a billion quids worth of BTL/Self certs,probably all 2006/7 vintage,all waiting for the axe to fall.I know @spygirl has talked about this before but it really brings it home, that after 15 years of Zirp,these loans are still sat there,unable to find another lender.

Not a massive amount in terms of the UK mortgage market but still,interesting to see

Edited April 3, 2023 by sancho panza

[sancho panza]

Having read through it looks like B&B laons have been sold on as the balance sheet shrinks drastically during 2022.I've read the report and it isn't expalined .Must be being thick.

Key point again being what's look like laods of legacy 2007 laons on the books still.Can't quite work out where theyve gone.If nayone has an idea,feel free.

With a bit of luck and half term kids running wild allowing,we'll see if Cov have pulbished their full year for 22 tmrw night.

B&B financial results 31/3/22

Interesting that even in March 22,there are 9% of customers in some sort of arrears

Also worth noting that they had struggling customers even in the 2% world that was pre Kwame Kaze.If 2% was tough,where will they be at 6%?

 

Edited April 3, 2023 by sancho panza

[Caravan Monster]

Got to wonder if something might happen in the UK banks over the coming long easter bank holiday, or one of the many bank holidays that come at this time of year.

[HousePriceMania]

 

[spygirl]

OK,

Dean Buckner is an ex PRA on the insunrace ratehr than banking side.

His concerns relate to acturarial fuckwittery.

PE are active in this area too.

Mr Bckner has been wavign a red flag on various insuance fuckwittery.

Regulation is masking the true condition of insurers

Rules that encouraged investment in risky assets could come back to bite them

https://www.ft.com/content/05d3479d-121e-4613-8e04-c9799f1fc9cd

Imagine that you hold a bond in a company whose debt is rated at BBB. The coronavirus lockdown strikes and shuts down parts of the issuer’s business, severely reducing its cash flows. 

The bond’s price falls from 100 per cent to 80 per cent of face value as the yield increases to compensate investors for all that extra risk they are taking. But the rating agencies are not yet sure how to quantify fully the impact. While putting the bond on ratings watch, they leave it for now as investment-grade. 

If you were a bank, you would mark the bond to market, recognising a consequent loss that would erode your equity capital. Fortunately, however, you are a life insurance company. The regulatory regime is different.

Granted, you still have to mark down the bond’s value. But that doesn’t mean taking the full loss through your equity. Under European legislation, UK insurers get a helpful regulatory concession. While they must recognise the loss on the asset side, they also get to adjust the value of their insurance liabilities (that is, the estimated present value of what they must pay in future to annuitants). 

They do this by discounting those liabilities at a higher rate, reflecting the additional yield on the now less valuable bond. The fall in the value of those liabilities magically absorbs a large chunk of the loss on the asset. 

This might all seem like a bewildering game of technical number crunching. But it serves an important purpose as far as insurers are concerned. And it has become especially pertinent with the impact of Covid-19. 

Thanks to the long period of low interest rates, insurers have herded into higher-yielding assets such as corporate bonds. Despite these being needed to fund an AA-rated annuity, about 35 per cent of these bonds are BBB. 

This has been a bit of a costless option for the insurance companies themselves. Despite the additional risk, they’ve not had to fund these assets with much more capital. The same regime that magically sweeps up bond losses also supplies the “capital” to support this riskier investment.

The regulator lets them discount the corresponding liabilities at a concomitantly higher rate through a process known as the “matching adjustment”. This essentially capitalises upfront the additional returns they hope to make from the bonds above the risk-free (or government bond) rate, after deducting a bit to provide for the long-run risk of default. 

Remember also that those extra returns accrue only to the insurer’s shareholders, and not to the annuitants whose pensions are fixed. 

In many cases, matching adjustment has actually become a major part of insurers’ capital. According to their 2019 regulatory filings, its matching adjustment accounted for 70 per cent of L&G’s solvency capital and 23 per cent of Aviva’s. With smaller entrepreneurial insurers, the numbers can be even higher. With Just Group, the percentage is 104.

Why is this so important now? Well, the big reason is that the outlook for corporate bonds has become so very murky.

True, bond prices have somewhat recovered after sharp falls in March and April, thanks to the giant emergency measures governments have taken. But there are fears that these could simply be deferring a deeper corporate solvency problem. S&P Global Ratings warned last month that it had on its radar globally a record 111 potential fallen angels, or companies that could be downgraded to junk status.

Meanwhile, UBS has estimated that 33 per cent of loans in the main US loan index could fall to CCC because of the dislocation. That compares to 11 per cent at the trough of 2009.

Take our imaginary bond that declined to 80 per cent, while nominally remaining investment-grade. An insurer might be tempted to run that loss on the assumption that illiquidity, not default risk, was behind the wider spread. With its helpful mathematics, the matching adjustment regime might even encourage such a conclusion. 

Analysis from Dean Buckner, a former insurance regulator at the UK watchdog, has estimated that six large UK insurers collectively ran up £28bn of mark-to-market losses on their bond holdings as of the beginning of June.

Yet while crystallising these losses would clearly be extremely painful, “cushioning” them with matching adjustment is not without its perils. The worry is that a large number of bonds subsequently default or get downgraded to junk. That would force the insurer to crystallise a sudden and potentially much more substantial loss. 

In a speech last year, David Rule, then head of insurance supervision at the UK watchdog, noted that the interests of owners and managers of insurers were not necessarily aligned with policyholders. “Owners share the benefits of taking more risk in a good outcome but have limited exposure to losses in a bad outcome because of limited liability.” 

Mr Rule thought the structure of regulation did not exacerbate this conflict. Coronavirus may subject that belief to a sterner test.

Coments - 

A few points:

1. The Matching Adjustment is not some new concession which came out of the European Solvency II legislation. Similar methodologies were part of the ICA regime and Solvency I. This goes back at least to the 1970s and I suspect much longer than that.

2. Life insurers often run risks which run over decades yet Solvency II forces them to build a balance sheet based on 1 year Value-at-Risk. This is a bad thing. One reason is that it makes insurers look more like banks and so makes the two sectors more likely to be under stress at the same time - the very definition of systemic risk. The MA is one of the things that helps to mitigate this risk. The market consistency zealots behind this article ("Dowd" and "eumaeus" from the comments) would have the whole world using one paradigm and so amplify crises (think of the "geniuses" at LTCM).

3. While it is true that life insurance shareholders have limited liability, there are multiple layers of policyholder protection. The chart above suggests that some insurers have no spare capital if you ignore the MA but there is ample historical evidence for a liquidity premium on bonds held to maturity over all time periods and Solvency II has other margins which are not shown here: a risk margin that is outrageously high in a low interest rate environment, the use of a risk free rate below government bonds yields, risk appetite limits, stress tests,... The effect is that it is hard to paint a scenario where policyholders cannot be paid.

4. You can always argue for higher capital requirements to protect policyholders. But the price will be paid mostly by customers (in the form of worse annuity rates) and society (as insurers won't finance risky ventures if the capital requirements are too high). I would argue that policyholder protection has gone too far already (see for example the leaching of UK insurance risks to Bermuda as a direct consequence of Solvency II).

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On the other hand

 

3 YEARS AGO

 

reply In reply to Hedge Trimmer

Very well said
There is sound economic rationale for matching adjustment
and the debate has been held a decade ago, suspect when Mr Buckner was the regulator

MA enforced strict rules on insurers most of which are to avoid ever being in a forced sale scenario

the benefit of MA accrues to policyholders/customers through keener pricing

what is this article really about?

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Jlo88

 

3 YEARS AGO

 

This argument is flawed and doesn't take account of diversification. Where your sources have a point, is that for some assets (e.g. equity release mortgages) it is sometimes inherently uncertain what/when those future pay outs will be. For most asset types (e.g. bonds, loans, etc) the cash flows for well-diversified portfolios are predicatable over the long-term. There seems little advantage in introducing mark-to-market volatility on long-term investments and liabilities. If this is your issue, then you should be railing against book value accounting which is still done in some major economics (e.g. the US, Germany, France, most of Europe)

Removing this kind of benefit disincentivises investments in the real economy. On the continent, this benefit isn't allowed and insurers are more incentivised to invest in government bonds as the European solvency regime requires no capital to be held against sovereign defaults. For example, take a look at how much government debt Generali owns (https://www.fitchratings.com/research/insurance/fitch-downgrades-generali-ifs-to-a-on-sovereign-downgrade-outlook-stable-05-05-2020)

UK insurers are proportionately more exposed to corporate bonds, infrastructure and property-type investments, which will definitely have more default events when all this (Covid) is over. A consequence of the rules means that they are already holding higher capital buffers due to being exposed to these risks (even with the use of the matching adjustment) and so should be able to weather the storm.

Regulations like this are intended to help improve government borrowing costs, but have unfortunately been too effective in a low-growth environment and helped propel most of Europe into a negative yield environment.

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eumaeus

 

3 YEARS AGO

 

reply In reply to Jlo88

"For most asset types (e.g. bonds, loans, etc) the cash flows for well-diversified portfolios are predictable over the long-term."

In what way is the value of a (risky) corporate bond, or loan, predictable over the long term??
 

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Jlo88

 

3 YEARS AGO

 

reply In reply to eumaeus

https://www.spglobal.com/ratings/en/research/articles/200429-default-transition-and-recovery-2019-annual-global-corporate-default-and-rating-transition-study-11444862#:~:text=The%20global%20speculative%2Dgrade%20corporate,triple%2Ddigit%20total%20since%202016.

It's in the data. For IG bonds the highest default rate in any given year since 1981 was 0.42% (both in 2002 and 2008). Who knows if this will continue going forward, but I guess that's the point of having a capital requirement to cover this risk. If the point of your question (as inferred by the "risky") is that a liquidity premium does not exist, then I think the article has pointed out the most salient example of recent years where investors flocked to liquidity.

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eumaeus

 

3 YEARS AGO

(Edited)

 

reply In reply to Jlo88

"For IG bonds the highest default rate in any given year since 1981 was 0.42% (both in 2002 and 2008)."

And for other periods? Say pre- 1940s?

On whether a liquidity premium exists: if it does then it should be possible systematically to make a profit by buying bonds when the price falls, in the expectation that the price will certainly revert.

There used to be desks in the City before 2008 which speculated on this assumption.

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Jlo88

 

3 YEARS AGO

 

reply In reply to eumaeus

Of course, much higher, probably around the mid-teens from memory. I would question the relevance of using data pre-1940 (or even between WW2 and 1981 which as you're aware was an especially benign period for corporate bonds). There are many reasons to suggest that capital markets are inherently different after 1940: Keynesian policies, independent central banks, complete abandonment of the gold standard, no "rail road" bonds,

It's also not about price reversion, it's about cash flow, and making more than you would on a risk-free asset over the duration to maturity (net of defaults, costs) no matter when you buy, which can (and is) done systematically on a well-diversified portfolio of bonds. The matching adjustment frameowrk doesn't allow for spread speculation, which I certaintly wouldn't want an insurer to do. As far as I'm aware the regulations do not incentivise that behaviour.

