ERP update – delayed response to a blog reader

I reader asked why so many practitioners use high Equity Risk Premiums in their valuations and fairness opinions.

In particular, he mentioned a specific assumption set he had seen including:

  • ERP of 6.8%
  • company specific risk premium of 4%

He also commented on how haphazard the use of risk premiums can be and referenced a few sources I’ve used myself.

The ERP of 6.8% does seem high. However, it really isn’t possible to comment on the specifics of the company specific risk premium without knowing the company.

Although I haven’t updated my research on this in a few years, in my own work I still generally stick with a range of 3% to 5% for an ERP, before considering company specific factors, liquidity, and so on. Historically / empirically estimated ERPs shouldn’t change frequently since the time series used is long. Another few years on a 20 year estimation period shouldn’t have much impact.

Why some practitioners persist in using too-high ERP estimates

This delves into the area of philosophy, but here are my top reasons (a post from 2011 also covers this): Continue reading “ERP update – delayed response to a blog reader”

Modelling one side of a two-sided problem

Ah models, my old friends. You’re always wrong, but sometimes helpful. Often dangerous too.

A recent article in The Actuary magazine addressed whether “de-risking in members’ best interests?”  I say “recent” even though it’s from August because I am a little behind on my The Actuary reading.

In the article, the authors demonstrate that by modelling the impact of covenant risk, optimal investment portfolios for Defined Benefit (DB) pensions actually have more risky assets than if this covenant risk is ignored.

The covenant they refer to is the obligation of the sponsor to make good deficits within the pension fund. Covenant risk then is the risk that the sponsor is unable (typically through its own insolvency) to make good on this promise.

On the surface it should seem counterintuitive that by modelling an additional risk to pensioners, the answer is to invest in riskier assets, thus increasing risk.

The explanation proffered by the authors is that the higher expected returns from riskier assets allow the fund to potentially build up surplus, thus reducing the risks of covenant failure.

I can follow that logic, particularly in the case where the dependence between DB fund insolvency and sponsor default is week. It doesn’t mean it’s a useful result. Continue reading “Modelling one side of a two-sided problem”

Progress on tax free savings vehicles, but scathing words for life insurers

Read the latest (14 March 2014) document from National Treasury on tax free savings vehicles for South Africa. I think it’s a fantastic idea – both from a policy perspective with carefully designed incentives to promote long-term savings and from a personal perspective. I’m definitely going to use one for my own savings. However, one paragraph stuck out as a pretty clear message from National Treasury on their views of life insurers – and views on current product offerings rather than any historical sins:

Insurance products

Products must permit flexible contributions and may not bind individuals into any future contribution schedules. Many insurance investment policies would currently not match these criteria. Government is not open to providing a tax incentive for products that have high charges and may have an adverse impact on household welfare at the point at which the household is increasingly vulnerable. In this regard some savings products, for example endowment policies and any similar investments that include excessively high penalties in the case of early termination of the policy, pose a policy challenge from a market conduct perspective and will not be allowed in these accounts.
As discussed, National Treasury will engage with the FSB and industry in determining a reasonable approach to charges and early termination.


Wow. I know there are many bad insurance products around and probably some still being sold. I also know of many insurance executives who strive for value for money and are reinventing products and distribution channels to this end.
Seems to me NT isn’t yet on board.

Credit Suisse annual update on market performance

Credit Suisse has for several years now put out an annual Credit Suisse Global Investment Returns Yearbook 2013 is out now.

It’s worth reading in its entirety for the insights. I don’t agree with everything there, and I certainly don’t agree with the widely held view (not among the authors) that the universe of countries included in the survey is supposed to be somehow representative of the world.

The countries chosen have an absolutely clear bias in their selection. They are successful economies with successful financial markets. They are included by virtue of their long-term success and capital growth and returns for investors.

The authors know this, but many readers don’t.  The returns per this survey are an overly rosy view of possible future returns.

Swap vs swop

Really now. A financial contract where two parties agree to exchange real or notional cash flows on some agreed basis is a “swap” and not a “swop”.

SAM Risk-free Rate Workshop

The Technical Provisions Task Group and KPMG ran a workshop for industry participation on risk-free rates recently. The idea was to see whether we could improve the extent and quality of industry comment on key, controversial areas of the proposed SAM regime.

Turnout was good, but not great, but the discussion and points raised were all fantastic. Plenty more to do from here onwards, but I thought it might be useful to include the presentations somewhere publicly available.

Some of the concepts that were on the agenda

  • Swaps vs Bonds, the theory as well as practical implications for insurers, banks and the capital markets
  • Extrapolation methods and what challenges this creates for practitioners
  • Identifying and measuring illiquidity premiums, credit spreads and the difference between Expected Default Loss and Credit Risk Premiums
  • European developments on Matching Adjustments and Countercyclical Premiums. Should we follow their path? Is bottom-up or top-down more practical?
  • Do we need a methodology for nominal and/or real yield curves?
  • Non-South African countries – what is the practical answer to requiring multiple yield curves?
  • Reducing regulatory arbitrage between banks and insurers for credit and market risk on swaps and bonds

Panel Members:

  • David Kirk
  • Ian Marshall
  • Philip Harrison
  • Brian Kipps
  • Lance Osburn
  • Lindy Schmaman
  • Louis Scheepers

Presentations (reproduced with permission from the authors)

Risk free rate workshop outline November 2012

Position Paper 40 (v 3)

Philip Harrison – Risk Free SAM Workshop

Risk free yield curves Brian Kipps

Risk-free rate workshop_LSchmaman

SAM Risk Free 29 Nov012 Louis Scheepers

SAM Workshop 20121129 Lance Osburn


Emerging Markets and Equity Performance

The astoundingly useful guys at FT Alphaville pointed me towards this Gerard Minack analysis of emerging market returns yesterday.

The message is that high growth economies don’t necessarily translate to high equity returns.

The argument can be summarised as this:

  • Earnings growth is correlated with economic growth
  • Valuation changes contribute significantly to equity returns and can have a major impact on equity returns distinct from underlying economic growth for long periods, 10 or 20 years
  • But in the long term these valuation changes should even out. We should still be left with a correlation between economic growth and equity returns
  • High growth economies need significant investment. This additional investment in companies comes at the cost of equity dilution. High growth economies are positively correlated with high dilution.
  • Thus, EPS correlation with economic growth is significantly lower than it would be without dilution.
  • This explains the virtually zero correlation between dividends and economic growth

Check out the full story for some pretty graphs.

What’s interesting for me here is that none of these arguments require or allow for market efficiency. It’s a totally separate way of looking at the issue with empirical evidence to support it.

I suppose the market efficiency counter would be that the change in valuation over long periods should be exactly as required to provide an appropriate risk-adjusted return to investors given the expected changes in all other variables. I don’t know if I buy that or not.

The key message for me is the counter argument to the “obvious” view that high growth emerging markets necessarily provide greater equity returns in the long run. The same can be said for why high growth companies don’t necessarily provide higher equity returns in the long run. As the low-growth companies are spitting out dividends to investors, the high-growth companies are diluting existing investors as they raise more capital.

The one question I haven’t full settled in my own mind is whether real dividends being correlated with economic growth is the best measure. High dividends now should result in low dividends in future. Low dividends now should result in high dividends in future. We should expect a point-in-time correlation between high growth economies (and companies) and low dividend yields. I would think that this correlation is needed in addition to the time series analysis performed by Dimpson, Marsh and Staunton since there can be weird lag effects that diminish the correlation there.

All the same, food for thought, especially living in a low-moderate growth emerging market country!