Bringing you live news and features since 2013
Bringing you news, views and analysis since 2013

13830

LTGA calibration continues to favour short-duration bonds, says EDHEC study

RELATED TOPICS​

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 EUR3.5trn invested in bonds, this bond risk calibration could undermine the financial stability and financing of both sovereigns and corporates.

Latest News

MSCI has launched MSCI AI Portfolio Insights, writing that it combines generative artificial intelligence “GenAI”..
The Capgemini Research Institute’s World Wealth Report 2024, published today, reveals the number of high-net-worth..
New research from cloud security firm Zscaler reports a disconnect between European company confidence in..

Related Articles

Waves
A joint statement from BNP Paribas Asset Management, Federated Hermes Limited, Mirova, Robeco and Storebrand Asset Management has been published, entitled The urgent need for better ocean-related data to make informed investment decisions...
A joint statement from BNP Paribas Asset Management, Federated Hermes Limited, Mirova, Robeco and Storebrand Asset Management has been published,..
Frozen soap bubble
From the end of this month, the UK’s Sustainability Disclosure Requirements (SDR) regime comes into force which the Financial Conduct Authority says has a simple aim: “Financial products that are marketed as sustainable should do as they claim and have the evidence to back it up.”..
From the end of this month, the UK’s Sustainability Disclosure Requirements (SDR) regime comes into force which the Financial Conduct..
Global ESG Investing
On May 15 Florida’s Republican Governor Ron DeSantis signed legislation that furthers his ongoing campaign to oppose the role of climate change and ESG factors in state policymaking...
On May 15 Florida’s Republican Governor Ron DeSantis signed legislation that furthers his ongoing campaign to oppose the role of..
Trends
The trend to buyout among the UK’s smaller defined benefit (DB) schemes continues with a slew of new sub GBP100 million deals announced this month alone...
The trend to buyout among the UK’s smaller defined benefit (DB) schemes continues with a slew of new sub GBP100..
Subscribe to the Institutional Asset Manager newsletter

Subscribe for access to our weekly newsletter, newsletter archive, updates on the site and exclusive email content.

Marketing by