My main concern would be that they do incentivise investments into internally-rated assets, mark-to-model assets, which I do think need a lot more scrutiny (particularly today) and I hope insurers have been responsible in their approaches to these assets.

I just don't find the lack of liquidity premium argument that compelling in the context of an insurance business model. You can point to many academic papers purporting the existence (or lack) of it, but fundamentally insurers' business models are based on making a spread. Legislating on the assumption that this isn't true is effectively asking/forcing insurers to only invest in govies and swaps.

This may be your goal, but I do not think it's a worthy one. The insurance industry doesn't need to be further capitalised and this would just be another tool to force this. In the end policyholders would lose out by being offered even worse rates on annuities, or DB schemes having to be in extreme levels of surplus before being bought out, which in turn would increase the burden on corporates. To compound this, you would be diverting investments from corporates into government bonds which isn't going to help anyone in society.

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eumaeus

 

3 YEARS AGO

 

reply In reply to Jlo88

"There are many reasons to suggest that capital markets are inherently different after 1940"

Of course. This time it's different.

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Rosencruz

 

3 YEARS AGO

 

“About that which we do not know, we must remain silent”- Wittgenstein
With no mention of liquidity, I must assume that the author does not know what he is talking about. These bonds are held to maturity, and therefore there is no need to allow for the liquidity risk in their price.

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Dave1000

 

3 YEARS AGO

 

reply In reply to Rosencruz

I think that’s the point that’s being made. If prices have moved due to a reassessment of the liquidity premium, then it’s fine to adjust liabilities in line with asset values. However, if the prices have moved because there’s now an increased probability of default, then it’s imprudent to simply offset this on the liabilities

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eumaeus

 

3 YEARS AGO

(Edited)

 

reply In reply to Dave1000

This is exactly what was meant.
" An insurer might be tempted to run that loss on the assumption that **illiquidity, not default risk**, was behind the wider spread. With its helpful mathematics, the matching adjustment regime might even encourage such a conclusion. "

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OhMyOhMy

 

3 YEARS AGO

 

reply In reply to eumaeus

The regime makes sense, sort of. The so-called fundamental spread is supposed to be a representation of credit risk over the long term. The price of credit risk, the spread, in the short term doesn’t affect whether a bond will pay out in full or not. That’s only affected if the amount of credit risk changes. The trouble is Actuaries love evaluating risks with data and the fundamental spread, supposedly, uses data. And you can’t recalibrate a long term average without quite a bit of *new* data. In other words we will know the result of the crisis before the calibration is changed.

Don’t blame the firms for what the rules say. Blame the regulators. Dean Buckner is a mark-to-market fundamentalist and sees the market price as the amount of credit risk. It isn’t. It’s amount x price per unit of risk. Insurers using MA are exposed to AMOUNT not PRICE.

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OhMyOhMy

 

3 YEARS AGO

 

reply In reply to OhMyOhMy

Point being you can’t tell right now. Blame the regime and actuaries. Don’t blame the insurers.

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Kevin Dowd

 

3 YEARS AGO

 

reply In reply to OhMyOhMy

>Don’t blame the firms for what the rules say.
Why shouldn't we blame them? They lobbied for those rules.

>Blame the regulators.
I agree: they gave in to the lobbying

>Dean Buckner is a mark-to-market fundamentalist
There are a few of them around.

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eumaeus

 

3 YEARS AGO

 

reply In reply to OhMyOhMy

"Dean Buckner is a mark-to-market fundamentalist and sees the market price as the amount of credit risk."

He sees it as a measure of risk. How do you tell whether any given spread is illiquidity risk or default risk? If it were all illiquidity risk, why not buy the market every time there is a dip and make a sure profit when it returns to 'normal'.

On the long-term average bit, depends entirely on which time series you are looking at, of course.

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OhMyOhMy

 

3 YEARS AGO

 

reply In reply to eumaeus

He, or more accurately you given you are he, appears to see the market price as THE reflection of the quantity of risk. It isn’t. As I said above. You can’t be sure what of the current spread increase is credit risk increase, liquidity risk increase, credit price increase or liquidity price increase. In other words you don’t know a lot. Your solution is to assume a short term blip in spread is all a sign that long term credit risk has increased. Yeah....

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Kevin Dowd

 

3 YEARS AGO

 

reply In reply to Rosencruz

The bonds being (intended to be) held to maturity is of little use to an insurance company if the increase in the credit spread is due to increased default risk.
If you think that the increase is due to some jump in the illiquidity spread, then where is the evidence to support that claim?

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OhMyOhMy

 

3 YEARS AGO

(Edited)

 

reply In reply to Kevin Dowd

But where is the evidence the other way? The PRA’s own leader said Banks should take account of the unprecedented nature of Bank and state intervention. And what evidence is there that all firms are equally affected? What evidence that BBB rated supermarkets are as badly hit as BBB rated car rental companies? What evidence this will be over by Christmas, or next week, or never? Too many uncertainties exist right now. And again, what evidence is there that the trailing data used for the FS calibration is even relevant to current markets and exposures? What about recovery rates in default from past data?

Mark to market ascribing everything to credit risk is wrong. Ignoring the market and saying its all illiquidity is wrong. The really hard part is telling how much of each on a forward looking basis.

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Kevin Dowd

 

3 YEARS AGO

 

reply In reply to OhMyOhMy

Traditionally, spreads are interpreted as reflecting default risk. Actuaries then come along and claim that some of those spreads reflect an illiquidity premium (ILP). The onus is then on them to give us evidence to support their claim and tell us how to estimate the ILP, and none of them have done so.

This is the central issue and your other points are irrelevant to it.

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Hedge Trimmer

 

3 YEARS AGO

 

reply In reply to Kevin Dowd

"Traditionally, spreads are interpreted as reflecting default risk." That isn't an argument it's just an assertion. And even if it were true, the fact that something is done traditionally is hardly a strong argument.
The evidence for an ILP, as I'm sure you know, rests in the historic outperformance of corporate bonds over government bonds. This was reviewed extensively by CEIOPS (now EIOPA) in the run-up to Solvency II. The resulting MA is of course a political fudge - one that is far more penal on insurers than the Solvency I regime.
 

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Kevin Dowd

 

3 YEARS AGO

 

reply In reply to Hedge Trimmer

>The evidence for an ILP, as I'm sure you know, rests in the historic outperformance of corporate bonds over government bonds.

Surely, the outperformance of corporate bonds over government bonds reflects the reward for taking on corporate default risk? And why is this spread evidence for an ILP?

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Mafiosi

 

3 YEARS AGO

 

reply In reply to Kevin Dowd

I recollect calculating the value of some assets held by these insurers that included an explicit illiquidity premium in the calculation ( depressing the price ). To not then use an illiquidity premium on the other side of the balance sheet in determining liabilities would then seem somewhat perverse.

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Kevin Dowd

 

3 YEARS AGO

 

reply In reply to Mafiosi

Yeah but you have still to justify ILP that you use, and justify why it applies to the liability side.

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Michael Milkinstein

 

3 YEARS AGO

 

reply In reply to Kevin Dowd

yes i think insurers do that kevin.

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Dom86

 

3 YEARS AGO

 

A lot rests here on the credit rating failing to keep up with the fundamentals. The implied point, that Matching Adjustment insurers' valuation of credit is much more a function of credit rating than price, is correct. But it's worth pointing out that the agencies have moved extremely quickly to downgrade companies over the past few months - as the FT itself has reported (the insurers can't rely 100% on the rating agencies, especially for non-listed investments, but they have to to a large extent). There might be some time lag between the markets spotting credit weakness and the rating decision - but frankly that doesn't strike me as much of a complaint. And it doesn't take much imagination to see that spread movements aren't a perfect predictor of credit conditions. The more interesting complaint would be if there was some evidence of systematic failure of the rating agencies - (expect snide remarks about CDOs in 2007). But on my (casual) reading of the data, it looks like the ratings roughly do their job.

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LibrarianCap

 

3 YEARS AGO

 

I think a lot of the "value" investors who say insurers are "cheap" because they are on less than 10x P/E on trailing earnings don't really know how to read insurer balance sheets *.

* I don't either, except for simpler non-life insurers. But I know this and don't invest in insurers.

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A diligent observer

 

3 YEARS AGO

 

reply In reply to LibrarianCap

Like banks, insurers have a lot of complication caused by regulation. But the regulation also creates a degree of safety.

It can be challenging to assess the "true" value of their balance sheets. But not impossible. I am more of a specialist in banking than insurance, but I do have one (very obscure) insurer in my value portfolio; previously I had Sagicor Financial, until it was bought out - and it was my biggest holding at the point the offer was made. I made a very significant return on that over my holding period.

That said, I'd be tempted to agree that if you scout around the FTSE100 for "value" stocks, you probably don't really understand the concept.

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LibrarianCap

 

3 YEARS AGO

 

reply In reply to A diligent observer

Thanks for sharing - interesting points.

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Padada

 

3 YEARS AGO

(Edited)

 

So the article discusses the headline "regulation masks the true condition of insurers". Quite frankly, insurer solvency rules are complex and its easy to draft an article that (unfairly?) picks issues with selected parts of them. Can you please address the "so what?". Is the FT saying that some of the insurers listed are on the cusp of financial difficulty and perhaps even default, are the FT saying the PRA is hiding something?

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ForrestGump

 

3 YEARS AGO

 

These Jonathan Ford articles are becoming wearysome. They continue to ignore key aspects of the Solvency II regime, like the role and magnitude of the SCR, and that illiquidity premium of itself isn't a contentious concept.

Ford continues to disparage insurers and the regulator for doing things permitted at law. That's why the Equitable case made such short shrift of Dowd and Buckner's arguments.

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eumaeus

 

3 YEARS AGO

 

reply In reply to ForrestGump

The law does not say what the illiquidity premium is.

"illiquidity premium of itself isn't a contentious concept." Really? Was the spread widening we say in Virgin Australia the effect of illiquidity? Really?

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Warthog Under The Bridge

 

3 YEARS AGO

(Edited)

 

In a nutshell:
Insurers are over-valued and consequently over-rated.

Fair enough on the long explanation 'though, would have been just assertion without the underpinning.


In terms of action: Fine to support them if needs be BUT not in the way the Bankers who crashed the economy twelve years ago walked away wealthy at the nation's expense.

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Smug ethnic Chinese

 

3 YEARS AGO

 

Thanks.
Note to writer and subbie: Move the chart higher up in the piece. I was starting to wondering what was the author's point until I saw the table.

[spygirl]

A letter - 

Nov 19

Capital created by matching adjustment is entirely artificial

From Dean Buckner and Kevin Dowd

I

Rothesay Life chairman Naguib Kheraj (Letters, November 1) makes a number of false and misleading complaints about a letter to the Prudential Regulation Authority, which we co-signed.

