SUSTAINABILITY 2005

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Resilience Reserve Taskforce Report
Anthony Asher (Convenor), Colin Grenfell, Anton
Kapel, Martin Paino, Ken Ragell, Michael Sherris
James Wang
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Introduction

• Refresh - ten years on
• Modeling
• Tail probabilities
• Correlation
• Other factors
• Diversification factor
• Mean reversion
• Credit risks

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Tail probabilities
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Correlations

• Required for
• Classification of assets
• Diversification
• Are non-linear and variable
• Different in the tails
• Change over time

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Diversification factor

• Inconsistencies in the current factor
• A theoretical approach
• The implications

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Diversification factor
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Asset classification

• International equities
• Property
• Different sectors
• Other assets

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Other factors

• Mean reversion
• Tendency to return to long term mean
• Serial correlation
• Tendency to overshoot and correct
• Fundamental variables
• Earnings yields vs interest rates
• Tobins q (marketbook value)
• Profits GNP

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Mean reversion
Currently assume ? 0. If not, is et smaller or
more symmetrical?
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Mean reversion statistics
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Mean reversion suggestions
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Credit risks

• Elements of credit risk
• Defaults
• Transition from one category to another
• Change in market credit spreads
• Granularity?

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Other issues

• Application to individual portfolios
• Reinvestment
• Yield curve slope and shape
• Gearing, derivatives and hybrids
• Inadmissible assets

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Suggested form
RR LA/A-vE2F2K22(.2(EF-EK)-FK) -
L L determined after mean reversion A
after mean reversion and credit shock E dollar
value of equity shock F dollar value of fixed
interest shock K dollar value of liability
shock

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Yield shock increases
Solvency Capital
Adequacy Real interest rates 0.8 1.2 Anticipat
ed inflation 0.2 0.5
20 F 30 F Dividend yields 1.25 2.0 Cu
rrency 14 20


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Proposed wording

Step 1 Determine adjustment for mean
reversion Step 2 Determine allowance for
currency and credit shocks Step 3 Determine
effects of prescribed yield shocks Step 4
Determine Resilience Reserve

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Step 1 Adjustment for mean reversion

• Change in real interest rates 25 of (3.4 -
  Current yield on 10 year government indexed
  bonds)
• Change in anticipated inflation 25 of (3 -
  Current level of anticipated inflation)
• Change in dividend yields 25 of (4 - Current
  dividend yields on the SP ASX200 index)
• Change in rental yields 25 of (8 - Current
  rental yields on the SP ASX 200 Property Trusts
  index).

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Step 1 Adjustment for mean reversion notes

• Equities include all non-interest bearing
  investments but not property.
• 2 Property includes listed and unlisted property
  trusts, and direct.
• 3 The actuary must consider the application of
  mean reversion to assets invested in countries
  outside Australia.
• 4 The adjusted value of Australian equities is
  determined assuming that the fund is invested in
  the index. i.e. current market value multiplied
  by the Yield on the SP ASX200 index/ Yield on
  the SP ASX200 index increased by the mean
  reversion adjustment.
• 5 The value of properties similarly. i.e. market
  value multiplied by the Yield on the SP ASX200
  property trust index/ Yield on the SP ASX200
  property trust index increased by mean reversion.

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Step 2 Currency and credit shocks

1 Calculate A1r separately for each rating group,
such that A1r is equal to A (in respect of each
rating group) adjusted for a further increase in
yields in accordance with the yield movements in
the table. 2 Calculate A2r separately for each
rating group, such that A2r is equal to A1r
multiplied by (1 the applicable default factor
taken from the table), and 3 Calculate A equal
to S A2r multiplied by (1 - 14/20 of the
proportion of liabilities backed by assets
denominated in a different currency, where that
exposure has not been hedged).

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Step 3 Prescribed shocks
A(E), A(P) and A(F) are the value of equities,
properties and fixed interest assets determined
in step 1 after the mean reversion
adjustment. A(E) A(E) multiplied by the
Yield on the SP ASX200 index increased for mean
reversion/ Yield on the SP ASX200 index
increased for mean reversion and the prescribed
yield increase. Similarly, A(P) (A(P)
multiplied by the Yield on the SP ASX200
property trust index increased for mean
reversion/ Yield on the SP ASX200 property trust
index for mean reversion and the prescribed yield
increase. A(F) is the value of fixed interest
liabilities at an interest rate that adds the
prescribed shock to the interest rate after the
adjustment for mean reversion. L is the value
of all liabilities valued at an interest rate
that adds the prescribed shock to the interest
rate2 after the adjustment for mean reversion.


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Step 3 Prescribed shocks - notes
1. Australian cash investments is fixed
interest, but should not affect F. 2. If a
direct link between the values of assets and
liabilities such that the changes in both cancel
each other out, the changes should be ignored for
the determination of E, F and K. A resilience
reserve required for other liabilities. 3. For
participating business, the liability can be
calculated assuming that future bonuses reduced
to level consistent with mean reversion and
shocks. 4. Unlisted investments should be
treated on a look through basis with the debt
included in liabilities, and subject to the same
adverse shocks. 5. E is increased by 10 if
the amount invested in any one sector or in a
foreign country exceeds 25 of the equity
portfolio. The sectors for this purpose are
Financial (ex Property), Property, Industrial and
Resources. 6. If the assets or liabilities
respond asymmetrically to up and down changes to
the variables listed, then the worst possible
value should be used.


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Step 4 Formula

RR L' A/ A- vE2F2K22(.2(EF-EK)-FK) - L

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APRA Spreadsheet
1 Intro and results 2 Credit 3 Current Solvency
Reserve and LIASB draft 4 Taskforce proposals
Solvency 5 Current Capital Adequacy Reserve
LIASB draft 6 Taskforce proposals Capital
Adequacy 7 Mean term checks on
assumptions 8 Questions


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(No Transcript)
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Conclusion

• Questions?
• Comments?
• Mean reversion
• Classification of assets (esp. property)
• New approach to diversification
• Credit risks
• Parameters

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