Market Risk Margin

Study guide: Exam 6C

The Market Risk Margin is the MCT component covering the risk that the value of an insurer's assets — or the relationship between its assets and liabilities — moves adversely with market conditions. It captures interest rate risk, equity risk, real estate risk, foreign exchange risk, and other market exposures.

• Interest rate risk is measured on the mismatch, not on the assets alone. An insurer whose asset duration matches its liability duration is largely immunised; one whose assets are much longer or shorter is exposed, and the margin reflects that gap.
• Equity risk applies a factor to common share holdings, and it is high — equities are volatile and their fall correlates with the economic conditions in which insurers also suffer underwriting losses. This is the principal reason Canadian P&C insurers hold predominantly bonds.
• Real estate and foreign exchange attract their own factors; currency exposure is measured net of matching liabilities in the same currency.
• The margin shapes portfolios. An insurer choosing between a bond yielding 4\% and an equity expected to return 8\% must compare the extra return against the capital the equity consumes. On a risk-adjusted basis the bond often wins, which is why Canadian P&C asset allocations look conservative.
• It interacts with IFRS 17 presentation. Assets at FVOCI move through OCI and hence through Capital Available; if the OCI option on liabilities is elected, part of that movement is offset and the capital effect is limited to the duration mismatch.
• It is the counterparty to the Diversification Credit, which recognises that market risk and insurance risk do not crystallise together.

The Capital Cost of an Equity Allocation An insurer holds \$600 million of investments, currently all in bonds yielding 4.2\%. It is considering moving \$90 million into equities with an expected return of 8.5\%. The equity risk factor is 30\%; the bonds attract an interest rate margin of 3\% on the mismatched portion, unchanged by the switch. Capital available is \$310 million and the base solvency buffer is \$185 million.

Evaluate.

Answer Additional expected return:

\begin{align*}
&= \$90\text{M} \times (0.085 - 0.042) \\
&= \$3.87\text{M} \text{ per year, pre-tax}
\end{align*}

Additional capital required:

0.30 \times \$90\text{M} = \$27\text{M}

Effect on the buffer and the ratio:

\begin{align*}
\text{New BSB} &= \$185\text{M} + 1.5(\$27\text{M}) \\
&= \$225.5\text{M} \\[4pt]
\text{New MCT} &= \frac{\$310\text{M}}{\$225.5\text{M}} = 137\%
\end{align*}

against \$310/\$185 = 168\% before. A 31-point fall in the capital ratio to earn \$3.87 million a year.

The return on the capital consumed, after tax at 27\%:

\frac{0.73 \times \$3.87\text{M}}{\$40.5\text{M} \text{ (buffer increase)}} = 7.0\%

which is at or below most insurers' cost of capital — before considering that equities can fall 30\% in a year, and tend to do so in the same conditions that produce underwriting losses.

Conclusion: decline, on these numbers. And note the more general result the calculation illustrates — the MCT's equity factor is high enough that a P&C insurer's equity allocation is a capital decision before it is an investment decision. This is precisely why Canadian P&C balance sheets are bond-dominated, and it is not conservatism for its own sake.