The Illiquidity Premium... …and other Aberrations

Transcription

The Illiquidity Premium...
…and other Aberrations
Philipp Keller
3 September 2011
Audit.Tax.Consulting.Corporate Finance.
© 2011 Deloitte AG. Private and confidential.
Contents
•
Price, Cost and Value
•
The History of Valuation
•
Market Consistent Valuation
•
The Illiquidity Premium…
•
….and other Aberrations
•
Market Consistent Valuation and its Discontents
•
Why the Illiquidity Premium?
•
The Future
2
The Illiquidity Premium
Overview
•
In 2009, CEIOPS set up a task force consisting of the CRO/CFO Forum, the CEA,
AMICE, Prof. Antoon Pelsser and the Groupe Consultatif to discuss the Illiquidity
Premium
•
In March, 2010 the task force published the ‚Report on the Illiquidity Premium‘
•
In the report, the task force - with the backing of the Groupe Consultatif – argued for the
introduction of the illiquidity premium
•
The task force defined ‚illiquid insurance liabilities‘ as liabilities with predictable cash
flows. Then, illiquid liabilities can be replicated with equally illiquid assets, leading to a
discount rate containing the spread for illiquidity
•
The SAV published a dissenting opinion ‚Some comments on the illiquidity premium’ in
March 2010
•
In March 2011, the Dutch National Bank invited academics for a Workshop on Liquidity
Premium in Solvency II: “Conceptual and Measurement Issues”. The academics –
including Mario Wuethrich – unanimously rejected the validity of the use of the illiquidity
premium for insurance liabilities
•
The Illiquidity Premium has been renamed as the ‘Counter-Cyclical Premium’
•
This presentation aims to give an overview of the topic, market consistent valuation in
general, and the role of actuaries
3
4
“Price is what you pay, value is what you get”, Warren Buffet
Cost refers to the actual cost of holding a liability,
due to claims payments, expenses, cost of holding
capital, cost due to regulatory restrictions and
requirements etc.
Value depends on the buyer or seller of a security,
on the diversification with other securities held, on
the risk appetite, etc.
Price is not necessarily a good proxy for value.
Prices emerge from the interplay between buyers
and sellers. If many buyers and sellers with different
preferences interact, market prices emerge.
CEIOPS CP 41: A market is defined to be deep, liquid and
transparent if it meets the following requirements:
(a) market participants can rapidly execute large-volume
transactions with little impact on prices;
(b) current trade and quote information is readily available
to the public;
(c) the properties specified in a. and b. are expected to be
permanent.
5
Deep, liquid and transparent markets supply
prices that have properties which make
them singularly suitable to assess the value
of a security:
• They reflect the consensus opinion of a
wide variety of market participants on the
value of traded securities
• They react quickly to changes in relevant
information
• The values are additive, i.e. the price of
two securities is the sum of the prices
• The price of a security does not depend
on the specifics of the buyer or the seller
• The market price is unique
The uniqueness of valuation at a certain
point in time is an emergent property of
the depth, liquidity and transparency of a
market.
The Importance of Valuation
“The freezing of the mortgage backed securities market, the “mark to market” losses that
decimated AIG’s book equity, the resulting downgrades by the rating agencies and the
collateral posting requirements that arose after the downgrades were beyond our
control.”, Statement of Robert B. Willumstad, CEO AIG 2008, before the US House of
Representatives Committee on Oversight and Government Reform, October 7, 2008
"If more institutions had properly valued their positions and commitments at the outset,
they would have been in a much better position to reduce their exposures“, Lloyd
Blankfein, CEO Goldman Sachs.
6
Valuation
The valuation of insurance liabilities is a very hard problem due to the long-term nature of
some guarantees. Some insurance liabilities have a life-time of 70 years and more during
which many things can occur.
