Limitations Of Solvency II Framework On The Application Of Matching Premium

TABLE OF CONTENTS

1.

OVERVIEW ......................................................................................................................................... 3 1.1 Matching premium .............................................................................................................................. 3 1.2 Restrictions on assigned assets ............................................................................................................ 4

2. 3. 4.

PROBLEM DEFINITION .................................................................................................................... 4 CONTRIBUTION AND LITERATURE REVIEW ............................................................................. 5 THE MODEL ....................................................................................................................................... 6 4.1 LMN Model......................................................................................................................................... 6 4.2 Extended LMN model ......................................................................................................................... 7 4.3 Portfolio loss ....................................................................................................................................... 8

5.

REFERENCES ................................................................................................................................... 12

1.

OVERVIEW

Solvency II is the new EU wide regulatory regime, due to come in force on Jan 1, 2013. Solvency II is intended to introduce greater levels of harmonization in the prudential regulation of insurers across Europe. According to Solvency II directive, the best estimate of insurance liabilities is to be calculated using a relevant risk free rate term structure which is derived and published by EIOPA . If the relevant risk free rates are applied to discount liabilities, the discount rate would not include any allowance for liquidity premium and would therefore not allow falls in asset values to be balanced by decreases to insurance liabilities. In order to address this issue the new draft consolidated level 2 released by the commission in November 2011 allows a matching premium to be added to the basic risk free rate to discount the liabilities with some restriction on the portfolio of assets assigned to offset the cash flow of liabilities. 1.1 Matching premium The matching premium is defined as the difference between: i. the annual effective rate, calculated as the single discount rate, where applied to the de-risked cashflows of the assigned assets, results in the market value of the assigned assets ii. the annual effective rate, calculated as the single discount rate, where applied to the cash-flows of the portfolio of insurance obligations, results in a value that is equal to the value of the best estimate of the portfolio of insurance obligations A de-risked cash-flow of an asset means the expected cash-flow of the asset where the expected default of the asset is taken into account in accordance with a probability of default that corresponds to the credit spread and a loss-given-default that is consistent with the calculation of fundamental spread. The fundamental spread is the sum of credit spread corresponding to the probability of default of the asset and a spread corresponding to the expected loss resulting from downgrading of the asset. The fundamental spread should not be lower than 75% of the long term average of the spread over the basic risk-free interest rate of assets. Essentially the matching premium is intended to capture the spread on assets over and above that resulting from (i) default risk and (ii) downgrade risk and the matching premium is capped at 25% of the long term average of the credit spread of the assets. So as the spreads increase due to illiquidity of the assets, asset values fall and the matching premium will increase allowing the insurers to reduce the best estimate of their insurance liabilities at the same time as they are having to reduce their asset values. This is prudentially acceptable because, where the assets will be held till maturity, their market value is only relevant to the extent that the fall in value reflects default risk or downgrade risk which is why the matching premium doesnt capture the spread which results from these risks.

1.2 Restrictions on assigned assets The matching premium can be applied in calculating the best estimate of insurance obligations with certain restrictions on the portfolio of assigned assets and liabilities. Once an insurer has opted to apply the matching premium, the insurer cannot choose to revert to an approach not including the matching premium. The portfolio of insurance obligations should consist only of the insurance contracts which do not give rise to future premium payments and either include no options for the policy holder or only include a surrender option. The key restrictions on the assigned assets are: i. the assigned assets should consist of bonds and other assets with similar cash-flow characteristics to cover the best estimate of the portfolio of insurance obligation. ii. the future cash-flows of the assigned portfolio of assets should replicate the expected future cashflows of insurance obligations in the same currency. iii. the assigned assets should be maintained over the lifetime of the obligations except when the expected cash-flows have changed, example due to default of a bond iv. the portfolio of insurance obligations and assigned assets are ring-fenced, managed and organized separately from other activities of the insurance undertaking v. no assets of the assigned portfolio of assets shall have a credit quality which has been assigned to credit quality step 4 or worse

2.

PROBLEM DEFINITION

The application of matching premium under Solvency II framework creates an incentive for the insurance companies to lookout for bonds that have high liquidity premium. This is because a higher liquidity premium would mean a high matching premium which would result in a higher discount rate for calculating the best estimate of insurance liabilities. However there are few limitations in the application of matching premium. The benefit of liquidity premium is realized only if the bonds are retained till the maturity. However under matching premium framework one of the restriction on the assigned assets is that the assets should be at least of investment grade and whenever the rating of a bond in the assigned assets migrates from investment grade to non-investment grade, the bond needs to be replaced by a bond of same rating (before downgrade) and cash-flow characteristics. Due to this restriction, the benefit of holding a bond till maturity in the form of liquidity premium is lost whenever a bond rating is downgraded below investment grade. The loss is even higher if the downgrades of the bonds in the portfolio of assigned assets are correlated since more bonds need to be liquidated at the same time when there is a downgrade. The portfolio loss is also dependent on how the liquidity premium is correlated between the bonds (in the

