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Implications of matching premium on portfolio selection for insurance companies Overview Matching premium is defined as the difference between

actual spread and fundamental spread for a portfolio of assigned assets. In order to apply the matching premium framework, the assigned assets should be bonds and other assets with similar cash flow characteristics to cover the best estimate of the portfolio of insurance obligations. The assigned assets should be ring-fenced, managed and organized separately. The fundamental spread used in calculating matching premium is the credit spread corresponding to the probability of default of the asset and a spread corresponding to the expected loss resulting from downgrade of the asset. The expected loss corresponds to the probability weighted loss that the insurance firm incurs if the asset is downgraded to a lower credit quality step and is replaced immediately afterwards by an asset that has the same cash flow pattern, belongs to same asset class and has the same credit quality step as the original asset that has been downgraded. Problem definition Matching premium is relatively a new concept being introduced in Solvency II and so far there is very little (or no) literature related to the matching premium. There have been several studies related to credit spread however the primary focus of these studies have been on the fundamental spread, i.e. the credit spread component corresponding to default risk and downgrade risk . The objective of the current research is to understand the implications of the matching premium on the portfolio selection by insurance companies. In particular I will try to address the following questions: Q1. Is there any correlation between matching premium and credit spread? The correlation between matching premium and credit spread is an important factor in portfolio selection because according to solvency II framework, the discount rate that should be applied to obtain the present value of liabilities is the sum of risk free rate and matching premium of the assigned assets. Hence by choosing assets whose matching premium is highly (positively) correlated with credit spread, the present value of liabilities will be positively correlated with market value of the assets which is beneficial in terms of capital buffer requirement. Q2. How does default and downgrade correlation in bond portfolio influence matching premium? Currently in the solvency II framework, there are few perquisites on the portfolio of assigned assets to qualify for the application of matching premium. Few of the important perquisites are: the portfolio of assigned assets should consist of bonds and other assets with similar cash flow characteristics to cover the best estimate of the portfolio of insurance obligations with two important restrictions: the portfolio of assigned assets are ring-fenced and managed separately from other activities of insurance undertakings and this assignment over the lifetime of the obligations unless the cash-flows have materially changed due to default of a bond or if the bond is downgraded to lower than investment grade no asset of the assigned portfolio shall have a credit quality less than investment grade (step 4 or worse)

These perquisites imply that whenever a bond has defaulted or downgraded below investment grade, it needs to be replaced by an asset of similar rating class and cash flow characteristics. Note that matching premium, which is added to risk free rate while discounting future liabilities, is intended to capture the spread on assets over and above that resulting from default risk and downgrade risk. This is prudentially acceptable when the assets are kept till maturity. However if the assets are liquidated before

maturity due to downgrade/default and replaced with assets of same rating class and cash flow (before downgrade/default), the matching premium becomes negative due to the intermediate losses incurred before maturity because of replacement. This would hurt the insurance undertaking since this would increase the present value of the liabilities. If the assets are highly positively correlated, the chances of matching premium becoming negative increases even more and the insurance undertaking could experience a steep rise in liabilities due to correlated defaults or downgrades in the assigned assets. As part of the current research I would like to study the impact of default and downgrade correlation on the evolution of a portfolio of assigned assets under matching premium framework. Along with simulations I would demonstrate the observations with simplified hypothetical examples. Research Method Part I : Is there any correlation between matching premium and credit spread? The following steps will be carried out for selected corporate bonds with different ratings in order to estimate the correlation between matching premium and credit spread. 1. 2. Obtain time series of credit spreads for selected IG corporate bonds spread across different ratings Decompose credit spread into matching premium and fundamental spread as below: Matching premium = Actual credit spread fundamental spread Fundamental spread = credit spread for default risk (assuming 30% recovery on market value) + spread corresponding to expected loss due to downgrade Credit spread corresponding to default risk is obtained as follows: a. b. Choose a structural model (ex: Leeland and toft model) and calibrate the structural model using the time series of equity. Estimate bond price according to the structural model and using the risk free term structure from EIOPA, obtain the credit spread corresponding to default risk

Expected loss due to downgrade: The expected loss due to downgrade is defined in solvency II as the probability weighted loss the insurance undertaking incurs if the asset is downgraded to a lower credit quality step and is replaced immediately afterwards by an asset with same cash flow pattern, same asset class and has same credit quality step. By assuming no transaction costs, we get the expected loss due to downgrade as: EL due to downgrade = (probability of downgrade from i to j ) *( average price difference between bonds of rating i and j) Probability of downgrade and default are obtained from transition probability matrix from corresponding rating agencies. Credit spread corresponding to expected loss = expected loss due to downgrade. 3. By regression, obtain the correlation between matching premium and fundamental spread.

Part II: How does default and downgrade correlation in bond portfolio influence matching premium? 1. 2. Create a virtual portfolio of bonds whose defaults and downgrades are correlated Simulate a number of paths for the evolution of the portfolio where the payoff on the portfolio is path dependent since the assets need to be replaced whenever the asset is downgraded below investment grade or whenever the asset default Repeat the above step by increasing and decreasing correlations and plot the evolution of best estimate of liabilities and assets under matching premium framework

3.

Discussion 1 Outcome: 1. 2. The relation between matching premium and interest rate is not important since it offsets the assets and liabilities equally. The impact of asset correlation on the matching premium of the portfolio. The relation between asset correlation and matching premium of the portfolio is important because if the rating transition of the assets are correlated, when assets rating move from IG to NIG the total matching premium is higher for correlated portfolio since the loss is incurred due to sale of the NIG assets (if matching premium increases with decrease in rating).

Data Requirements

Data: The Merrill Lynch investment-grade indices of corporate bond spreads, for bonds denominated in sterling, dollars and euros. These spreads are already adjusted for any option features in the corporate bonds. A more complete description of the data, the calibration and the procedure can be found in Churm and Panigirtzoglou (2005). For example, there are other parameters that are not described here, including bankruptcy costs and the effective tax advantage of debt. Credit spreads of Investment Grade Corporate bonds (Since the requirement to use matching premium is that the assigned assets should be of investment grade.)

References Part I i. ii. iii. Decomposing credit spreads Decomposing corporate bond spreads Exploring relation between credit spread and default probabilities