1940
2011
Great Depression
Era of Bretton Woods
US leaves gold standard
Oil crises, high inflation
Subprime
Crisis
Great Moderation
7
The History of Valuation
8
History of Valuation
Compound Interest
Liber Abaci, Fibonacci, 1202
Inflation Financing
Song dynasty financing of war against
Mongols
Debt Financing
Italian city states financing of
crusades / war against Byzantium
Present Value
Marine Insurance
Diversification
Summa de arithmetica, geometria,
proportioni et proportionalità, Fra Luca
Bartolomeo de Pacioli, 1494
Accounting
Liber de ludo aleae , Gerolamo Cardano, 1526
Global Corporations
Probability Theory
Renaissance
Dutch East India Company, 1602
Office of Assurance at the Royal
Exchange in London, 1575
Natural and Political Observations made
upon the bills of Mortality, De Gaunt. 1662,
Specimen Theoriae Novae de Mensura
Sortis, Daniel Bernoulli, 1738
Contract Certainty
Mortality Tables
Forward Contracts on Dutch East
India Company
Stock Market
Dutch Stock Market
Debt Financing
Governments sell Annuities
Utility Theory
Share Companies
Sur les rentes viageres,
Leonard Euler 1767
Valuation by Replication
Financialization
Compagnie de l’Occident
Statistics
Adam Smith, The
Wealth of Nations,
1776
Elements of a Pure
Economics, Leon Walras, 1872
9
Classical Physics
Economic Theory
Classical Economics
History of Valuation
Random Walk Processes
Theorie de la speculation,
Louis Bachelier, 1900
Corporate Responsibility, Transparency
Free Market Excesses
King Leopold‘s Congo
Deep and liquid stock markets
Statistical Analysis of stock returns
The Costs of Capital, Corporation Finance,
and the Theory Of Investment, Modigliani +
Merton, 1958
Efficient Market Hypothesis
Capital asset prices: A theory of market equilibrium
under conditions of risk , W.F. Sharpe, 1964,
Theory of Rational Option
Pricing, Merton,. 1973
Computers
Finance
Portfolio Models
CAPM
Option Pricing using No-Arbitrage and
Replication Arguments
Proliferation of Leverage, 1970+
Chicago Option Market
VaR Methodology, RAROC
Kenneth Garbade, 1987, Assessing and
allocating interest rate risk for a multi-sector bond
portfolio consolidated over multiple profit centers
Risk Based Regulation
Covariance approaches, VaR
Debt Financing
SEC Uniform Net Capital Rule
(~95% VaR), 1975
De-Regulation, 1980+
Shareholder Value
Financialization of Society
Hancock, Huber, Koch, The Economics of
Insurance, 2001
SST, Solvency II
European Embedded Option
Crisis, 2001+
MCEV
CDOs, CDO^2, CDO^3,…
Economic Capital Models
Hans Buehlmann, Multidimensional Valuation, 2004
Credit Crisis
Debt Financing
EU Sovereign Crisis
Debt Financing
⁞
10
11
What is Market Consistent Valuation?
How do you use the law of one price to determine value? If you want to estimate the value of
a target security, the law of one price tells you to find some other replicating portfolio, a
collection of more liquid securities that, collectively, has the same future payouts as the
target, no matter how the future turns out. The target’s value is then simply the price of the
replicating portfolio.
Emanuel Derman, The boy’s guide to pricing and hedging, 2003
In finance, models are used less for divination than in order to interpolate or extrapolate from
the known prices of liquid securities to the values of illiquid securities at the current time.
Emanuel Derman, Metaphors, Models & Theories
12
Principles
Market consistent valuation is based on:
•
current and reliable information; and
•
The law of one price
The law of one price: Two financial
instruments with identical cash
flows in all future states of the
world have the same market price
Everything else is a corollary
For the market consistent value of insurance liabilities, the cash flows contain all costs to the
insurer:
•
Claims costs
•
Expenses
•
Costs for holding capital that is necessary to buffer risks
Market consistent valuation has a long history. It goes back to Leonard Euler who used
replication arguments for discounting life annuities in Sur les rentes viagères, in Mémoires de
l’académie des sciences de Berlin 16, 1767
13
Market Consistent Valuation: Concept
Insurance Liabilities
Replicating Instruments
No reliable market prices exist
Reliable market prices exist
Transfer the problem of valuing illiquid
cash flows to a problem of the
valuation of liquid financial instruments
Risk margin for
non-hedgeable
risks
Market price of
the replicating
portfolio
The market price of the replicating
portfolio is reliable as it consist of deeply
and liquidly traded financial instruments
The point of market consistent valuation consists of transferring the problem of valuing
illiquid insurance liabilities to a setting where reliable market prices are available.
