Standard formula ‘an inadequate risk measure’ for high-risk bonds

European policy-makers has been urged to adjust Solvency II’s treatment of bonds, after a study found that the current calibration of the standard formula does not adequately reflect the risks associated with very high-risk bond types.

The research, by Edhec Business School, also found that the standard formula underestimates losses on high-risk bonds during periods of crisis and does not reflect the differences in geographical risk of bonds.

The European Insurance and Occupational Pensions Authority (Eiopa) should, Edhec argues, adjust the bond solvency capital requirement (SRC) to incorporate the effects of macro-economic cycles and differences in geographical risk. It should also change the way high-risk bonds are assessed.

Edhec warns that the current calibrations of the bond SCR could lead to insurers shortening the duration of their bond portfolios and could threaten corporate funding by the insurance industry, Edhec warns.

“The current calibration of Solvency II is likely to prompt insurers to distance themselves from investing in long-term bonds, particularly those with ratings of BBB or lower. Naturally, this raises many questions on the future financing of the economy by the insurance industry,” says Philippe Foulquier, director of the Edhec Financial Analysis and Accounting Research Centre, based in Lille.

“Solvency II could, therefore, dry up a major source of corporate funding and thus counter the growth and financing objectives of the economy,” Foulquier adds.

The analysis of 4,279 fixed-rate bonds listed between 1999 and 2011 found that the standard formula produced an “irrelevant” risk measure for long maturity investment grade bonds and high-yield bonds with maturities of more than seven years.

This was because the standard formula’s focus on interest rate spread risk produced an inaccurate risk assessment for these bond categories, which have sensitivities to risk factors different to those of other bonds.

High-yield bonds, the valuation of which is highly sensitive to the risk of default and not less sensitive to movements in the interest rate terms structure, could be assessed using a model in which default risk is paramount, the study found.

Long maturity investment grade bonds, which are typically held for ALM purposes, could be treated in a similar way to Eiopa’s proposed approach for equities backing ring-fenced pensions liabilities, Edhec said.

Unrated bonds were also treated by the standard formula’s treatment in a way that was not in line with the historical risk premium.

“Bond SCR – as defined by the standard Solvency II formula – is, overall, an appropriate measure of risk. However, given their specificities, SCR does not fully reflect the risk associated with long-maturity investment grade bonds, high yield and unrated bonds,” Foulquier says.

But the bond SCR had a tendency to underestimate high-risk bond losses during periods of crisis and overstate losses in non-crisis periods. A geographical analysis of the relationship between value-at-risk and bond SCR produced heterogeneous results between the geographical areas studied.

“Eiopa should consider implementing a bond SCR that incorporate the effects of macroeconomic cycles as the equity dampener does. It would also be useful for Eiopa to integrate these differences in geographic risk via an adjustment to the SCR,” Foulquier adds.

No one from Eiopa was available for comment in time for publication.


This article was first published on Risk

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