On Active Markets & the Solvency II ‘DLT’ definition
Posted on 28-02-2011 | 0 comments
In recent years market prices have taken on far greater prominence in insurance valuation and capital management as a new paradigm has been adopted by insurance regulators and accountants. This central role of market prices is recognised and, as a result, Solvency II regulators and international accountants (IASB/FASB) have drafted rules and guidance with the aim of defining which prices should be used and in what circumstances unreliable prices may be replaced with other valuation measures. However, the current rules and guidance are not well aligned (between SII and IASB/FASB) and there is a dearth of detailed thinking on how to turn aspirational regulation into practical reality.
Choices over which prices may be used (and why) will have a material impact on valuation and risk management actions. A topical example is the choice of ‘longest liquid point’ in the extrapolation of swap curves for SII valuations. The value of long-term cash flows and the connection between balance sheet assets and liabilities will depend on how the quality of individual instrument markets is judged.
The diagram provides a crude comparison of the terminology in use among European insurance regulators, accountants and European firms (CRO forum). The CRO forum and accountants’ definitions of Active markets and Hedgeable market risks look aligned.
..quoted prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agency, and those prices represent actual and regularly occurring market transactions on an arm's length basis.
For non-hedgeable risk (no Active markets), accountants make a distinction between model-based valuations based on the observability of the model’s inputs. Although this is a useful distinction, in practice its application will be rather grey. I would view the extrapolated price of a cash flow falling only 1 year beyond the liquid market as qualifying for level-2 whereas a 50-year extrapolation clearly falls under the level-3 definition. Most of us would struggle to say where the cut-off lies. More problematic is the additional layer of analysis applied by European regulators in defining reliable prices which additionally must trade in ‘deep’, ‘liquid’ and ‘transparent’ markets. Taking these definitions at face value suggests only a small set of instruments may pass the ‘DLT’ test. Where market prices are observable, but fail the DLT requirement, it is not clear how much weight should be placed on them in valuations. Strictly speaking, any non-DLT price will require the addition of a risk margin under Solvency II. The QIS 5 technical specification suggests that it is possible that non-DLT prices could be completely ignored (which creates a worrying potential disconnect between non-DLT assets on the balance sheet and liability valuations). A further requirement for ‘permanence’ which appeared in early versions of technical guidance has been removed (for the time being at any rate). Whilst the DLT definitions could be clarified further, the basic properties of an instrument market they seek to measure are:
- Depth. The ‘normal market size’ (NMS) of trades. You might easily ask whether qualification as ‘deep’ require an absolute or relative amount?
- Liquidity. This can be interpreted as a measure of the impact of abnormal trade sizes i.e. if an insurer aims to trade 10 x NMS, what impact on the price is expected.
- Transparency. What information makes a market transparent? When must it be disclosed and how?
These words are somewhat different to the SII definitions but aim to convey the intention of the regulator. To help understanding of these properties of a market price, consider the chart below. It shows offers to buy and sell in a market where the amounts offered (or bid) are indicated by the size of the circles. It happens to be a market for bets on a tennis tournament. It is interesting because this ‘public order book’ provides a clear view of dealing intentions in a market so that a trader can understand the likely impact of a trade of a specific size. You can see that for Federer, it is possible to buy or sell relatively large amounts (of the bet) across a narrow price range. The market for Federer is both deep (large size) and liquid (low impact). Markets for Nadal and Djokovic are less liquid and, although there are bids and offers for Murray, only small trades are feasible and they will suffer a large impact cost.
In their report on the ‘Flash Crash’ of May 6 2010, the US CFTC provide a useful description of ‘depth’ as follows:
We use the term market depth.. to refer to resting orders that market participants place to express their willingness to buy or sell at prices equal to, or outside of .. current market levels. These orders are referred to as “buy interest” and “sell interest”, and the number of shares of each type of order interest represent “buy-side market depth” and “sell-side market depth.” Collectively, buy-side and sell-side resting orders form a “liquidity pool” against which incoming sell or buy orders can be executed.
Of course, you need to remember that this picture excludes the hidden intentions of dealers or investors who would offer liquidity but either do not bother to advertise through the order book or prefer to keep their dealing intentions secret. Dealers are notoriously cagey about revealing information to other market participants. The picture above gives an ideal view of what a market – where dealing intentions are publicly available – could look like. In practice, few markets offer this level of transparency. However, this view is useful because it can help us understand what we would like to measure.
So where are we now? To summarise:
- Some clarification of language would be helpful.
- The divergence between accounting and insurance terminology and emerging practice is worrying and has the potential to create an inconsistency between accountants’ fair vales and Solvency II technical provisions.
- Whatever the result, firms will need to gather evidence on the reliability of the prices used in their valuations.
- An informed discussion requires the development of objective, operationally-feasible measures of the various characteristics discussed in this article.
It’s a big job. We should start soon.
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