Market consistent valuation of insurance liabilities does not rely on the Efficient Market
Hypothesis but on the law of one price only.
14
Risk Margin and Replication
The risk margin is equal the expected cost of having to hold solvency capital for nonhedgeable risk (cash flows generated by risk that cannot be replicated by financial
instruments) during the life-time of the insurance liabilities.
Assets Liabilities
…
Balance sheet at t=2,
with assets given by
replicating instruments
Balance sheets at t=3
for all possible states of
the world at t=3, given
information at t=2
SCRnh ( X 2 (ω ))
At year 2, the SCR for
non-hedgeable risk
depends on the change in
value of the replicating
portfolio and the liabilities
SCRnh ( X 3 (ω ))
SCRnh ( X 2 (ω ))
nh
nh
SCR1 = SCR ( X 1 (ω))
ω
ω
The image
cannot be
display ed.
Your
computer m
X 3 (ω)
The risk margin requires to
determine the change in
market consistent value of
the replicating portfolio
over 1-year time-intervals
SCR for non-hedgeable
risk for a trajectory ω
ω Possible trajectories of the
X 2 (ω )
X 1 (ω )
evolution of the states of the
world
t=3
t=2
t=1
Stochastic cash flows
t=0
15
Replicating with Risky Financial Instruments
• Financial instruments used for replication have to be traded in a deep and liquid market so
that their market prices are reliable
• Risk inherent in the replicating instruments enters into the component of the insurance
liability cash flow that cannot be replicated, i.e. into the risk margin. In situations where the
replicating instruments perfectly replicate the liabilities in all possible future states of the
world, the risk margin is zero
• It is important that the basis risk (i.e. the non-replicable risk) is quantifiable
• Lack of default risk is an advantage but in absence of financial instruments that are truly
default risk-free (e.g. government bonds that are subject to sovereign default), risky assets
must be used for replication
• In general, the risk associated with illiquidity is not amenable to quantification
• Credit risk and market risk are in general better understood and can be captured more easily
in the risk margin than illiquidity risk and in particular risk associated with additional valuation
uncertainty stemming from markets that are not deep and liquid
16
Replication: Liquid, Risky and Illiquid
Insurance Liabilities
Replicating Instruments
Replication such that the non-replicable cash flow is free of default- and illiquidity risk
Market value of replicating portfolio,
equivalent to discounting with risk-free rate
Risk Margin
Replication such that the non-replicable cash flow is free of illiquidity risk
including spread for credit risk
Risk Margin, including credit risk
of replicating instruments
Credit risk component of the risk margin
Replication such that the non-replicable cash flow contains illiquidity risk (not appropriate
for valuation)
Illiquidity risk component induced by illiquid
replicating instruments, highly uncertain to quantify
17
including spread for illiquidity → uncertain
Risk Margin, including credit and
illiquidity risk of replicating instruments
Credit risk component of the risk margin
Illiquidity risk component of the risk margin
Replication: Liquid, Risky and Illiquid
The market consistent value (market price of the replicating portfolio + risk margin)
of the technical provisions should not depend sensitively on the replicating instruments used.
The more risky and/or illiquid the replicating instruments, the lower the market value of the
replicating portfolio but the higher the risk margin that captures risks that are not replicated.
Default riskfree replication
Risk Margin
Replication introducing
default risk, e.g. using
swap rates
Risk Margin
Market Value of
Replicating Portfolio
Stable and reliable
calculation of the market
value of the replicating
portfolio and the risk margin
Small valuation uncertainty
18
Replication introducing
illiquidity and credit
risk (not appropriate)
Risk Margin
‘Market Value’ of
replicating portfolio
Unstable calculation of the market
Stable calculation of the
value of the replicating portfolio and
market value of the
replicating portfolio; more the risk margin due to lack of reliable
market prices for the replicating
complex calculation of the
instruments & complex and
risk margin due to
quantification of credit risk of uncertain quantification of credit and
illiquidity risk for the risk margin
replicating instruments
Medium valuation
uncertainty
High valuation uncertainty
Replicating Instruments, Discount Rate and Risk Margin
Replicates perfectly in all
possible future state of the
world the replicable component
of the cash flow (no basis risk)
Replicating
Portfolio
The risk margin includes
the risk that can not be
hedged by the replicating
instruments (basis risk)
Risk Margin
Replicating
Instruments
The replicating instruments
define the discount rate
Discount Rate
As the risk margin in the SST and Solvency II
is based on a dynamical replication (yearly),
the illiquidity risk of the replicating instruments
is included in the risk margin
The discount rate gives information on the
replicating instruments: If a risk free yield
curve is used, replication is by risk-free
government bonds only, otherwise, also other
instruments are used
It is not possible to have different assumptions for the replicating instruments, for the
discount rate and for the risk margin without the valuation standard becoming
inconsistent.