portfolio of assigned assets) and how the liquidity premium of the bond is correlated with the probability of downgrade. An extreme case would be when the liquidity premium of the bonds are positively correlated, the probability of downgrades of the bonds are positively correlated and the liquidity premium of a bond is positively correlated with the probability of the downgrade of the bond. In this case, although the requirements under Solvency II may be met, the portfolio losses incurred could be extremely high because if the downgrades are correlated and if liquidity premium is higher for downgraded assets, the insurance undertaking is forced to liquidate and replace the downgraded bonds when the bond market is extremely illiquid since the portfolio of assigned assets should not contain any bond below investment grade. The objective of the current research is to study the sensitivity of the portfolio losses to correlations between liquidity premium and downgrades. The portfolio under consideration will be a portfolio of corporate bonds which meets the matching premium restrictions as mentioned in section 1.2.

3.

CONTRIBUTION AND LITERATURE REVIEW

There are several studies which focus on the components of credit spread and the determinants of credit spreads. Elton, Gruber, Agrawal and Mann (2001) provided the estimates of the size of each factor-related component of the credit spread for investment grade corporate bond portfolios and they found that default risk accounts for only a small portion of credit spreads, which is consistent with most credit-spread studies (e.g. Ng and Phelps [2011]). In 2011, Siddhartha and Bruce found that this excess spread can be explained as the spread corresponding to expected liquidity cost and risk premia and by using regression they decomposed the credit bonds option adjusted spread into three components: a market wide risk premium, expected loss from default and expected liquidity cost. Because the expected liquidity cost for a credit bond is typically greater than for comparable-maturity treasury, a credit investor who may later sell the bond wants compensation for this expected liquidity cost in the form of a wider spread at time of purchase. While Siddhartha and Bruce used regression to decompose the credit spread, there are few other studies which rely on structural models for decomposing the credit spread. Lewis Webber and Rohan Churm (2007) have decomposed the yield spread of investment grade and high-yield corporate bonds into credit related component and non-credit related component by using an extension to the Merton(1974)s structural model. Similarly Churm. R and Panigirtzogfou. N (2005) have calibrated Leland and Toft (2006)s structural model to historic default frequencies of both investment -grade and high-yield US firms and subsequently used this model to generate a time series decompositions for the observed credit spreads. In another paper Driessen (2003) provides an empirical decomposition of corporate bond returns into several factors such as default event risk, liquidity premium, common factors risk.

The basic conclusion made in the studies outlined above is that the yield spread for corporate bonds is composed of three main components which are: expected loss from default event, market wide risk premium and liquidity premium. Although the presence of liquidity premium on the yield spread of corporate bonds forms the basis for the current research, the primary focus of the current research is not to decompose the yield spread but to understand the behavior of the liquidity premium component of the yield spread with regards to portfolio losses. The modeling of liquidity premium in yield spreads in the current research is based on the model proposed by Duffie and Singleton (1997) in which the liquidity and default adjusted short rate process are assumed to be a sum of two independent square root diffusions (a 2- factor model). A similar model is used by Longstaff, Neis and Mithal (2004) to obtain direct measures of the size of the default and non-default components in corporate spreads by using the information in credit default swap. They also find that the non-default component of the corporate spread is primarily due to illiquidity of corporate bonds. The application of matching premium in discounting liabilities is relatively a new concept which is being introduced through Solvency II framework and currently there arent any studies which focus on the implication of the matching premium application for the insurance undertakings. The current study would benefit the insurance undertakings in portfolio selection and hedging by understanding the impact of downgrade and liquidity premium correlations on portfolio losses. The current research is different from the existing literature on decomposing credit spreads and modeling liquidity premium since the focus of this research is to model the correlations in liquidity premium and downgrades in order to assess the impact on the portfolio losses for a portfolio which meets the restrictions for the application of matching premium (refer section 1.2) under Solvency II framework.

4.

