Fri, Apr 20, 2018
A A A
Welcome Guest
Free Trial RSS
Get FREE trial access to our award winning publications
Industry Updates

LTGA calibration continues to favour short-duration bonds, could undermine sovereigns and corporates' financial stability

Tuesday, November 12, 2013
Opalesque Industry Update - Discussions on the Omnibus II Directive have been in deadlock since July 2012. The main points of contention relate to the integration of ALM mechanisms into the standard formula. Their omission from the QIS5 impact study led to increased artificial volatility of prudential balance sheets and consequently to regulatory capital requirements that are sometimes overestimated.

The aim of the Long-Term Guarantees Assessment (LTGA), conducted in the first semester of 2013, was to test a variety of measures which aim to integrate ALM mechanisms into long-term insurance activities, (life insurance, pensions, liability insurance, etc.). These measures relate to the valuation of insurance liabilities (extrapolation of long-term rates, implementation of a counter-cyclical premium and a matching adjustment) as well as to new risk calibrations, particularly that of spread risk.

In a study entitled, “LTGA Impact Assessment and Bond Management: Has Solvency II reached a Deadlock?”, the EDHEC Financial Analysis and Accounting Research Centre analyses the effect of the new LTGA spread risk calibration on bond management.

This analysis is conducted comparatively to the QIS5 calibration in order to evaluate the potential contributions of the LTGA study, particularly with respect to the quality of the bond SCR risk measure and its impact on bond investment choices. The paper is produced as part of the research chair on “Solvency II” at EDHEC-Risk Institute, supported by Russell Investments, the purpose of which is to design new benchmarks for European insurance companies that are representative of a dynamic allocation strategy to equities.

The study shows that the application of the LTGA spread risk calibration theoretically leads to a reduction in the SCR spread for a number of rating-maturity pairs. However, in practice, this effect is significantly reduced because bond issuances, hence insurance company bond portfolios, do not include bonds that would benefit from this significant reduction in regulatory capital requirements.

Our research shows that the sophistication of the spread risk measure introduced in the LTGA impact study hardly impacts the quality of the bond risk measure. Bond SCR remains a measure of risk that is generally relevant for fixed-rate bonds. However, as SCR does not always reflect the overall risk level, it could provide room for improvement by integrating the effects of economic cycles (via a bond Dampener), incorporating the specificities of ALM for long-term commitments (flat-rate treatment for long-maturity investment grade bonds as is applied to equities), as well as those of high-yield bonds (substitution using a default model).

Additionally, the LTGA calibration maintains the strong correlation of bond SCR to VaR and volatility. There is therefore no need for Solvency II to add a fourth dimension to bond management, which is currently based on the return-volatility-VaR triple factor. It would in fact be possible to manage fixed-rate debt instruments using only the bond return-SCR pair.

Lastly, an analysis of the impact on bond choices shows that the LTGA calibration continues to favour short-duration bonds. Solvency II therefore naturally encourages insurers to reduce their levels of investment in long-term bonds, especially those rated BBB or lower. Given that the insurance sector plays a leading role in financing the European economy, with €3.5 trillion invested in bonds, this bond risk calibration could undermine the financial stability and financing of both sovereigns and corporates.

A copy of “LTGA Impact Assessment and Bond Management: Has Solvency II reached a Deadlock?” can be downloaded via the following link:

EDHEC Publication LTGA Impact Assessment DEF

This research was supported by Russell Investments as part of the research chair at EDHEC-Risk Institute on “Solvency II.”

This research chair has also given rise to the following publications:

The Impact of Solvency II on Bond Management

Introducing the EDHEC-Risk Solvency Benchmarks – Maximising the Benefits of Equity Investments for Insurance Companies facing Solvency II Constraints

Press release

EDHEC-Risk Institute www.edhec-risk.com

Russell Investments www.russell.com

Bg

What do you think?

   Use "anonymous" as my name    |   Alert me via email on new comments   |   
Today's Exclusives Today's Other Voices More Exclusives
Previous Opalesque Exclusives                                  
More Other Voices
Previous Other Voices                                               
Access Alternative Market Briefing

 



  • Top Forwarded
  • Top Tracked
  • Top Searched
  1. Investing - Sequoia takes Facebook stake as shares slide in data controversy, $1.4b hedge fund sees intact fundamentals for Facebook, Jim Cramer reveals some 'suggested hedge fund trades' amid the Trump tariffs[more]

    Sequoia takes Facebook stake as shares slide in data controversy From Bloomberg.com: The $4.2 billion Sequoia Fund bought a small position in Facebook Inc. as the stock slid late in the first quarter, investment manager Ruane, Cunniff & Goldfarb told clients. "The recent controversy enab

  2. Activist Investors - Blue Sky-owned Wild Breads faces uncertain future[more]

    From AFR.com: A Blue Sky private equity investment in artisan-style baker Wild Breads enjoyed multiple valuation upgrades despite losing millions and breaching its lending covenants, accounts lodged with the regulator last week show. Wild Breads lost $2.4 million in 2017, but Blue Sky ascribed a hig

  3. Opalesque Exclusive: Barnegat to close hedge fund to outside investors on weak opportunities[more]

    Komfie Manalo, Opalesque Asia: Bob Treue's Barnegat Fund Management said it is closing its $666m fixed income relative value hedge fund to outside investors. "The negative side to gains in Fixed Income Arbitrage is that unless we find new opportunit

  4. Investing - Hedge fund makes a big bet on malls, British hedge fund manager Odey short UK government bonds on QE bet[more]

    Hedge fund makes a big bet on malls From Barrons.com: The dominant narrative on American shopping malls is that they're dead. Crushed by Amazon.com, many brick-and-mortar retail stores are destined for bankruptcy. And where is the most retail, clustered all together? Malls. From a

  5. Performance - Hedge funds suffer first back-to-back loss in two years, Netflix performance burns hedge fund short sellers, Macro hedge fund up 14.5% in first quarter sees dollar falling, Renaissance Technologies rebounds across hedge funds in March[more]

    Hedge funds suffer first back-to-back loss in two years From Bloomberg.com: Hedge Fund returns sank for a second straight month in March, the first back-to-back loss since the first two months of 2016, as trade wars, tech-sector woes and a Fed rate hike dragged down the S&P 500 from its