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Market Consistent Valuation: Conclusion
• The basis of market consistent valuation is replication of the (stochastic) insurance liability
cash flows with financial instruments
• For the replicating financial instruments to have reliable market prices, they have to be
traded in a deep and liquid market
• The replicating instruments do not need to be risk-free but the basis risk that can not be
hedged by the replicating instruments has to be captured in the risk margin
• The replication in theory is dynamic with at least 1-year time steps, in practice a static
replication can be acceptable
• If replication were to be done by financial instruments that are not traded in a deep and
liquid market, the illiquidity risk (in particular the valuation uncertainty) would have to be
captured in the risk margin. This holds true for both static and dynamic replication
• Illiquidity risk and valuation uncertainty are very difficult to quantify, therefore replication
with financial instruments that are not traded in a deep and liquid market would also lead to
a more uncertain market consistent value
• The choice of replicating instruments is key: It determines the discount rate and the risk
margin. Assumptions on the discount rate and the risk margin have implications for the
choice of the replicating instruments
20
21
Definition
The illiquidity of an insurance liability measures the extent up to which its cash flows are
certain in amount and in timing due consideration being given to the resilience to forced
sales.
Most life insurance liabilities can be considered to be at least partially illiquid.
A prerequisite for the application of a liquidity premium to illiquid liabilities is the existence of
objective and reliable methods allowing to measure the degree of illiquidity.
Report of the Task Force on the Illiquidity Premium, 10 March 2010
22
Arguments
The (simplified) arguments for the illiquidity premium are:
• The value of an illiquid asset, all other things equal, is lower than
that of a liquid one
• Insurance liabilities are illiquid too
• An illiquid liability is defined as one that has predictable cash flows
• Depending on the ‚illiquidity‘ of the insurance liability, an illiquidity
premium is added to the risk-free rate used for discounting
Liquid cash flow
Another – equivalent - argument is:
• An ‘illiquid’ or predictable insurance liability can be replicated by
equally illiquid financial instruments that are held to maturity
Another more intuitive argument is that insurance liability cash flows
should be replicated by assets with similar characteristics, in
particular with similar illiquidity
Illiquid cash flow
According to a CEIOPS Paper :
the illiquidity of an insurance liability measures thus the extent up to
which its cash flows are predictable, i.e. are certain in amount and
in timing
23
The Illiquidity Premium and Terminology
• To call a predictable cash flow ‚illiquid‘ is rather eccentric
• A US government zero coupon bond is highly predictable but nevertheless also liquid
• A complex OTC derivative linked to a CDO cubed is highly unpredictable and also
highly illiquid
• The only reason to call a predictable insurance liability cash flow ‚illiquid‘ is to then use
arguments by analogy
• Predictability of insurance liability cash flows has only a relevance for an illiquidity premium,
if a hold-to-maturity argument is used, which is inconsistent with market consistent
valuation
24
The Illiquidity Premium: Implications and Assumptions
The use of the illiquidity premium implies
•
Replication with illiquid financial instruments: The CEIOPS paper argues that ‚illiquid‘
insurance liability cash flows can be replicated with illiquid financial instruments
•
A hold-to-maturity view: Not including liquidity risk is then equivalent to assume that the
risk that prices of the illiquid assets (that are not traded deeply or publicly) are not
relevant, implying that the assets do not need to be sold or re-valued. The entire
argument of replicating ‘illiquid’ or ‘predictable’ insurance liability cash flows hinges on the
fact that for these cash flows the replicating instruments do not have to be sold/traded.
