A real world stress test

Editor's letter

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For many Life & Pensions readers, the fascinating thing about the current market turmoil is how it replaces theoretical questions of risk with real-life answers. Were you curious about whether pushy regional banks or Wall Street securities firms could survive a downturn? Now you know the answer. Was it prudent for bank regulators to allow institutions to make expensive acquisitions at the top of a bubble? Now you know the answer to that one too. Was off-balance sheet maturity transformation resilient to funding stress? No it wasn't.

Insurance companies and pension funds with longer-term liabilities (at least longer than the day-to-day horizon of panicky bank depositors) may look on the carnage with slightly detached horror. Some might even be working up an appetite at the prospect of picking over the carcasses of the fallen giants of the financial landscape. But the market volatility provides a real-life test for our readers too.

For the hardy souls who have laboured over the Solvency II QIS4 spreadsheets and documents, there are now far simpler questions to ask. Will you reach the end of 2008 without burning through your solvency capital requirement? How far would equity markets need to continue falling in 2009 and 2010 for the French 'dampener approach' to break down and require you to raise more capital? If you work for a local subsidiary of a multinational giant, would your policyholders be protected by the promise of group support in an AIG scenario?

If you are a pension trustee, now you know what investment bank insolvencies look like. Would your liability-driven investment programme survive a counterparty default? How did your equity and bond portfolio cope during a wave of depositor-friendly bank nationalisations? What about a hedge fund investment losing 50% of its value?

It might be naive to suggest that hundreds of pages of solvency capital rules and internal risk reports might be replaced by the '2008 test', but that might be an improvement over what is currently on offer. But the biggest real-life test of all is political. The banking crisis has replaced once-academic musings about moral hazard and systemic risk with a flood of real-time case studies. Finance ministries faced with runs on banks are making rapid decisions with little time for reflection on winners and losers.

Aside from its role as an investor in the banking system, the insurance and pension sector is not directly affected by these dramas. But it will have an impact on the political mood for anything that smacks of progressive regulation. It's hard to imagine increasing political support for market consistency when there is talk of suspending fair value accounting for banks as a way out of the crisis. And as the debates in US Congress about a financial bailout demonstrate, consensus in a time of turmoil is far from a done deal.

When risk meets reality, things have a habit of getting sorted out in a brisk and not necessarily perfect fashion.

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