05 March 2010
Published in: Capital - models, Insurance risk, ALM, Regulation - supervision
Liquidity premium report is a step forward, says Towers Watson
The liquidity premium report, published this week by a task force for the Committee of European Insurance and Pensions Supervisors (CEIOPS), is a step in the right direction but will still result in a higher technical provisions for annuities, according to Towers Watson's Mark Chaplin.
That the report recognizes most insurance liabilities can be considered at least partly illiquid is encouraging, he told InsuranceERM: the report specifies some principles for the use of an illiquidity premium and considers a possible approach for determining it. "The report also addresses the extrapolation of the risk-free curve and considers in more detail the possibility of basing the basic risk-free interest term structure on the swap curve with an adjustment to remove credit risk," he added.
This compares to the "early provisions on the risk-free rate from CEIOPS [which] were relatively absolute," Chaplin said. In CEIOPS' first advice, for example, it ruled out the inclusion of a liquidity premium in Solvency II level 2 implementing measures, and its final advice suggested that any liquidity premium should be subject to severe limitations. "The task force report moves that debate further forward and starts talking in terms of how one could quantify and apply the liquidity premium," Chaplin noted. "That's all positive."
Overall, however, the report does not go far enough to maintain the status quo under which UK insurers have typically used higher discount rates to value their annuity liabilities, he explained. "It will have an upward influence on the price of annuities compared to Solvency I, and annuity providers will need to hold more capital in respect of this business."
Towers Watson yesterday issued a statement saying the inclusion of an illiquidity premium for valuing reasonably predictable liability cashflows is justifiable given certain conditions, and it welcomed the "balanced" report. However, the statement noted that it "still leaves a number of unresolved issues and therefore uncertainty for the industry."
By way of example, the Towers Watson report highlights liquidity premium principle 3 on achievability as open to a wide range of interpretation: "Further work remains to produce a tighter definition, particularly in financial climates where illiquidity premia are very large and those illiquid markets are no longer accessible to insurers who do not already own the assets."
Chaplin was keen to stress that it is difficult to make a blanket assessment on how the report will impact the annuity market. "A lot of annuity providers write many other types of business as well. So whether it will actually mean they have to raise more capital than they currently hold will depend on many other factors beyond the liquidity premium issue."
The report has been submitted to the European Commission which will make the final decision on whether, and to what extent, it gives annuity providers recognition for the liquidity premium. Chaplin anticipates that the recommendations in the report will be important in this process. "I think it will be influential not least because the Commission doesn't have the resources to do its own detailed research. I would expect the report to shape QIS 5, which in itself will carry a lot of weight in determining the final position."
Towers Watson commentary
- We believe the inclusion of an illiquidity premium for valuing reasonably predictable liability cashflows is justifiable in a market consistent valuation, whether for embedded value, FASB/IASB Phase II or Solvency II purposes, provided the liquidity premium is observable and suitable restrictions are applied to its use. We therefore welcome the progress made by this task force.
- The report presents a balanced view of both sides of the discussion on illiquidity premia, and we commend the task force for producing such a report so quickly. However the report still leaves a number of unresolved issues and therefore uncertainty for the industry. Resolution of the differences may come down to political negotiation.
- To calculate the liquidity component within asset yields, industry members proposed a simplified method with a sample calibration. Such a method is to be welcomed as it would enable the industry to move on from the debate about how much illiquidity is found within asset yields, to how much should be capitalised in a market-consistent valuation.
- In particular, liquidity premium principle 3 on achievability seems to be capable of a wide range of interpretation, given the phrases "can be earned", "illiquid assets free of credit risk" and "available in the financial markets". Further work remains to produce a tighter definition, particularly in financial climates where illiquidity premia are very large and those illiquid markets are no longer accessible to insurers who do not already own the assets.
- The sample calibration would represent some, but far from complete, mitigation for the impact of the recent financial crisis on the value of immediate annuity business.
- There is no explanation on the recommendation to allow no illiquidity premium at durations under one year. There is evidence to suggest material illiquidity premia at shorter durations.
- The industry proposal to allow a granular liquidity premium clearly needs further work. If this is accepted then it might imply significant effort for firms to demonstrate the degree of illiquidity of their liabilities, involving detailed analysis of their product terms and conditions and past policyholder behaviour.
- The industry welcomed the reduction in standard formula credit spread stresses in CEIOPS' final advice, but it seems as though this relief may be short-lived as the spread stresses will need to be recalibrated and seem likely to increase.
- The extrapolation methodology will be welcomed by many seeking financial stability where market data runs out, although the approach used to set the unconditional ultimate long-term forward rate has not been determined. The consistency of this approach with FASB/IASB fair value developments remains to be seen.
- The report shows that potential movement on the proposed risk free rate from government bonds to swap rates is desired by the CFO and CRO Forums. This should aid convergence with MCEV calculations. This approach aids hedgeability for insurers, in contrast to a "minimum cost matching asset" approach to the valuation of liabilities, which could combine use of both government bonds and swaps and so reduce market distortions.