•
Replication with illiquid financial instruments implies the use of unreliable market prices
to value the replicating portfolio: This essentially transfers the problem of valuing illiquid
insurance liabilities with none or unreliable market prices to valuing illiquid financial
instruments with equally non-existing or unreliable market prices
•
Hold-to-maturity implies not to take into account current information
The basis of the illiquidity premium is far away from principles of market consistent
valuation. If it is used, the valuation cannot be considered market consistent anymore
and technical provisions will always be lower than those based on a proper market
consistent valuation standard.
25
…and Other Aberrations
26
… and other Aberrations
Assuming that all financial market
risk are hedgeable and neglecting
financial market risk in the risk
margin
Detached from reality
Neglecting sovereign risk for EUR
government bonds
Putting lipstick on PIGS
27
The Ultimate Forward Rate and
making heroic assumptions on the
long term interest rate
A miracle occurs
Taking the maximum of swap rates
and government rates for discounting
Heads you win, tails you win…
28
The Matching Premium and
discounting with the expected return
of the actual assets held
29
Back to the 70s
The Illiquidity Premium and other Aberrations
Assumptions on Replication
Replication with illiquid
financial instruments
Illiquidity
Premium
Replication of part of
assets with risk-free
government bonds
Discounting
risk margin
with riskfree rate
No EUcredit risk
Replication with
hypothetical government
bonds without sovereign
risk
Matching
Premium
Replication with
actual assets held
Replication
Replication with either
Max of
corporate bonds or
Swap and
government bonds,
government
rates
whichever results in
lower technical provisions
No nonhedgeable
market risk
Replication with hypothetical financial
instruments that completely hedge market risk
30
The Illiquidity Premium and other Aberrations
It is an act of evil to accept the state of evil as either inevitable or final,
Rabbi Abraham Joshua Heschel
The illiquidity premium and the other approaches are based on hope that future asset returns
or increases in asset values will overcome the insufficiency of technical provisions.
The deficiency is assumed to be compensated over the lifetime of the liabilities by
• Returns on illiquid assets that will not have to be sold (illiquidity premium)
• The return on the assets held (matching premium)
• Heroic growth of the economy (Ultimate Forward Rate)
• Tax payers, as the EU is assumed to always bail out their member states by assumption
(no-default risk for EU government bonds)
• Hope alone (max(government bonds, swap rates))
Actuaries using these approaches are betting that they can fulfill
the promises to policyholders by achieving high returns with no risk
The credit crisis has shown, this rarely works over the long-term
Valuation should be based on science, rather than on faith and
hope alone
31
Market Consistent Valuation and its
Discontents
32
Arguments against Market Consistent Valuation
[…] Wie wohltuend war es aber im Herbst 2008 zu vernehmen, dass die schweizerische
Nationalbank den Kauf der riesigen und unveräusserlichen Risikopositionen, auf denen die
Banken sitzen, zuliess. Nicht die Transaktion an und für sich war wohltuend, sondern das
Argument, dass sie im Unterschied zu den Banken diese Risiken über lange Jahre, ja bis zur
Fälligkeit, auf ihren Büchern halten könne, unabhängig von der kurzfristigen Verfassung der
durch Nervosität geprägten Märkte. Was auf keinem liquiden Markt gehandelt wurde und
keine „marktnahe“ Bewertung aufwies, musste damals bei den Banken abgeschrieben oder
am besten gleich veräussert werden, was immer es kostete.
[…] An die Stelle des tatsächlichen Marktes tritt eine „marktnahe Bewertung“ – also die
Fiktion eines Marktes, den es nicht gibt. Man unterstellt damit eine Veräusserbarkeit von
Risiken, wo diese weder existiert, noch angestrebt oder erforderlich ist.
[…] Welche der angeschlagenen Institutionen wurde in der Krise zu einem marktnahen Wert
übernommen? Lehman ging Konkurs – eine Übernahme fand nicht statt. Welche Rolle
spielten marktkonsistente Werte für die Subprime-Kredite bei den deutschen Landesbanken
oder bei der UBS? Und bei der Sanierung der AIG oder den beiden staatlich unterstützten
US-Hypothekenfinanzierern?
[…] Gerade jene Investoren, welche aufgrund ihrer ökonomischen Natur eine langfristige
Anlagestrategie verfolgen und illiquide Anlagen halten könnten, werden durch die
gesetzlichen Vorschriften gezwungen, sich wie Händler zu verhalten.