THE MODEL

4.1 LMN Model The current model for default, downgrade and liquidity intensity processes is an extension to the model proposed by Longstaff, Mithal and Neis (2004) (referred as LMN model from here onwards) which is based on the model originally formulated by Duffie and Singleton (1997). According to the LMN model, the risk neutral dynamics of the default intensity process t of a corporate bond is given as: ( ) (1)

where , and are positive constants and Z is a standard Brownian motion. These dynamics allow for mean reversion and conditional heteroskedasticity in corporate spreads and guarantee that intensity process is always non-negative. The liquidity process lt is used capture the extra return investors may

require, above and beyond compensation for credit risk, from holding corporate rather than riskless securities. The risk neutral dynamics of the liquidity process is given as: (2) where is a positive constant and Zl is also a standard Brownian motion. These dynamics allow the liquidity process to take on both positive and negative values. In the LMN model it is assumed that the riskless interest rate rt, the default intensity and the liquidity process are assumed to be independent. Under these dynamics, the value of a riskless zero-coupon bond D(T) with maturity T and the value of a corporate bond CB(c,w,T), which pays coupons continuously with coupon rate c, are given by the expressions: ( ) ( * ) ( * * + *( )+ ( ( ) ( )+ ) + (4) ) + (3)

where it is assumed that a bondholder recovers a fraction (1-w) of the par value of the bond in the event of default. 4.2 Extended LMN model In this paper, we modify the LMN model in order to incorporate the following properties of default intensity, downgrade intensity and liquidity intensity processes of the corporate bonds which are observed by various researchers based on their empirical analysis in the past: i. The risk neutral default intensity process contains a common factor and a firm specific factor. This is in line with the default intensity processes assumed by Duffie (1999) and Driessen (2002). We make this modification in order to capture the default correlations between the bonds. ii. The liquidity processes contain a common liquidity factor (which is based on the liquidity of the treasury bonds because treasury bonds trade at a premium because of their unique role in financial markets as highly-liquid or marketable havens) and a bond specific liquidity component which would create a cross sectional variation in the non-default component of the spread across corporate bonds . This modification is based on the observation by Longstaff, Mithal, Neis (2004) who found that the non-default component of the corporate bond credit spread contained a common liquidity component which is due to the high liquidity of treasury bonds and an idiosyncratic liquidity component.

iii.

The average liquidity risk premium for sub-investment grade corporate bonds is substantially high compared to the liquidity risk premium of investment grade corporate bonds. This is based on the finding by de Jong and Driessen (2006) in which they show that for US long term investment grade the total estimated liquidity premium is around 0.6% and for speculative grade bonds, which have higher exposure to liquidity factors, the liquidity risk premium is around 1.5% per annum. The observations for European bonds are similar.

iv.

An investment grade corporate bond issued by firm i is subject to both default risk and downgrade risk and both the processes are dependent on the common economic factor. This is in line with previous work in modeling downgrade intensities such as Moodys credit transition model (2007) and Figlewski, Frydman, Liang (2010). The downgrade intensity processes, similar to default intensity process, is mean reverting and square root diffusion process.

Based on the observations and findings listed above, we propose that the default intensity id , downgrade intensity ig and liquidity intensity li for bond i follow the processes given by: Default intensity process: ( Downgrade intensity process: ( Liquidity intensity process: (7) ( ) * + * + ( ) ( ) (8) ) (6) ) (5)

where id, id, id, id, ig, ig, ig, ig, il, il are positive constants, Zid, Zig, Z, Zil and Zl are all standard Brownian motions. IG and NIG are average values of liquidity intensity for investment grade and noninvestment grade bonds respectively. We use an indicator function I{}for the liquidity intensity in order to accommodate property (iv) listed above, i.e. the average liquidity premium for non-investment grade is substantially higher than the average liquidity premium for investment grade .The macroeconomic factors (or common factors) that influence the downgrade and default intensities are captured in Z and the common factors that affect the liquidity of treasury yields is captured in Zl. 4.3 Portfolio loss In order to model the losses of a portfolio under matching premium framework, we first state few assumptions and simplifications for a portfolio which is in accordance with the matching premium restrictions. The assumptions and simplifications are:

a. The credit quality of the bonds is classified into two distinct categories : investment grade and sub-investment grade and we ignore the sub categories under investment grade and noninvestment grade for the portfolio loss simulations b. All the bonds in the portfolio are discount bonds which mature at the same time T c. A bond in the portfolio is retained until maturity unless otherwise it defaults or downgrades before maturity d. Whenever a bond in the portfolio downgrades to sub-investment grade or defaults, it is replaced by a bond of exactly same characteristics (before default/downgrade), i.e. same rating class, cashflows, default intensity process and downgrade intensity process e. The bond holder recovers a fraction (1-w) of the face value at default f. We use a double decrement model where the bond in the portfolio of assigned assets is subject to default risk and downgrade risk. In a short time interval dt, the bond can either default or downgrade but not both g. The risk free interest rate process r(t) is independent of default intensity process, downgrade intensity process and liquidity process

Default

id
id Bond i IG

ig

Downgrade NIG

Figure 1: In the double decrement model, bond i leaves the portfolio under two possible transitions which are default and downgrade to sub investment grade.