Our letter took issue with the PRA’s handling of the recent Rothesay-Prudential Part VII pension case, which could have permitted the transfer of £12bn in pension funds from Prudential to Rothesay, a company only established in 2007.

The main issue is the unsoundness of the matching adjustment (MA), a practice based on the strange idea that some of the spread in excess of the risk-free rate is itself risk free. This is akin to allowing punters at a horse race to demand some of their winnings just before the race has started, on the grounds that the claimed winnings can be deemed to be certain.

MA is then implemented by companies applying a discount rate to their pension liabilities that is higher than risk free, on the presumption that assets will, with certainty, earn more than the risk-free rate. This higher discount rate results in lower pension valuations which inflate companies’ reported capital. However, the extra capital “created” in this way is entirely artificial.

Our letter went on to mention the views of a number of distinguished independent experts who have expressed similar concerns about the MA, including Professor David Miles (former member of the Bank of England’s monetary policy committee) who described MA as “nonsense and a dangerous road to go down”, and Martin Taylor (of the Bank of England financial policy committee) who described the underlying idea as “one of the weirdest emanations of the human mind”.

Mr Kheraj seeks to dismiss these concerns without addressing them. His core complaint is that our letter gave an inaccurate depiction of Rothesay’s capital position. In fact, the numbers were taken from page 57 of Rothesay Life’s own 2018 Solvency and Financial Condition Report and apply to year-end 2018. Eligible own funds, ie, Solvency II capital, is reported as £3.9bn and the amount of artificial capital created from the application of MA is £4.6bn. The company’s net capital, when the artificial MA capital is removed, is therefore £3.9bn minus £4.6bn, or minus £700m. We therefore stand by our earlier claim that “there is no conceivable circumstance in which such a capital position could be regarded as a ‘strong’ one”.

It is interesting that other financial companies, such as banks, are not eligible for MA benefit. Indeed, a bank with negative capital would be correctly described as technically insolvent and considered a problem case. But a life company that would be technically insolvent but for artificial MA capital has, we are told, a “very strong” capitalisation. Fancy that.

Dean Buckner The Eumaeus Project; ex-PRA Kevin Dowd Durham University, UK

[spygirl]

Linsk to some more - 

Apr 19

Matching adjustment is open to abuse

From Dean Buckner and Kevin Dowd

 

https://www.ft.com/content/af94c662-56c4-11e9-a3db-1fe89bedc16e

Actuarial ‘trick’ protects against solvency risks

From John Taylor, President-Elect, Institute and Faculty of Actuaries, London WC1, UK

https://www.ft.com/content/6a790162-6108-11e9-b285-3acd5d43599e

Comments - 

My understanding of the benefit being discussed is that the yields available on corporate bonds above risk free interest rates exceed the long term observed defaults on said assets. The matching adjustment allows insurers to take credit for this ‘excess return’ due to the fact that they are long term buy and hold investors. Insurers also hold capital equivalent to an estimate of the additional funds they would require in an very adverse scenario.

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eumaeus

 

4 YEARS AGO

 

reply In reply to Pleading_sanity

Pleading_sanity "the yields available on corporate bonds above risk free interest rates exceed the long term observed defaults on said assets. "

Surely you mean 'are going to exceed'? And if , how can you be certain of that future excess?

Note also, as I said below, even if the future excess return were absolutely guaranteed, in what sense to shareholders of insurance companies 'take credit' for the return? The excess return is there to support pensioner liabilities.

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Pleading_sanity

 

4 YEARS AGO

 

reply In reply to eumaeus

Good points. If I take the first, totally agree that they cannot be guaranteed. However, a useful indicator is past experience and at the end of the day, if you buy and hold then it is the level of defaults that one is interested in. Even during the recent financial crisis, these were relatively low.

Regarding the second point, on new business some of these yields are being passed on to pensioners, e.g. aggressive pricing on transferring pensioner liabilities from a pension fund to an insurer. Hence not all of the expected excess return accrues to the insurance company.

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eumaeus

 

4 YEARS AGO

 

reply In reply to Pleading_sanity

Pleading_sanity My understanding (I may be wrong) is that the transfer does not impact the contractual rights of the pensioners, which remain the same as before. The company effectively borrows at a rate close to swap/gilts, in return for taken on the pre-existing contractual liabilities. It then uses MA to discount at a higher rate, thereby creating capital on the balance sheet. Who benefits? Existing shareholders. But not prospective ones, who will be overpaying for that capital by the amount they paid.

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langbourner

 

4 YEARS AGO

 

I thought the original article was poor, although admittedly a challenging subject.

I think the following questions should have been tackled in a clearer way:

• Is it better to have a cheap simple rule-of-thumb-based regulatory capital regime, which is flawed but where the flaws are well understood? Or a complicated expensive regime, which is less transparent?
• Do we want to reward insurers for taking asset-liability matching seriously? Presumably yes!
• If , is the matching adjustment the best way to do this? If not, what are the alternatives?

 

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eumaeus

 

4 YEARS AGO

 

reply In reply to langbourner

langbourner Who are 'insurers'? You mean prospective shareholders of insurance companies? How do they benefit from MA. A worked example will do.

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Euroactuary

 

4 YEARS AGO

 

reply In reply to langbourner

langbourner I recognise these questions although they hardly admit of easy answers. I note that both EIOPA and IFRS have acknowledged the difficulty of reflecting the liquidity characteristics of liabilities in valuation. It is a truism that a debt which may be called at the discretion of the creditor is more onerous than one which may not - the value difference is small most of the time but large in circumstances such as prevailed in late 2008 and early 2009. MA is a flawed representation of this difference but no alternative has attracted significant support yet to my knowledge.

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eumaeus

 

4 YEARS AGO

 

reply In reply to Euroactuary

Euroactuary langbourner Again, to what benefit is MA to prospective shareholders of a firm using MA?

Let's grant (which is dubious) that there is a substantial premium to be earned on long dated bonds if only we had the patience to wait. Let's suppose that is true.

I might want to invest in such a bond, since I have patience.

But then an insurance firm suggest I buy its shares, on the strength of having realised this premium.

Why should I? I can see how existing shareholders can benefit without needing any patience, since they have realised the premium through the equity created. They will instantly receive the premium by selling the shares to me. But how do I benefit?

 

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Euroactuary

 

4 YEARS AGO

 

reply In reply to eumaeus

I think the question of whether to invest in an insurer involves too many other considerations to be useful. Perhaps an alternative is to posit a run-off insurer making use of the MA - how should a potential acquirer evaluate this. Leaving everything else out of account I would tend to agree that an acquirer should not attribute full value to the ‘MA boost’ most of the time. Not simple!

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eumaeus

 

4 YEARS AGO

 

reply In reply to Euroactuary

Euroactuary Seems quite simple to me. The amount of fake equity created by MA is the amount by which the ordinary shareholder has been overcharged by this clever method of false accounting.

Thanks for replying.

Its aa dry tehnical area.

The Dean bloke is calling shenegans on onthe last gasp of what was thescam that was Life Insurance industry.

 

[spygirl]

18 hours ago, sancho panza said:

Mortgage expresss was a big lender into the GFC bubble 2008.The BTLer I know who's surveying their options in terms of bankruptcy has 12 or 13 of their mortgages with them.All legacy mortgages from that period,all IO.Currently,likely 100% LTV or more likely higher still

The BTLer informed me that when they spoke with ME,they appear to use the Zoopla valuation which they thought was liekly over valuing the portfolio.

ME,were part of Bradford & Bingley,which was taken over by UK Asset Resolution and then sold as below.

The UK govt in a rare moment of goodtiming,managed to palm it off at the covid peak.

https://www.bbg.co.uk/about-us

Our history

On 29th October 2021 ownership of Bradford & Bingley transferred to Davidson Kempner Capital Management LP, a global institutional investment management firm. Bradford & Bingley also became a private limited company and is now named Bradford & Bingley Limited. Mortgage Express continues to be a subsidiary of Bradford & Bingley.

Prior to 29th October 2021 Bradford & Bingley was directly owned by UK Asset Resolution Limited, a holding company itself directly owned by HM Treasury, which acquired Bradford & Bingley in October 2010.

In 2008 Bradford & Bingley was nationalised, and its savings book and branch network was transferred to Santander. If you were previously a Bradford & Bingley Savings customer, please visit the Santander website.

 

These appear to be the results for Mortgage Express for the year to Mar 31 2022.It looks like the loan book was moved onto B&B's books prior to sale to DKCM.

However there are some interesting things to note.My writing is in italics

 

 

Mortgage Express results to 31/3/22

The servicing of the loans is now B&Bs  business as the loans were consolidated into it.

What's interesting here is the pre sael no laons were categorsied as stage 1 due to the lack of data/onerous costs etc.

 

Here's the really interesting bit on page 25 of 36.Nearly a billion quids worth of BTL/Self certs,probably all 2006/7 vintage,all waiting for the axe to fall.I know @spygirl has talked about this before but it really brings it home, that after 15 years of Zirp,these loans are still sat there,unable to find another lender.

Not a massive amount in terms of the UK mortgage market but still,interesting to see

Back to housing and banks.

There are two massive housign events that are comign to home to roost.

From ~2000 to 2008/~MMR, the majority (90%) of mortgages were IO.

Not even an atempt to put a crappy endowment poicy to cover the capital.

Naked.

Nadah.

he bulk were from 2000-2008 ,when the banks did slow down but not entirely stop.

MMR abbned IO for resi. But that was ~2014ish. Call it 2012 as bank had to comply with MMR a few years before it came into force.

There was ~12y of IO mortgages tosort.

Thats a lot.

The Boe n FCA have killed 50% of them off, creating RIO to suck up OAPs with equity, and moving younger people onto repayment whilst low IR are in place.

But that leaves a lot left - see the mortgage prisoners who crop up al the time

After IO mortgqges, there was ZIRP, which allowed of lot of people to over consume housing.

Combine that with the funny time beween 2008 and MMR, and ther still is a lot of people who cannot repay their mortgge with IRs anywhere close to normal.

On IO mortgages you are now starting to see this mature - mortgages are mainly 20-25y.

With ZIRP mortgages Im seeing afew places bought 2008-MMR where I suspect theyve borrowed way too mcuh, come up for sale - at stupid higher prices then they bought.

But these people are in trouble.

Borrowing 200/300k at @ 2% IO only takes 4k/6k to serve, keep the illusion.

Maybe 8k/9k for repayment,. Bit more but still doable ...

Change IR to 6% and that IO now becomes 12k/18k. Repymant 18k/25k.

Ow.

So you get the likes of this fukwittery - 

(From How does BTL end?)

SIR – My buy-to-let mortgage is increasing from £400 a month to £1,200 a month. My tenants can’t afford such a steep rent increase, but I can no longer afford to subsidise them living there. What do I do?