Weltwoche, Januar 2011
33
Counterarguments
There are four main criticisms against market consistent valuation
1. It makes investing in certain asset classes more difficult
This is true, since risk and illiquid assets will require more capital than safe and liquid
assets
2. It leads to pro-cyclical situations
This is questionable. Lack of transparency is likely the biggest source of pro-cyclical
effects, as investors lose confidence in companies with opaque balance sheets. Once a
company has to sell its assets to survive, only market values will be relevant
3. The Efficient Market Hypothesis has been shown to be wrong during the credit crisis
This Is true, but market consistent valuation depends on the law of one price, not on the
EMH
4. It is based on a transfer valuation, which is not realistic for insurance liabilities
Not true, market consistent valuation in the SST and Solvency II is based on fulfillment
value, i.e. the cost of holding the insurance liabilities.
34
Liquidity vs. Solvency
I am in blood stepp’d in so far that, should I wade no more,
returning were as tedious as go o’er, Macbeth, Act 3, Scene 4
While market can be wrong, to gamble that illiquid assets with collapsing market prices will
recover can be dangerous.
There is no evidence that the CB [Central Bank] or the FR [Financial Regulator] had
substantial concerns regarding an emerging solvency risk among the banks. By inference,
the Commission must therefore conclude that little credibility was given to perceptions in
the market of exposures and risks in Irish banks. The risk that the Guarantee would be
called was apparently also judged to be small. The overriding goal was simply to make the
Guarantee as effective as possible in the shortest of terms.
Report of the Commission of Investigation into the Banking Sector in Ireland, March 2011
The Irish government in 2008 was betting that the problem was purely a liquidity crisis rather
than a solvency crisis, with evident consequences
35
36
Central Bank Policies
Low interest rates leading to
misallocation of capital
Offshore
Jurisdictions
Illiquid assets transferred to
insurance sector
Implicit Government
Guarantees
Governments driving
central bank policies,
e.g. home-ownership
Sovereigns
Sovereign
Increased
Sovereign Risk
Regulatory
Arbitrage
Central
Bank
Low interest
rates ultimately
to be paid for by
the sovereign
Banks
Low interest rates
to support banks
Trade wars,
Protectionist
measures
Sovereigns
• Higher taxes
• Capital flight
• Increasing sovereign risk
• Protectionist tendencies to
retain tax base
37
Liquid assets transferred
to corporate sector
Insurers
Corporates
Competitive
Disadvantage
Liquid assets transferred to
banking sector
Change in Accounting Standards
(IFRS 9), regulation, tax laws
• Higher profits
• High risk appetite
• Build-up of
systemic risk likely
Illiquid assets transferred to
insurance sector
Liabilities of insurers increasing
due to low interest rates
• Capital depletion due to lower • Corporate bond
returns and higher debt
market supported by
• Deterioration of quality of
insurers
assets held; portfolios
• Increased credit risk
becoming more illiquid
due to misallocation
• Insurers and pension funds
of capital
functioning as a sink for illiquid
assets
Insurers as Liquidity Providers
Yesterday, the Bank issued for consultation some ideas on how we might be able to extend
our liquidity insurance, through the APF, to facilities for working capital finance. They cover a
possible facility for secured commercial paper, where the underlying assets would be
portfolios of SME trade-finance credit, and a facility for supply chain finance. I would hope
that the insurance industry, and the liquidity and investment funds you run, might be
investors in such paper, whose liquidity would receive some underpinning.
Paul Tucker, Deputy Governor, Financial Stability, Bank of England, 9 June 2009
• Banks have already started to aggressively sell liquidity trades to insurers. Banks have to
be invested in liquid assets and insurers are looking for yield enhancements, making this
seem to be a win-win proposition.
• These transactions typically work by the insurer lending part of its liquid bond portfolio to
the bank and receiving a security in the form of a structure that is collateralized with
illiquid assets. The bank uses the bonds to obtain low-cost funding from central banks.
• Insurers are then heavily exposed to contract risk, collateral risk and counterparty risk to
the bank.
38
The Future
39
The Future…
…is already here
Some of Britain’s biggest banks have begun quietly ridding themselves of billions of pounds
of assets they have found difficult to sell following the financial crisis, moving them off their
balance sheets and into staff pension funds.