Now consider a bond portfolio of N discount bonds which belong to investment grade, with maturity T and face value of 1. Under the above setup, at any time t, the loss incurred in time interval dt due to replacing the bonds that have either defaulted or downgraded to sub investment grade is { | } ( ) { | } ( ) (9)

where id, ig and default time and downgrade times of bond i, Cid(t), Cig(t) are the costs of replacing bond i at time t when it defaults or downgrades to sub investment grade. The first term captures the loss due to defaults in the portfolio and the second term captures to the loss due to downgrades in the portfolio. i.e.

(10) where Ld is the loss incurred due to replacing the defaulted bonds and Lg is the loss incurred due to replacing the downgrades in the portfolio. The costs of replacing a defaulted bonds at time t is Cid(t) = Price of a similar investment grade bond at t recovery at default * * ( ( ( ) ( ) ( ) ( ) ( ) ) ( ( ) )+ ( ) ) ( )+

Since we assume that the riskless rate r(t) is independent of default intensity, downgrade intensity and liquidity intensity, we get () ( ) * ( ( ) ( ) ( ) )+ ( ) (11)

where D(t,T) is the value at time t of a riskless zero coupon bond that matures at time T and given by the equation: ( ) * ( ( ) )+ (12)

Similarly the cost of replacing a downgraded bond at time t is Cig(t) which is derived as: Cig(t) = Price of a similar investment grade bond at t Price of downgraded bond at t [ ( ( ( ( ( ( ) ( ) ( ) ( ) ( ) ) )) )+ ( ( ) ( ( ) )) ( ) ( ) ( ) )) * ) ( ) ( ) ) ] )

( )

( ( ( )

( )

( )

( )

Since riskless rate is independent of downgrade intensity and liquidity process, we get ( ) ( )( ( ) ( )+ ( )) ( ( ))) * ( ( ) ( ) (13)

From equation (9), (10) and (12), the total loss due to defaults in the portfolio from 0 to T can be derived as: { ( ) ( ) ( ) { )+ ( )) )+ ( | }( ( )) | }( ( ) * ( ( ) ( ) (14) ) * ( ( ) ( )

Similarly from equation (9), (10) and (13), the total loss due to downgrades in the portfolio from 0 to T can be derived as: ))) ( ) ))) * { * { ( ( ) ( ( ) | } ( ( ) )( ( ) | } ( ( ) ( ) ( )+ )( )+ ( ( )) ( ( (15) ( )) ( (

The total loss on the portfolio due to replacing the defaulted and downgraded bonds from 0 to T is ( ) ( ) ( ) (16)

5.

REFERENCES

1. Duffie, Darrell, and Kenneth J. Singleton, 1997, An Econometric Model of the Term Structure of Interest-Rate Swap Yields, Journal of Finance 52, 1287-1321. 2. Longstaff, F. A., E. Neis and S. Mithal, 2004, Corporate yield spreads: Default risk or liquidity? New evidence from the credit-default swap market, Journal of Finance, forthcoming. 3. Elton, E., M. Gruber, D. Agrawal, and C. Mann, 2001. Explaining the rate spread on corporate bonds. Journal of Finance 56, 247-277. 4. Driessen, J., 2002, Is default event risk priced in corporate bonds? Working paper, University of Amsterdam. 5. Figlewski, S., Frydman, H.,Liang, W., "Modeling the Effect of Macroeconomic Factors on Corporate Default and Credit Rating Transitions".December 2010,forthcoming in the International Review of Economics and Finance 6. de Jong, F., Driessen, J., 2004, Liquidity risk premia in corporate bond markets. Working paper, University of Amsterdam. 7. Duee, G., 1999, Estimating the price of default risk, Review of Financial Studies 12, 197-226. 8. Ng, K.-Y., and B. Phelps. Capturing the Credit Spread Premium. Financial Analysts Journal, forthcoming 2011. 9. Driessen, J (2003): Is default event risk priced in corporate bonds?, mimeo,University of Amsterdam. 10. Churm, R and Panigirtzoglou, N (2005), Decomposing credit spreads, Bank of England Working Paper no. 253. 11. Siddhartha g. Dastidar and Bruce D. Phelps. Credit Spread Decomposition: Decomposing BondLevel Credit OAS into Default and Liquidity Components. 12. Decomposing corporate bond spreads. Lewis Webber and Rohan Churm. Bank of England quarterly bulletin 2007 Q4. 13. Kavvathas, Dimitrios, Estimating credit rating transition probabilities for corporate bonds. Thesis (Ph. D.), University of Chicago, Dept. of Economics, March 2001. 14. Moodys credit policy, August 2007.