Scabby is still around 2004 nominal prices.

Whitby is higher - thers so much hot money thats poured in that its removal/reversal  is going to be v painful.

Both are low wage eocvnoie, where the onyl buyer, psot ZIRP and MMR, is not goign to be able to pay anywhre close to what the fuckwits paid.

Theres goign to be some very painful losses. Somewhere.

I expect Scabby to go back to late 90s prices soon, which takes them back to the same nomianly price as the late 80s - ~35 years ago and no nominal price increase.

 

 

And just now - 

Huge Arse -

https://www.ft.com/content/6890be22-9280-460a-bd2a-3c45f2cf531f

Bank of England’s chief economist hints at May interest rate rise

Huw Pill stresses that policymakers face tight decision on whether to push borrowing costs higher

[Funn3r]

On 03/04/2023 at 17:50, Chewing Grass said:

These are all within a 500 metre radius of the Spar shop, all except one have been on the market for years with the Massive one with the Warehouse attached being new. They are all fully refurbished.

Must be hundreds of thousands of square feet in total, if I walk further I can find more. The bigger they are the harder it is to lease them.

It's like the only business in town is trying to outcompete other commercial property investors.

 

Bracknell has been like this for years. All sorts of office blocks have been empty for a long time. 

Several of them have been converted into flats. I lived in one for a while in 2016 it was not very nice but later ones look (from the outside) somewhat better.

[King Penda]

4 hours ago, spygirl said:

Back to housing and banks.

There are two massive housign events that are comign to home to roost.

From ~2000 to 2008/~MMR, the majority (90%) of mortgages were IO.

Not even an atempt to put a crappy endowment poicy to cover the capital.

Naked.

Nadah.

he bulk were from 2000-2008 ,when the banks did slow down but not entirely stop.

MMR abbned IO for resi. But that was ~2014ish. Call it 2012 as bank had to comply with MMR a few years before it came into force.

There was ~12y of IO mortgages tosort.

Thats a lot.

The Boe n FCA have killed 50% of them off, creating RIO to suck up OAPs with equity, and moving younger people onto repayment whilst low IR are in place.

But that leaves a lot left - see the mortgage prisoners who crop up al the time

After IO mortgqges, there was ZIRP, which allowed of lot of people to over consume housing.

Combine that with the funny time beween 2008 and MMR, and ther still is a lot of people who cannot repay their mortgge with IRs anywhere close to normal.

On IO mortgages you are now starting to see this mature - mortgages are mainly 20-25y.

With ZIRP mortgages Im seeing afew places bought 2008-MMR where I suspect theyve borrowed way too mcuh, come up for sale - at stupid higher prices then they bought.

But these people are in trouble.

Borrowing 200/300k at @ 2% IO only takes 4k/6k to serve, keep the illusion.

Maybe 8k/9k for repayment,. Bit more but still doable ...

Change IR to 6% and that IO now becomes 12k/18k. Repymant 18k/25k.

Ow.

So you get the likes of this fukwittery - 

(From How does BTL end?)

SIR – My buy-to-let mortgage is increasing from £400 a month to £1,200 a month. My tenants can’t afford such a steep rent increase, but I can no longer afford to subsidise them living there. What do I do?

Scabby is still around 2004 nominal prices.

Whitby is higher - thers so much hot money thats poured in that its removal/reversal  is going to be v painful.

Both are low wage eocvnoie, where the onyl buyer, psot ZIRP and MMR, is not goign to be able to pay anywhre close to what the fuckwits paid.

Theres goign to be some very painful losses. Somewhere.

I expect Scabby to go back to late 90s prices soon, which takes them back to the same nomianly price as the late 80s - ~35 years ago and no nominal price increase.

 

 

And just now - 

Huge Arse -

https://www.ft.com/content/6890be22-9280-460a-bd2a-3c45f2cf531f

Bank of England’s chief economist hints at May interest rate rise

Huw Pill stresses that policymakers face tight decision on whether to push borrowing costs higher

I’ve told my fuckwitt of a friend in Telford on intetest only for a decade and with 3 lodgers to do overtime and pay at least 1k a month of his morgage .his morgage has rocketed . He ows about 80k his plan was for it to get to about 170k sell it clear his morgage and buy a terrace outright. If house prices crash he is toast his house is worth about 140k.he said the kids homes closing we are looking at buying it out (staff) I’m like oh fuck off 

[sancho panza]

5 hours ago, spygirl said:

OK,

Dean Buckner is an ex PRA on the insunrace ratehr than banking side.

His concerns relate to acturarial fuckwittery.

PE are active in this area too.

Mr Bckner has been wavign a red flag on various insuance fuckwittery.

Regulation is masking the true condition of insurers

Rules that encouraged investment in risky assets could come back to bite them

https://www.ft.com/content/05d3479d-121e-4613-8e04-c9799f1fc9cd

Imagine that you hold a bond in a company whose debt is rated at BBB. The coronavirus lockdown strikes and shuts down parts of the issuer’s business, severely reducing its cash flows. 

The bond’s price falls from 100 per cent to 80 per cent of face value as the yield increases to compensate investors for all that extra risk they are taking. But the rating agencies are not yet sure how to quantify fully the impact. While putting the bond on ratings watch, they leave it for now as investment-grade. 

If you were a bank, you would mark the bond to market, recognising a consequent loss that would erode your equity capital. Fortunately, however, you are a life insurance company. The regulatory regime is different.

Granted, you still have to mark down the bond’s value. But that doesn’t mean taking the full loss through your equity. Under European legislation, UK insurers get a helpful regulatory concession. While they must recognise the loss on the asset side, they also get to adjust the value of their insurance liabilities (that is, the estimated present value of what they must pay in future to annuitants). 

They do this by discounting those liabilities at a higher rate, reflecting the additional yield on the now less valuable bond. The fall in the value of those liabilities magically absorbs a large chunk of the loss on the asset. 

This might all seem like a bewildering game of technical number crunching. But it serves an important purpose as far as insurers are concerned. And it has become especially pertinent with the impact of Covid-19. 

Thanks to the long period of low interest rates, insurers have herded into higher-yielding assets such as corporate bonds. Despite these being needed to fund an AA-rated annuity, about 35 per cent of these bonds are BBB. 

This has been a bit of a costless option for the insurance companies themselves. Despite the additional risk, they’ve not had to fund these assets with much more capital. The same regime that magically sweeps up bond losses also supplies the “capital” to support this riskier investment.

The regulator lets them discount the corresponding liabilities at a concomitantly higher rate through a process known as the “matching adjustment”. This essentially capitalises upfront the additional returns they hope to make from the bonds above the risk-free (or government bond) rate, after deducting a bit to provide for the long-run risk of default. 

Remember also that those extra returns accrue only to the insurer’s shareholders, and not to the annuitants whose pensions are fixed. 

In many cases, matching adjustment has actually become a major part of insurers’ capital. According to their 2019 regulatory filings, its matching adjustment accounted for 70 per cent of L&G’s solvency capital and 23 per cent of Aviva’s. With smaller entrepreneurial insurers, the numbers can be even higher. With Just Group, the percentage is 104.

Why is this so important now? Well, the big reason is that the outlook for corporate bonds has become so very murky.

True, bond prices have somewhat recovered after sharp falls in March and April, thanks to the giant emergency measures governments have taken. But there are fears that these could simply be deferring a deeper corporate solvency problem. S&P Global Ratings warned last month that it had on its radar globally a record 111 potential fallen angels, or companies that could be downgraded to junk status.

Meanwhile, UBS has estimated that 33 per cent of loans in the main US loan index could fall to CCC because of the dislocation. That compares to 11 per cent at the trough of 2009.

Take our imaginary bond that declined to 80 per cent, while nominally remaining investment-grade. An insurer might be tempted to run that loss on the assumption that illiquidity, not default risk, was behind the wider spread. With its helpful mathematics, the matching adjustment regime might even encourage such a conclusion. 

Analysis from Dean Buckner, a former insurance regulator at the UK watchdog, has estimated that six large UK insurers collectively ran up £28bn of mark-to-market losses on their bond holdings as of the beginning of June.

Yet while crystallising these losses would clearly be extremely painful, “cushioning” them with matching adjustment is not without its perils. The worry is that a large number of bonds subsequently default or get downgraded to junk. That would force the insurer to crystallise a sudden and potentially much more substantial loss. 

In a speech last year, David Rule, then head of insurance supervision at the UK watchdog, noted that the interests of owners and managers of insurers were not necessarily aligned with policyholders. “Owners share the benefits of taking more risk in a good outcome but have limited exposure to losses in a bad outcome because of limited liability.” 

Mr Rule thought the structure of regulation did not exacerbate this conflict. Coronavirus may subject that belief to a sterner test.

Coments - 

A few points:

1. The Matching Adjustment is not some new concession which came out of the European Solvency II legislation. Similar methodologies were part of the ICA regime and Solvency I. This goes back at least to the 1970s and I suspect much longer than that.

2. Life insurers often run risks which run over decades yet Solvency II forces them to build a balance sheet based on 1 year Value-at-Risk. This is a bad thing. One reason is that it makes insurers look more like banks and so makes the two sectors more likely to be under stress at the same time - the very definition of systemic risk. The MA is one of the things that helps to mitigate this risk. The market consistency zealots behind this article ("Dowd" and "eumaeus" from the comments) would have the whole world using one paradigm and so amplify crises (think of the "geniuses" at LTCM).

3. While it is true that life insurance shareholders have limited liability, there are multiple layers of policyholder protection. The chart above suggests that some insurers have no spare capital if you ignore the MA but there is ample historical evidence for a liquidity premium on bonds held to maturity over all time periods and Solvency II has other margins which are not shown here: a risk margin that is outrageously high in a low interest rate environment, the use of a risk free rate below government bonds yields, risk appetite limits, stress tests,... The effect is that it is hard to paint a scenario where policyholders cannot be paid.

4. You can always argue for higher capital requirements to protect policyholders. But the price will be paid mostly by customers (in the form of worse annuity rates) and society (as insurers won't finance risky ventures if the capital requirements are too high). I would argue that policyholder protection has gone too far already (see for example the leaching of UK insurance risks to Bermuda as a direct consequence of Solvency II).

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On the other hand

 

3 YEARS AGO

 

reply In reply to Hedge Trimmer

Very well said
There is sound economic rationale for matching adjustment
and the debate has been held a decade ago, suspect when Mr Buckner was the regulator

MA enforced strict rules on insurers most of which are to avoid ever being in a forced sale scenario

the benefit of MA accrues to policyholders/customers through keener pricing

what is this article really about?

