Understanding Liquidity Premiums.

May 13 & 15, 2009 Michael Stumbles (Zurich)

How have markets dealt with 31.12.2008 valuations ?

Falling asset prices have hit insurers balance sheets hard Has knock-on effects for Solvency, Liability Adequacy Testing and Market Consistent Embedded Value Has led to many insurers moving away from market consistent principles In MCEV valuations:
Using average volatilities rather than volatility at 31.12 to calibrate models Adding liquidity premiums to reference yield curve

2009 B&W Deloitte GmbH

Assumptions Liquidity premiums in published MCEVs

350

300

250

200

150

100

50

0 Aviva UK Aviva US IA IA SW IA Axa Europe Generali Europe Fortis Europe Axa NonEurope Fortis NonEurope Aviva US Aviva US IA Other Old Mutual US

Immediate Annuities
3

In Europe

Non-European

USA
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Three Aspects of Liquidity

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of

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Illiquidity Effects in Annuity Prices

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Analysing Asset Yields

Illi

qu i di As ty Pr se em t Y iu i el m s ds in

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Elements of Corporate Bond Yields: Illustrative

Bond Gross Redemption Yield less expected default losses less illiquidity losses on forced sale less management expenses Expected Bond Return less cost of default risk capital less cost of liquidity capital less cost of expense capital less unexplained residual Liquid risk-free rate Yield (%)
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Tools for Estimating Liquidity Premiums

qu i di As ty Pr se em t Y iu i el m s ds in

DIRECT METHODS 1. Cross-sectional Regression 2. Liquidity Demand models 3. Liquidity Rent Rates

Illi

INDIRECT METHODS 4. Spread less historic default losses 5. Spread less Merton implied spread 6. Spread less CDS spread

2009 B&W Deloitte GmbH

Direct Methods for Estimating Liquidity Premiums

Direct methods focus explicitly on the liquidity element Cross section regression analyses
Spread (in excess of government bonds or in excess of swaps) As a function of liquidity (measured by bid-offer spread or estimated trade impact on market price)

Liquidity demand models

Estimate liquidity costs on forced sale Compensation to attract investors to demand the market supplied quantity

Liquidity renting

2009 B&W Deloitte GmbH

Liquidity Renting
Before: Insurer / Pension Fund After: Bank Insurer / Pension Fund

Bank

Illiquid Asset

Cash

Cash

Illiquid Asset Illiquid asset return Asset Swap

LIBOR + liquidity premium

Problem for the Bank: Must regularly refinance the illiquid asset at uncertain future cost of funds.
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Problems for the Insurer: LIBOR may understate available cash return. Joint default risk of bank and illiquid asset.
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Direct and Indirect Estimates of Liquidity

Direct Historic Default Spread Historic Expense Spread Historic Illiquidity Spread

Unexplained Residual

Indirect

Total Yield Spread

Note: An indirect estimate of default risk, after taking out illiquidity, would allocate most of the spread to defaults. Whatever you choose not to analyse explicitly gets the unexplained residual.
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Estimating Default Losses Historic Spreads (UK 7-10 year) and Mertons Model
8% 7% 6% 5% 4% 3% 2% 1% 0% 06/98
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Spread vs government bonds

AAA AA A BBB

Mertons model works in a liquid world of no transaction costs or other frictions. This is not a promising start for calibrating illiquidity premiums.

06/99

06/00

06/01

06/02

06/03

06/04

06/05

06/06

06/07

06/08
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Bank of England Model Investment Grade bonds

Basis points 500
Date 10/10/2008 11/12/2008 Residual -0.09% +2.29% Residual (including compensation for illiquidity) Compensation for uncertainty about default losses Compensation for expected default losses

400 300

Actual

200 100 0

97
12

98

99

00

01

02

03

04

05

06

07

08

09

Source: Bank of England

2009 B&W Deloitte GmbH

Indirect Methods Credit Default Swaps

Estimate

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Estimating Losses Credit Default Swaps

Reference Credit OK CDS Writer OK Reference Credit Default

CDS contract pays out

CDS price reflects: writer is providing liquidity, writer might default. No good reason to suppose these two effects cancel.
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Writer Defaults

Costs and Risks of Illiquid Investments

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Measuring the Cost of Liquidity: Market Level

Base Estimate: Liquidity event #1 p.a 20% of assets sold Sale discount 5%

Sacrifice Effect Sell most liquid assets first

Clientele Effect Long term investors hold a high proportion of illiquid assets

Quantifying these elements forms the basis of a liquidity premium model, which analyses how the two elements of cost reduction are shared in a competitive market between bond issuers and different investor clienteles.

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2009 B&W Deloitte GmbH

Equilibrium Investment in Illiquid Assets

1.0%

Optimal strategy
0.9% 0.8%

0.7%

Illiquidity Gain.

0.6%

0.5%

Low r equir ed

liquid i

ty

0.4%

0.3%

0.2%

High

0.1%

requ ired

liqui d
50%

ity
60% 70% 80% 90% 100%

0.0% 0% 10% 20% 30% 40% Proportion invested in illiquid asets

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Implication for Annuity Prices

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Illiquidity Effects in Annuity Prices

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Implication for Annuity Pricing

Asset return assumptions Liquidity premium Liability pricing basis

Po s

sib

le

Own Credit Risk

pr

ox

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Liquidity Premium Estimation by Replicating Portfolios (Replios)

Discount at Swap yields Replio = cash + swap Discount at government Replio = bond yields government bonds Discount at AA less spread Replio for credit risk = ??

Discount at AA yields Replio = AA bonds

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2009 B&W Deloitte GmbH

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