“The pension scheme has the ability to take liquidity risk with assets that aren’t liquid
temporarily,” Mr Clark said. Pension funds’ liabilities are long-term, so short-term illiquidity is
unimportant.
Banks shift assets to cut pension deficits, Financial Times, 21 August 2011
40
The Future
A likely scenario
κακοῦ δ᾽ οὐκ ἔσσεται ἀλκή, (there will be no help against evil)
Hesiod, Works and Days
Low interest rates and high liquidity lead to
commodity bubble.
The bubble bursts, leading to the dissolution
Banks are financially strained due to legacy
of the EUR. The US and the UK are inflating
problems from the credit crisis and exposures
debt away. Demand collapses, protectionist
to failing sovereigns.
policies are implemented and the GBP and
Regulatory systems (e.g. Solvency II) are
USD depreciate, leading to a hard landing
increasingly geared to give incentives for
of Asian export driven economies.
insurers to support directly and indirectly the
banking industry and indebted sovereigns.
Euro Dissolution
Bubble Bursts
US Inflating debt away
China Hard Landing
Insurers invest heavily in risky assets in a hunt
for yield. Competitors with rational investment
strategies are outperformed and lose market
share.
Governments give incentives for insurers and
pension funds to prop up weak home markets
and local banks, leading to a build-up of risk
41
Illiquid assets collapse in value.
Insurers that are invested
heavily in illiquid assets default.
Strained sovereigns will not have
sufficient resources for bailing out the
insurance and pension industry.
The Future…
…are we feeling lucky?
You've got to ask yourself a question: do I feel lucky? Well do
ya, punk? Clint Eastwood as Harry Callahan in Dirty Harry
The current economic and financial situation and the lack of timely measures taken in the
aftermath of the credit crisis have likely led to a situation where the future will be either
• Bleak: a long and drawn-out contraction with reduced opportunities, especially for the
young;
• Miserable: the EUR dissolving, beggar-thy-neighbor policies implemented and fragile and
risk-averse markets;
• Catastrophic: rising social unrest, the poor not anymore accepting the widening income
gaps and the rich defending their privileges.
The only uncertainty is the mix, duration and sequence of the different phases with which we
will be faced
The question then is, do we as actuaries feel lucky enough to support measures that lower
technical provisions and the quality of assets backing liabilities given the future facing us?
42
Valuation, Risk and the Actuarial Profession
Transparency
Wir müssen wissen. Wir werden wissen
David Hilbert
Valuation is the basis of risk management. Without a sound valuation, economic capital
models and regulatory requirements are merely fig leaves which give a false sense of
security
We as actuaries should aim to enhance transparency on the economic state of insurers and
to protect the interests of policy holders. In the current uncertain environment, the valuation
standard should be as transparent and as consistent as possible. Concepts as the illiquidity
premium, the matching premium and other valuation aberrations are gambles that move the
problems to the future, in the hope that a miracle will occur in the meantime.
43
Valuation, Risk and the Actuarial Profession
Valuation is the basis of risk management. Without a sound valuation, economic capital
models and regulatory requirements are merely fig leaves which give a false sense of
security
44
Contact
Philipp Keller
Head Financial Risk Management
Deloitte AG
Switzerland
Tel:
+41 44 421 6290
Mobile:
+41 79 874 2575
Email:
[email protected]
45
Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited (“DTTL”), a UK private company limited by guarantee, and its network of member firms,
each of which is a legally separate and independent entity. Please see www.deloitte.com/ch/about for a detailed description of the legal structure of DTTL
and its member firms.
Deloitte AG is a subsidiary of Deloitte LLP, the United Kingdom member firm of DTTL.
Deloitte AG is recognised as auditor by the Federal Audit Oversight Authority and the Swiss Financial Market Supervisory Authority.
This publication has been written in general terms and therefore cannot be relied on to cover specific situations; application of the principles set out will
depend upon the particular circumstances involved and we recommend that you obtain professional advice before acting or refraining from acting on any of
the contents of this publication. Deloitte AG would be pleased to advise readers on how to apply the principles set out in this publication to their specific
circumstances. Deloitte AG accepts no duty of care or liability for any loss occasioned to any person acting or refraining from action as a result of any
material in this publication.
© 2011 Deloitte AG. All rights reserved.

The Illiquidity Premium... …and other Aberrations

Transcription

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