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Jlo88

 

3 YEARS AGO

 

This argument is flawed and doesn't take account of diversification. Where your sources have a point, is that for some assets (e.g. equity release mortgages) it is sometimes inherently uncertain what/when those future pay outs will be. For most asset types (e.g. bonds, loans, etc) the cash flows for well-diversified portfolios are predicatable over the long-term. There seems little advantage in introducing mark-to-market volatility on long-term investments and liabilities. If this is your issue, then you should be railing against book value accounting which is still done in some major economics (e.g. the US, Germany, France, most of Europe)

Removing this kind of benefit disincentivises investments in the real economy. On the continent, this benefit isn't allowed and insurers are more incentivised to invest in government bonds as the European solvency regime requires no capital to be held against sovereign defaults. For example, take a look at how much government debt Generali owns (https://www.fitchratings.com/research/insurance/fitch-downgrades-generali-ifs-to-a-on-sovereign-downgrade-outlook-stable-05-05-2020)

UK insurers are proportionately more exposed to corporate bonds, infrastructure and property-type investments, which will definitely have more default events when all this (Covid) is over. A consequence of the rules means that they are already holding higher capital buffers due to being exposed to these risks (even with the use of the matching adjustment) and so should be able to weather the storm.

Regulations like this are intended to help improve government borrowing costs, but have unfortunately been too effective in a low-growth environment and helped propel most of Europe into a negative yield environment.

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eumaeus

 

3 YEARS AGO

 

reply In reply to Jlo88

"For most asset types (e.g. bonds, loans, etc) the cash flows for well-diversified portfolios are predictable over the long-term."

In what way is the value of a (risky) corporate bond, or loan, predictable over the long term??
 

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Jlo88

 

3 YEARS AGO

 

reply In reply to eumaeus

https://www.spglobal.com/ratings/en/research/articles/200429-default-transition-and-recovery-2019-annual-global-corporate-default-and-rating-transition-study-11444862#:~:text=The%20global%20speculative%2Dgrade%20corporate,triple%2Ddigit%20total%20since%202016.

It's in the data. For IG bonds the highest default rate in any given year since 1981 was 0.42% (both in 2002 and 2008). Who knows if this will continue going forward, but I guess that's the point of having a capital requirement to cover this risk. If the point of your question (as inferred by the "risky") is that a liquidity premium does not exist, then I think the article has pointed out the most salient example of recent years where investors flocked to liquidity.

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eumaeus

 

3 YEARS AGO

(Edited)

 

reply In reply to Jlo88

"For IG bonds the highest default rate in any given year since 1981 was 0.42% (both in 2002 and 2008)."

And for other periods? Say pre- 1940s?

On whether a liquidity premium exists: if it does then it should be possible systematically to make a profit by buying bonds when the price falls, in the expectation that the price will certainly revert.

There used to be desks in the City before 2008 which speculated on this assumption.

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Jlo88

 

3 YEARS AGO

 

reply In reply to eumaeus

Of course, much higher, probably around the mid-teens from memory. I would question the relevance of using data pre-1940 (or even between WW2 and 1981 which as you're aware was an especially benign period for corporate bonds). There are many reasons to suggest that capital markets are inherently different after 1940: Keynesian policies, independent central banks, complete abandonment of the gold standard, no "rail road" bonds,

It's also not about price reversion, it's about cash flow, and making more than you would on a risk-free asset over the duration to maturity (net of defaults, costs) no matter when you buy, which can (and is) done systematically on a well-diversified portfolio of bonds. The matching adjustment frameowrk doesn't allow for spread speculation, which I certaintly wouldn't want an insurer to do. As far as I'm aware the regulations do not incentivise that behaviour.

My main concern would be that they do incentivise investments into internally-rated assets, mark-to-model assets, which I do think need a lot more scrutiny (particularly today) and I hope insurers have been responsible in their approaches to these assets.

I just don't find the lack of liquidity premium argument that compelling in the context of an insurance business model. You can point to many academic papers purporting the existence (or lack) of it, but fundamentally insurers' business models are based on making a spread. Legislating on the assumption that this isn't true is effectively asking/forcing insurers to only invest in govies and swaps.

This may be your goal, but I do not think it's a worthy one. The insurance industry doesn't need to be further capitalised and this would just be another tool to force this. In the end policyholders would lose out by being offered even worse rates on annuities, or DB schemes having to be in extreme levels of surplus before being bought out, which in turn would increase the burden on corporates. To compound this, you would be diverting investments from corporates into government bonds which isn't going to help anyone in society.

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eumaeus

 

3 YEARS AGO

 

reply In reply to Jlo88

"There are many reasons to suggest that capital markets are inherently different after 1940"

Of course. This time it's different.

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Rosencruz

 

3 YEARS AGO

 

“About that which we do not know, we must remain silent”- Wittgenstein
With no mention of liquidity, I must assume that the author does not know what he is talking about. These bonds are held to maturity, and therefore there is no need to allow for the liquidity risk in their price.

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Dave1000

 

3 YEARS AGO

 

reply In reply to Rosencruz

I think that’s the point that’s being made. If prices have moved due to a reassessment of the liquidity premium, then it’s fine to adjust liabilities in line with asset values. However, if the prices have moved because there’s now an increased probability of default, then it’s imprudent to simply offset this on the liabilities

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eumaeus

 

3 YEARS AGO

(Edited)

 

reply In reply to Dave1000

This is exactly what was meant.
" An insurer might be tempted to run that loss on the assumption that **illiquidity, not default risk**, was behind the wider spread. With its helpful mathematics, the matching adjustment regime might even encourage such a conclusion. "

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OhMyOhMy

 

3 YEARS AGO

 

reply In reply to eumaeus

The regime makes sense, sort of. The so-called fundamental spread is supposed to be a representation of credit risk over the long term. The price of credit risk, the spread, in the short term doesn’t affect whether a bond will pay out in full or not. That’s only affected if the amount of credit risk changes. The trouble is Actuaries love evaluating risks with data and the fundamental spread, supposedly, uses data. And you can’t recalibrate a long term average without quite a bit of *new* data. In other words we will know the result of the crisis before the calibration is changed.

Don’t blame the firms for what the rules say. Blame the regulators. Dean Buckner is a mark-to-market fundamentalist and sees the market price as the amount of credit risk. It isn’t. It’s amount x price per unit of risk. Insurers using MA are exposed to AMOUNT not PRICE.

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OhMyOhMy

 

3 YEARS AGO

 

reply In reply to OhMyOhMy

Point being you can’t tell right now. Blame the regime and actuaries. Don’t blame the insurers.

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Kevin Dowd

 

3 YEARS AGO

 

reply In reply to OhMyOhMy

>Don’t blame the firms for what the rules say.
Why shouldn't we blame them? They lobbied for those rules.

>Blame the regulators.
I agree: they gave in to the lobbying

>Dean Buckner is a mark-to-market fundamentalist
There are a few of them around.

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eumaeus

 

3 YEARS AGO

 

reply In reply to OhMyOhMy

"Dean Buckner is a mark-to-market fundamentalist and sees the market price as the amount of credit risk."

He sees it as a measure of risk. How do you tell whether any given spread is illiquidity risk or default risk? If it were all illiquidity risk, why not buy the market every time there is a dip and make a sure profit when it returns to 'normal'.

On the long-term average bit, depends entirely on which time series you are looking at, of course.

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OhMyOhMy

 

3 YEARS AGO

 

reply In reply to eumaeus

He, or more accurately you given you are he, appears to see the market price as THE reflection of the quantity of risk. It isn’t. As I said above. You can’t be sure what of the current spread increase is credit risk increase, liquidity risk increase, credit price increase or liquidity price increase. In other words you don’t know a lot. Your solution is to assume a short term blip in spread is all a sign that long term credit risk has increased. Yeah....

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Kevin Dowd

 

3 YEARS AGO

 

reply In reply to Rosencruz

The bonds being (intended to be) held to maturity is of little use to an insurance company if the increase in the credit spread is due to increased default risk.
If you think that the increase is due to some jump in the illiquidity spread, then where is the evidence to support that claim?

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OhMyOhMy

 

3 YEARS AGO

(Edited)

 

reply In reply to Kevin Dowd

But where is the evidence the other way? The PRA’s own leader said Banks should take account of the unprecedented nature of Bank and state intervention. And what evidence is there that all firms are equally affected? What evidence that BBB rated supermarkets are as badly hit as BBB rated car rental companies? What evidence this will be over by Christmas, or next week, or never? Too many uncertainties exist right now. And again, what evidence is there that the trailing data used for the FS calibration is even relevant to current markets and exposures? What about recovery rates in default from past data?

Mark to market ascribing everything to credit risk is wrong. Ignoring the market and saying its all illiquidity is wrong. The really hard part is telling how much of each on a forward looking basis.

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Kevin Dowd

 

3 YEARS AGO

 

reply In reply to OhMyOhMy

Traditionally, spreads are interpreted as reflecting default risk. Actuaries then come along and claim that some of those spreads reflect an illiquidity premium (ILP). The onus is then on them to give us evidence to support their claim and tell us how to estimate the ILP, and none of them have done so.

This is the central issue and your other points are irrelevant to it.

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Hedge Trimmer

 

3 YEARS AGO

 

reply In reply to Kevin Dowd

"Traditionally, spreads are interpreted as reflecting default risk." That isn't an argument it's just an assertion. And even if it were true, the fact that something is done traditionally is hardly a strong argument.
The evidence for an ILP, as I'm sure you know, rests in the historic outperformance of corporate bonds over government bonds. This was reviewed extensively by CEIOPS (now EIOPA) in the run-up to Solvency II. The resulting MA is of course a political fudge - one that is far more penal on insurers than the Solvency I regime.
 

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Kevin Dowd

 

3 YEARS AGO

 

reply In reply to Hedge Trimmer

>The evidence for an ILP, as I'm sure you know, rests in the historic outperformance of corporate bonds over government bonds.

Surely, the outperformance of corporate bonds over government bonds reflects the reward for taking on corporate default risk? And why is this spread evidence for an ILP?

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Mafiosi

 

3 YEARS AGO

 

reply In reply to Kevin Dowd

I recollect calculating the value of some assets held by these insurers that included an explicit illiquidity premium in the calculation ( depressing the price ). To not then use an illiquidity premium on the other side of the balance sheet in determining liabilities would then seem somewhat perverse.

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Kevin Dowd

 

3 YEARS AGO

 

reply In reply to Mafiosi

Yeah but you have still to justify ILP that you use, and justify why it applies to the liability side.

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Michael Milkinstein

 

3 YEARS AGO

 

reply In reply to Kevin Dowd

yes i think insurers do that kevin.

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Dom86

 

3 YEARS AGO

 

A lot rests here on the credit rating failing to keep up with the fundamentals. The implied point, that Matching Adjustment insurers' valuation of credit is much more a function of credit rating than price, is correct. But it's worth pointing out that the agencies have moved extremely quickly to downgrade companies over the past few months - as the FT itself has reported (the insurers can't rely 100% on the rating agencies, especially for non-listed investments, but they have to to a large extent). There might be some time lag between the markets spotting credit weakness and the rating decision - but frankly that doesn't strike me as much of a complaint. And it doesn't take much imagination to see that spread movements aren't a perfect predictor of credit conditions. The more interesting complaint would be if there was some evidence of systematic failure of the rating agencies - (expect snide remarks about CDOs in 2007). But on my (casual) reading of the data, it looks like the ratings roughly do their job.

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LibrarianCap

 

3 YEARS AGO

 

I think a lot of the "value" investors who say insurers are "cheap" because they are on less than 10x P/E on trailing earnings don't really know how to read insurer balance sheets *.

* I don't either, except for simpler non-life insurers. But I know this and don't invest in insurers.

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A diligent observer

 

3 YEARS AGO

 

reply In reply to LibrarianCap

Like banks, insurers have a lot of complication caused by regulation. But the regulation also creates a degree of safety.

It can be challenging to assess the "true" value of their balance sheets. But not impossible. I am more of a specialist in banking than insurance, but I do have one (very obscure) insurer in my value portfolio; previously I had Sagicor Financial, until it was bought out - and it was my biggest holding at the point the offer was made. I made a very significant return on that over my holding period.

That said, I'd be tempted to agree that if you scout around the FTSE100 for "value" stocks, you probably don't really understand the concept.

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LibrarianCap

 

3 YEARS AGO

 

reply In reply to A diligent observer

Thanks for sharing - interesting points.

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Padada

 

3 YEARS AGO

(Edited)

 

So the article discusses the headline "regulation masks the true condition of insurers". Quite frankly, insurer solvency rules are complex and its easy to draft an article that (unfairly?) picks issues with selected parts of them. Can you please address the "so what?". Is the FT saying that some of the insurers listed are on the cusp of financial difficulty and perhaps even default, are the FT saying the PRA is hiding something?

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ForrestGump

 

3 YEARS AGO

 

These Jonathan Ford articles are becoming wearysome. They continue to ignore key aspects of the Solvency II regime, like the role and magnitude of the SCR, and that illiquidity premium of itself isn't a contentious concept.

Ford continues to disparage insurers and the regulator for doing things permitted at law. That's why the Equitable case made such short shrift of Dowd and Buckner's arguments.

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eumaeus

 

3 YEARS AGO

 

reply In reply to ForrestGump

The law does not say what the illiquidity premium is.

"illiquidity premium of itself isn't a contentious concept." Really? Was the spread widening we say in Virgin Australia the effect of illiquidity? Really?

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Warthog Under The Bridge

 

3 YEARS AGO

(Edited)

 

In a nutshell:
Insurers are over-valued and consequently over-rated.

Fair enough on the long explanation 'though, would have been just assertion without the underpinning.


In terms of action: Fine to support them if needs be BUT not in the way the Bankers who crashed the economy twelve years ago walked away wealthy at the nation's expense.

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Smug ethnic Chinese

 

3 YEARS AGO

 

Thanks.
Note to writer and subbie: Move the chart higher up in the piece. I was starting to wondering what was the author's point until I saw the table.

Spy thanks for these some very titnereign sutuff.Ill reply tmrw or day after when I have more time.

Kids are on half temr and have ragged me all day and eveninfg.And Imean ragged...the 5 &6 year old particularly seem to sense my physical weakness at 2000 hrs and exploit it well.

I had dreams of doing the covs balance sheet tonight but they are gone,dashed on the roskcs like a scab getting landed on by a 25 stone fat bloke.

[jamtomorrow]

Cracking stuff @spygirl

Are these the same life companies that recently came unstuck over LDIs, where Chief Clown Bailey had to take a few moments out of his busy stepping-on-rakes schedule to bail them out?

Either way, the smell coming from the pensions industry isn't good. Thoughts at this stage:

- they seem to be getting liquidity and solvency increasingly tangled up (as in: "we're temporarily illiquid, not insolvent" - even though there are signs it's both or even the other way round). Can't tell whether it's incompetence or deliberate can-kicking yet - maybe a bit of both?

- I wouldn't go all-in on an annuity. I'd still consider one as a diversified part of my "retirement" income on the basis they'll get bailed out if the problems are systemic. But they're a risk asset now, as far as I'm concerned

- I feel for the poor bastards that were either forced or chose to buy an annuity - uncertain times ahead methinks

[HousePriceMania]

Flight to safety ?

[Funn3r]

3 hours ago, HousePriceMania said:

Flight to safety ?

I logged into my account last night for the first time in 5 years. The "security image" and "reverse passphrase" which I was supposed to get had just vanished. They insisted on sending me a code via SMS, which always pisses me off because there is no signal here unless I go outside and hold my phone in the air.

Then to cap everything they said my browser was "not supported" and I should use Microsoft Edge instead. I have not seen that sort of fuckwittery since 1999 when sites used to have "best viewed with Internet Explorer" or whatever was their lead developer's favourite browser.

I have a very bad feeling about NS&I's competence.

[Dave Bloke]

20 hours ago, spygirl said:

There are two massive housign events that are comign to home to roost.

Three: Net Zero will kill landlords. I'm sure the idea is to rince the last bit of wealth out of individuals and into large corps.

First they came for your pay increases

Then they came for your pensions

Now they are coming for your BTLs

[sancho panza]

On 04/04/2023 at 18:16, spygirl said:

OK,

Dean Buckner is an ex PRA on the insunrace ratehr than banking side.

His concerns relate to acturarial fuckwittery.

PE are active in this area too.

Mr Bckner has been wavign a red flag on various insuance fuckwittery.

Regulation is masking the true condition of insurers

Rules that encouraged investment in risky assets could come back to bite them

https://www.ft.com/content/05d3479d-121e-4613-8e04-c9799f1fc9cd

Imagine that you hold a bond in a company whose debt is rated at BBB. The coronavirus lockdown strikes and shuts down parts of the issuer’s business, severely reducing its cash flows. 

The bond’s price falls from 100 per cent to 80 per cent of face value as the yield increases to compensate investors for all that extra risk they are taking. But the rating agencies are not yet sure how to quantify fully the impact. While putting the bond on ratings watch, they leave it for now as investment-grade. 

If you were a bank, you would mark the bond to market, recognising a consequent loss that would erode your equity capital. Fortunately, however, you are a life insurance company. The regulatory regime is different.

Granted, you still have to mark down the bond’s value. But that doesn’t mean taking the full loss through your equity. Under European legislation, UK insurers get a helpful regulatory concession. While they must recognise the loss on the asset side, they also get to adjust the value of their insurance liabilities (that is, the estimated present value of what they must pay in future to annuitants). 

They do this by discounting those liabilities at a higher rate, reflecting the additional yield on the now less valuable bond. The fall in the value of those liabilities magically absorbs a large chunk of the loss on the asset. 

This might all seem like a bewildering game of technical number crunching. But it serves an important purpose as far as insurers are concerned. And it has become especially pertinent with the impact of Covid-19. 

Thanks to the long period of low interest rates, insurers have herded into higher-yielding assets such as corporate bonds. Despite these being needed to fund an AA-rated annuity, about 35 per cent of these bonds are BBB. 

This has been a bit of a costless option for the insurance companies themselves. Despite the additional risk, they’ve not had to fund these assets with much more capital. The same regime that magically sweeps up bond losses also supplies the “capital” to support this riskier investment.

The regulator lets them discount the corresponding liabilities at a concomitantly higher rate through a process known as the “matching adjustment”. This essentially capitalises upfront the additional returns they hope to make from the bonds above the risk-free (or government bond) rate, after deducting a bit to provide for the long-run risk of default. 

Remember also that those extra returns accrue only to the insurer’s shareholders, and not to the annuitants whose pensions are fixed. 

In many cases, matching adjustment has actually become a major part of insurers’ capital. According to their 2019 regulatory filings, its matching adjustment accounted for 70 per cent of L&G’s solvency capital and 23 per cent of Aviva’s. With smaller entrepreneurial insurers, the numbers can be even higher. With Just Group, the percentage is 104.

Why is this so important now? Well, the big reason is that the outlook for corporate bonds has become so very murky.

True, bond prices have somewhat recovered after sharp falls in March and April, thanks to the giant emergency measures governments have taken. But there are fears that these could simply be deferring a deeper corporate solvency problem. S&P Global Ratings warned last month that it had on its radar globally a record 111 potential fallen angels, or companies that could be downgraded to junk status.

Meanwhile, UBS has estimated that 33 per cent of loans in the main US loan index could fall to CCC because of the dislocation. That compares to 11 per cent at the trough of 2009.

Take our imaginary bond that declined to 80 per cent, while nominally remaining investment-grade. An insurer might be tempted to run that loss on the assumption that illiquidity, not default risk, was behind the wider spread. With its helpful mathematics, the matching adjustment regime might even encourage such a conclusion. 

Analysis from Dean Buckner, a former insurance regulator at the UK watchdog, has estimated that six large UK insurers collectively ran up £28bn of mark-to-market losses on their bond holdings as of the beginning of June.

Yet while crystallising these losses would clearly be extremely painful, “cushioning” them with matching adjustment is not without its perils. The worry is that a large number of bonds subsequently default or get downgraded to junk. That would force the insurer to crystallise a sudden and potentially much more substantial loss. 

In a speech last year, David Rule, then head of insurance supervision at the UK watchdog, noted that the interests of owners and managers of insurers were not necessarily aligned with policyholders. “Owners share the benefits of taking more risk in a good outcome but have limited exposure to losses in a bad outcome because of limited liability.” 

Mr Rule thought the structure of regulation did not exacerbate this conflict. Coronavirus may subject that belief to a sterner test.

Coments - 

A few points:

1. The Matching Adjustment is not some new concession which came out of the European Solvency II legislation. Similar methodologies were part of the ICA regime and Solvency I. This goes back at least to the 1970s and I suspect much longer than that.

2. Life insurers often run risks which run over decades yet Solvency II forces them to build a balance sheet based on 1 year Value-at-Risk. This is a bad thing. One reason is that it makes insurers look more like banks and so makes the two sectors more likely to be under stress at the same time - the very definition of systemic risk. The MA is one of the things that helps to mitigate this risk. The market consistency zealots behind this article ("Dowd" and "eumaeus" from the comments) would have the whole world using one paradigm and so amplify crises (think of the "geniuses" at LTCM).

3. While it is true that life insurance shareholders have limited liability, there are multiple layers of policyholder protection. The chart above suggests that some insurers have no spare capital if you ignore the MA but there is ample historical evidence for a liquidity premium on bonds held to maturity over all time periods and Solvency II has other margins which are not shown here: a risk margin that is outrageously high in a low interest rate environment, the use of a risk free rate below government bonds yields, risk appetite limits, stress tests,... The effect is that it is hard to paint a scenario where policyholders cannot be paid.

4. You can always argue for higher capital requirements to protect policyholders. But the price will be paid mostly by customers (in the form of worse annuity rates) and society (as insurers won't finance risky ventures if the capital requirements are too high). I would argue that policyholder protection has gone too far already (see for example the leaching of UK insurance risks to Bermuda as a direct consequence of Solvency II).

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On the other hand

 

3 YEARS AGO

 

reply In reply to Hedge Trimmer

Very well said
There is sound economic rationale for matching adjustment
and the debate has been held a decade ago, suspect when Mr Buckner was the regulator

MA enforced strict rules on insurers most of which are to avoid ever being in a forced sale scenario

the benefit of MA accrues to policyholders/customers through keener pricing

what is this article really about?

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Jlo88

 

3 YEARS AGO

 

This argument is flawed and doesn't take account of diversification. Where your sources have a point, is that for some assets (e.g. equity release mortgages) it is sometimes inherently uncertain what/when those future pay outs will be. For most asset types (e.g. bonds, loans, etc) the cash flows for well-diversified portfolios are predicatable over the long-term. There seems little advantage in introducing mark-to-market volatility on long-term investments and liabilities. If this is your issue, then you should be railing against book value accounting which is still done in some major economics (e.g. the US, Germany, France, most of Europe)

Removing this kind of benefit disincentivises investments in the real economy. On the continent, this benefit isn't allowed and insurers are more incentivised to invest in government bonds as the European solvency regime requires no capital to be held against sovereign defaults. For example, take a look at how much government debt Generali owns (https://www.fitchratings.com/research/insurance/fitch-downgrades-generali-ifs-to-a-on-sovereign-downgrade-outlook-stable-05-05-2020)

UK insurers are proportionately more exposed to corporate bonds, infrastructure and property-type investments, which will definitely have more default events when all this (Covid) is over. A consequence of the rules means that they are already holding higher capital buffers due to being exposed to these risks (even with the use of the matching adjustment) and so should be able to weather the storm.

Regulations like this are intended to help improve government borrowing costs, but have unfortunately been too effective in a low-growth environment and helped propel most of Europe into a negative yield environment.

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eumaeus

 

3 YEARS AGO

 

reply In reply to Jlo88

"For most asset types (e.g. bonds, loans, etc) the cash flows for well-diversified portfolios are predictable over the long-term."

In what way is the value of a (risky) corporate bond, or loan, predictable over the long term??
 

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Jlo88

 

3 YEARS AGO

 

reply In reply to eumaeus

https://www.spglobal.com/ratings/en/research/articles/200429-default-transition-and-recovery-2019-annual-global-corporate-default-and-rating-transition-study-11444862#:~:text=The%20global%20speculative%2Dgrade%20corporate,triple%2Ddigit%20total%20since%202016.

It's in the data. For IG bonds the highest default rate in any given year since 1981 was 0.42% (both in 2002 and 2008). Who knows if this will continue going forward, but I guess that's the point of having a capital requirement to cover this risk. If the point of your question (as inferred by the "risky") is that a liquidity premium does not exist, then I think the article has pointed out the most salient example of recent years where investors flocked to liquidity.

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eumaeus

 

3 YEARS AGO

(Edited)

 

reply In reply to Jlo88

"For IG bonds the highest default rate in any given year since 1981 was 0.42% (both in 2002 and 2008)."

And for other periods? Say pre- 1940s?

On whether a liquidity premium exists: if it does then it should be possible systematically to make a profit by buying bonds when the price falls, in the expectation that the price will certainly revert.

There used to be desks in the City before 2008 which speculated on this assumption.

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Jlo88

 

3 YEARS AGO

 

reply In reply to eumaeus

Of course, much higher, probably around the mid-teens from memory. I would question the relevance of using data pre-1940 (or even between WW2 and 1981 which as you're aware was an especially benign period for corporate bonds). There are many reasons to suggest that capital markets are inherently different after 1940: Keynesian policies, independent central banks, complete abandonment of the gold standard, no "rail road" bonds,

It's also not about price reversion, it's about cash flow, and making more than you would on a risk-free asset over the duration to maturity (net of defaults, costs) no matter when you buy, which can (and is) done systematically on a well-diversified portfolio of bonds. The matching adjustment frameowrk doesn't allow for spread speculation, which I certaintly wouldn't want an insurer to do. As far as I'm aware the regulations do not incentivise that behaviour.

My main concern would be that they do incentivise investments into internally-rated assets, mark-to-model assets, which I do think need a lot more scrutiny (particularly today) and I hope insurers have been responsible in their approaches to these assets.

I just don't find the lack of liquidity premium argument that compelling in the context of an insurance business model. You can point to many academic papers purporting the existence (or lack) of it, but fundamentally insurers' business models are based on making a spread. Legislating on the assumption that this isn't true is effectively asking/forcing insurers to only invest in govies and swaps.

This may be your goal, but I do not think it's a worthy one. The insurance industry doesn't need to be further capitalised and this would just be another tool to force this. In the end policyholders would lose out by being offered even worse rates on annuities, or DB schemes having to be in extreme levels of surplus before being bought out, which in turn would increase the burden on corporates. To compound this, you would be diverting investments from corporates into government bonds which isn't going to help anyone in society.

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eumaeus

 

3 YEARS AGO

 

reply In reply to Jlo88

"There are many reasons to suggest that capital markets are inherently different after 1940"

Of course. This time it's different.

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Rosencruz

 

3 YEARS AGO

 

“About that which we do not know, we must remain silent”- Wittgenstein
With no mention of liquidity, I must assume that the author does not know what he is talking about. These bonds are held to maturity, and therefore there is no need to allow for the liquidity risk in their price.

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Dave1000

 

3 YEARS AGO

 

reply In reply to Rosencruz

I think that’s the point that’s being made. If prices have moved due to a reassessment of the liquidity premium, then it’s fine to adjust liabilities in line with asset values. However, if the prices have moved because there’s now an increased probability of default, then it’s imprudent to simply offset this on the liabilities

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eumaeus

 

3 YEARS AGO

(Edited)

 

reply In reply to Dave1000

This is exactly what was meant.
" An insurer might be tempted to run that loss on the assumption that **illiquidity, not default risk**, was behind the wider spread. With its helpful mathematics, the matching adjustment regime might even encourage such a conclusion. "

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OhMyOhMy

 

3 YEARS AGO

 

reply In reply to eumaeus

The regime makes sense, sort of. The so-called fundamental spread is supposed to be a representation of credit risk over the long term. The price of credit risk, the spread, in the short term doesn’t affect whether a bond will pay out in full or not. That’s only affected if the amount of credit risk changes. The trouble is Actuaries love evaluating risks with data and the fundamental spread, supposedly, uses data. And you can’t recalibrate a long term average without quite a bit of *new* data. In other words we will know the result of the crisis before the calibration is changed.

Don’t blame the firms for what the rules say. Blame the regulators. Dean Buckner is a mark-to-market fundamentalist and sees the market price as the amount of credit risk. It isn’t. It’s amount x price per unit of risk. Insurers using MA are exposed to AMOUNT not PRICE.

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OhMyOhMy

 

3 YEARS AGO

 

reply In reply to OhMyOhMy

Point being you can’t tell right now. Blame the regime and actuaries. Don’t blame the insurers.

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Kevin Dowd

 

3 YEARS AGO

 

reply In reply to OhMyOhMy

>Don’t blame the firms for what the rules say.
Why shouldn't we blame them? They lobbied for those rules.

>Blame the regulators.
I agree: they gave in to the lobbying

>Dean Buckner is a mark-to-market fundamentalist
There are a few of them around.

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eumaeus

 

3 YEARS AGO

 

reply In reply to OhMyOhMy

"Dean Buckner is a mark-to-market fundamentalist and sees the market price as the amount of credit risk."

He sees it as a measure of risk. How do you tell whether any given spread is illiquidity risk or default risk? If it were all illiquidity risk, why not buy the market every time there is a dip and make a sure profit when it returns to 'normal'.

On the long-term average bit, depends entirely on which time series you are looking at, of course.

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OhMyOhMy

 

3 YEARS AGO

 

reply In reply to eumaeus

He, or more accurately you given you are he, appears to see the market price as THE reflection of the quantity of risk. It isn’t. As I said above. You can’t be sure what of the current spread increase is credit risk increase, liquidity risk increase, credit price increase or liquidity price increase. In other words you don’t know a lot. Your solution is to assume a short term blip in spread is all a sign that long term credit risk has increased. Yeah....

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Kevin Dowd

 

3 YEARS AGO

 

reply In reply to Rosencruz

The bonds being (intended to be) held to maturity is of little use to an insurance company if the increase in the credit spread is due to increased default risk.
If you think that the increase is due to some jump in the illiquidity spread, then where is the evidence to support that claim?

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OhMyOhMy

 

3 YEARS AGO

(Edited)

 

reply In reply to Kevin Dowd

But where is the evidence the other way? The PRA’s own leader said Banks should take account of the unprecedented nature of Bank and state intervention. And what evidence is there that all firms are equally affected? What evidence that BBB rated supermarkets are as badly hit as BBB rated car rental companies? What evidence this will be over by Christmas, or next week, or never? Too many uncertainties exist right now. And again, what evidence is there that the trailing data used for the FS calibration is even relevant to current markets and exposures? What about recovery rates in default from past data?

Mark to market ascribing everything to credit risk is wrong. Ignoring the market and saying its all illiquidity is wrong. The really hard part is telling how much of each on a forward looking basis.

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Kevin Dowd

 

3 YEARS AGO

 

reply In reply to OhMyOhMy

Traditionally, spreads are interpreted as reflecting default risk. Actuaries then come along and claim that some of those spreads reflect an illiquidity premium (ILP). The onus is then on them to give us evidence to support their claim and tell us how to estimate the ILP, and none of them have done so.

This is the central issue and your other points are irrelevant to it.

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Hedge Trimmer

 

3 YEARS AGO

 

reply In reply to Kevin Dowd

"Traditionally, spreads are interpreted as reflecting default risk." That isn't an argument it's just an assertion. And even if it were true, the fact that something is done traditionally is hardly a strong argument.
The evidence for an ILP, as I'm sure you know, rests in the historic outperformance of corporate bonds over government bonds. This was reviewed extensively by CEIOPS (now EIOPA) in the run-up to Solvency II. The resulting MA is of course a political fudge - one that is far more penal on insurers than the Solvency I regime.
 

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Kevin Dowd

 

3 YEARS AGO

 

reply In reply to Hedge Trimmer

>The evidence for an ILP, as I'm sure you know, rests in the historic outperformance of corporate bonds over government bonds.

Surely, the outperformance of corporate bonds over government bonds reflects the reward for taking on corporate default risk? And why is this spread evidence for an ILP?

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Mafiosi

 

3 YEARS AGO

 

reply In reply to Kevin Dowd

I recollect calculating the value of some assets held by these insurers that included an explicit illiquidity premium in the calculation ( depressing the price ). To not then use an illiquidity premium on the other side of the balance sheet in determining liabilities would then seem somewhat perverse.

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Kevin Dowd

 

3 YEARS AGO

 

reply In reply to Mafiosi

Yeah but you have still to justify ILP that you use, and justify why it applies to the liability side.

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Michael Milkinstein

 

3 YEARS AGO

 

reply In reply to Kevin Dowd

yes i think insurers do that kevin.

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Dom86

 

3 YEARS AGO

 

A lot rests here on the credit rating failing to keep up with the fundamentals. The implied point, that Matching Adjustment insurers' valuation of credit is much more a function of credit rating than price, is correct. But it's worth pointing out that the agencies have moved extremely quickly to downgrade companies over the past few months - as the FT itself has reported (the insurers can't rely 100% on the rating agencies, especially for non-listed investments, but they have to to a large extent). There might be some time lag between the markets spotting credit weakness and the rating decision - but frankly that doesn't strike me as much of a complaint. And it doesn't take much imagination to see that spread movements aren't a perfect predictor of credit conditions. The more interesting complaint would be if there was some evidence of systematic failure of the rating agencies - (expect snide remarks about CDOs in 2007). But on my (casual) reading of the data, it looks like the ratings roughly do their job.

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LibrarianCap

 

3 YEARS AGO

 

I think a lot of the "value" investors who say insurers are "cheap" because they are on less than 10x P/E on trailing earnings don't really know how to read insurer balance sheets *.

* I don't either, except for simpler non-life insurers. But I know this and don't invest in insurers.

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A diligent observer

 

3 YEARS AGO

 

reply In reply to LibrarianCap

Like banks, insurers have a lot of complication caused by regulation. But the regulation also creates a degree of safety.

It can be challenging to assess the "true" value of their balance sheets. But not impossible. I am more of a specialist in banking than insurance, but I do have one (very obscure) insurer in my value portfolio; previously I had Sagicor Financial, until it was bought out - and it was my biggest holding at the point the offer was made. I made a very significant return on that over my holding period.

That said, I'd be tempted to agree that if you scout around the FTSE100 for "value" stocks, you probably don't really understand the concept.

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LibrarianCap

 

3 YEARS AGO

 

reply In reply to A diligent observer

Thanks for sharing - interesting points.

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Padada

 

3 YEARS AGO

(Edited)

 

So the article discusses the headline "regulation masks the true condition of insurers". Quite frankly, insurer solvency rules are complex and its easy to draft an article that (unfairly?) picks issues with selected parts of them. Can you please address the "so what?". Is the FT saying that some of the insurers listed are on the cusp of financial difficulty and perhaps even default, are the FT saying the PRA is hiding something?

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ForrestGump

 

3 YEARS AGO

 

These Jonathan Ford articles are becoming wearysome. They continue to ignore key aspects of the Solvency II regime, like the role and magnitude of the SCR, and that illiquidity premium of itself isn't a contentious concept.

Ford continues to disparage insurers and the regulator for doing things permitted at law. That's why the Equitable case made such short shrift of Dowd and Buckner's arguments.

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eumaeus

 

3 YEARS AGO

 

reply In reply to ForrestGump

The law does not say what the illiquidity premium is.

"illiquidity premium of itself isn't a contentious concept." Really? Was the spread widening we say in Virgin Australia the effect of illiquidity? Really?

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Warthog Under The Bridge

 

3 YEARS AGO

(Edited)

 

In a nutshell:
Insurers are over-valued and consequently over-rated.

Fair enough on the long explanation 'though, would have been just assertion without the underpinning.


In terms of action: Fine to support them if needs be BUT not in the way the Bankers who crashed the economy twelve years ago walked away wealthy at the nation's expense.

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Smug ethnic Chinese

 

3 YEARS AGO

 

Thanks.
Note to writer and subbie: Move the chart higher up in the piece. I was starting to wondering what was the author's pThats oint until I saw the table.

Thats annabsolutely fascinating post.I find it simply incredible that if some REIT that owns lots of emptying shopping cetnres sees it dbonds lose 50% en route to bankruptcy that insurers can simply use the increased yield to extend and rpetend.

Buckner gets called a 'mark to market ' fanatic or whatever for stating the obvious.It's anotehr facet of this mess I was unaware of so thanks for posting and eplinging

the chart is incredible

Edited April 6, 2023 by sancho panza

[spygirl]

1 minute ago, sancho panza said:

Thats annabsolutely fascinating post.I find it simply incredible that if some REIT that owns lots of emptying shopping cetnres sees it dbonds lose 50% en route to bankruptcy that insurers can simply use the increased yield to extend and rpetend.

Buckner gets called a 'mark to market ' fanatic or whatever for stating the obvious.It's anotehr facet of this mess I was unaware of so thanks for posting and eplinging

UK life insurance cos i.e. with profits policies, as a means of invemnt was a total con, ponzi, scam.

Theres a fair few regulators who were after jailing/fining a lot of the companies.

I was suropuise the LI just disppeared to almost nthing.

By the late 80s LifeCos were massive - market influencers, employers, lobby etc etc.

By 2000, after the penson then endowment scandals, finished,. AT elast as new ivnesmtent.

The big where they are hangign on is large scale peorpedee stuff -offices n shopping centres.

Both sectors that are totally fucked.

This is marked to amrket issue - they have stuff that is nowhere near the book value.

PE are in it too, havign similar invenstents that are junk.

 

 

 

 

[sancho panza]

On 04/04/2023 at 18:40, spygirl said:

Borrowing 200/300k at @ 2% IO only takes 4k/6k to serve, keep the illusion.

Maybe 8k/9k for repayment,. Bit more but still doable ...

Change IR to 6% and that IO now becomes 12k/18k. Repymant 18k/25k.

This is it.First time in twenty years we've had rates moving up enough to cause dislocations.

The BTLer I know(and prob the reason I started this thread timing wise),tells us the chickens are eyeing the skyline for bed spaces.

Said BTLer was pocketing £4k per month for a long time,now lsoing £4k,the switch took about three or four months and is really bedding in now.So from £4k profit pcpm to £4k loss in 4 months,then another 8 months buring savings until bankruptcy.All thsoe hosues will be hitting the market and he won't be the only one.

Ground zero banking wise is small BS's with commercial exposure.Its the weaknessess in their balance sheets that will lead to the bigger banks struggling.

Am adding nationwide to my BS lsit after I've done the cov 22 results.NW is the mother ship in that sector and I think theyre exposed.

On 04/04/2023 at 18:40, spygirl said:

And just now - 

Huge Arse -

https://www.ft.com/content/6890be22-9280-460a-bd2a-3c45f2cf531f

Bank of England’s chief economist hints at May interest rate rise

Huw Pill stresses that policymakers face tight decision on whether to push borrowing costs higher

I lsitned to a BoE panel led by Huw and he may have been playing to the crowd and trying not to scare people but my underlying worry is that he jsut doesnt understand where we are in the credit or economci cycle

Worse,we're not the US with the worlds reserve currency.If US halt rate rises it may not even be good news for us as we're so beholden to food and fuel imports.

 

[sancho panza]

Back later

PS does anyone know a good youtube link for me to learn how to do graphs from excel.Nothing complex.I jsut want to map coventry's balance sheet grwoth in a chart alongsdie some other lines.

Please feel free to isnult my intelligence,I havent got much of a clue with tech

https://www.coventrybuildingsociety.co.uk/content/dam/cbs/member/pdfs/financial-results/2022/annual-report-and-accounts-2022.pdf

interims only avaliable with NW but pillar 3 available.

https://www.nationwide.co.uk/about-us/governance-reports-and-results/results-and-accounts/

[sancho panza]

Just dropping this in here for reference going forwards re the differnce between standardized approach to risk weighting and IRB approach.Tehcnical differnce possibly but goes a long way to explain why certain instituions suddenly have problems.

Standardzxied used by smaller isntituions with little of their own data.IRB used by companies with broad sets of data so they can use their own rather than the extrenal models

https://www.bis.org/basel_framework/chapter/CRE/20.htm?tldate=20191231&inforce=20191215&published=20191215

Introduction

20.1

Banks can choose between two broad methodologies for calculating their risk-based capital requirements for credit risk. The first is the standardised approach, which is set out in chapters CRE20 to CRE22:

 

(2)

To determine the risk weights in the standardised approach for certain exposure classes, banks may use assessments by external credit assessment institutions that are recognised as eligible for capital purposes by national supervisors. The requirements covering the use of external ratings are set out in chapter CRE21.1

 

20.2

The second risk-weighted capital treatment for measuring credit risk, the internal ratings-based (IRB) approach, allows banks to use their internal rating systems for credit risk, subject to the explicit approval of the bank’s supervisor. The IRB approach is set out in chapters CRE30 to CRE36.

 

 

 

and while I'm on that page this is interesting

Claims on sovereigns

20.4

Claims on sovereigns and their central banks will be risk weighted as follows:

Credit Assessment	AAA to AA-	A+ to A-	BBB+ to BBB-	BB+ to B-	Below B-	Unrated
Risk Weight	0%	20%	50%	100%	150%	100%

20.5

At national discretion, a lower risk weight may be applied to banks’ exposures to their sovereign (or central bank) of incorporation denominated in domestic currency and funded2 in that currency.3 Where this discretion is exercised, other national supervisory authorities may also permit their banks to apply the same risk weight to domestic currency exposures to this sovereign (or central bank) funded in that currency.

[sancho panza]

Cov 21/22 comparisons.Interesting point ref stage 2 in 2022 was £4.354bn up from £3.549bn in 2021

Srage 1 is perfomring

Stage 2=deterirorating or in trouble.

Stage 3 default stage

Ill dig up the table later.

2021 full year

 

20-22 full year

[spygirl]

An early topic on TOS was if people taking out io mortgages knew what they were.

No ones that stupid they said.

When people say mortgage, they think pays the house off I said.

https://www.thenorthernecho.co.uk/news/23439271.newton-aycliffe-mum-suing-tsb-becoming-mortgage-prisoner/

Claire Young, 40, took out a £96,500 mortgage with Northern Rock 16-years ago to buy her two-bed end-terrace in Newton Aycliffe, County Durham.

But when the beleaguered bank collapsed, her mortgage was transferred to another lender, TSB’s Whistletree brand, where she became a ‘mortgage prisoner’ was stuck interest rates higher than the market average and found her interest rate climbing to 6.2% and her monthly repayments rising to £600.

Capital repayments on a 25y mortgage are only 30% of the monthly repayment.

Theres handy online tools to drive under peoples noses these days.

Difference between a 25y io n 25y repayment for her  would have  only going to be ~£300/m - 4k/y.

But shes sat there, done fuckall.

Even if shed kept the repayments level before Zirp, using lower or to catch up on capital repayment.

Nope.

Blown it.