Large scale asset purchases (QE) - intent & after effects!!
2013-las-session-59
1. SOA 2013 Life & Annuity Symposium
May 6-7, 2013
Session 59 PD, Impact of the Low Interest Rate
Environment on Life Insurers
Moderator:
Richard C. Pretty, FSA, MAAA
Presenters:
Joseph R. Dziwura
Yidong (Winter) Liu, FSA, MAAA
Primary Competency
External Forces & Industry Knowledge
2. 1
Session 59 Panel Discussion:
Impact of the Low Interest Rate
Environment on Life Insurers
2013 SOA Life & Annuity Symposium
Richard Pretty, FSA, MAAA
Agenda
I. Welcome & Introductions ………………….. Richard Pretty, Senior Managing Director
Product Actuarial, TIAA-CREF
Joseph Dziwura, Senior Managing Director
Market Risk, TIAA-CREF
Winter Liu, Principal
Oliver Wyman
II. Opening Remarks …………………………. Richard Pretty
III. Presentations ……………….……………... Joseph Dziwura
2
Winter Liu
IV. Q&A ………….………………………….….. Richard Pretty
3. 2
Opening Remarks
Industry fundamentals mixed
life insurers generally well-capitalizedg y p
revenue & operating margins under increasing pressure
Headwinds
• intense competition
• weak global economy
3
weak global economy
• sustained low interest rates
– reinvestment risk
– spread compression
Opening Remarks
Company responses to spread compression:
• lower crediting rates … but guarantee limits
• higher priced new business … but competitive limits
• Investment strategy changes
increased credit risk taking … but RBC limits
Increased liquidity risk taking … but ALM limits
4
• de-emphasis on interest rate sensitive products … but consumers
want safety
• emphasis on variable and indexed products … but market volatility
5. 4
Impact of the Low Interest Rate
Environment on Life Insurers
2013 SOA Life & Annuity Symposium
Joseph R. Dziwura
Overview
• Accommodative Federal Reserve Policy lowers interest rates through important
channels:
– The Federal Reserve’s ongoing purchases of Treasury and agency mortgage-backedg g y g y g g
securities (MBS) has led to a Federal Reserve balance sheet that is now roughly $3.0
trillion. The Fed is buying $40 billion per month of MBS, and $45 billion per month of long
term U.S. treasury securities to keep long term rates low and to support the mortgage and
housing market and to stimulate cyclical parts of the US economy including autos and
consumer durables and other parts of the economy and promote stable financial conditions.
At the same time, short-term interest rates have a zero lower bound constraint, and with
expectations based on Federal Reserve “forward guidance” that rates will stay low for an
extended period of time.
8
– The Federal Reserve purchases reduce interest rates and ease financial conditions through
important channels. One important channel is the portfolio balance channel. The portfolio
balance channel relies on the premise that financial assets are imperfect substitutes in
investor’s portfolios, and a rise in the demand for a particular asset relative to supply will
increase its price and reduce its yield. After selling assets to the Federal Reserve, investors
may rebalance their portfolios by investing in other assets, raising the prices of those
assets, lowering their yields and easing overall financial conditions, reflecting the Fed’s
asset purchase program.
6. 5
Overview
• Accommodative Federal Reserve Policy removes interest rate risk and duration
risk including prepayment risk and overall market volatility from the economy:
– The Federal Reserve asset purchase program was designed to remove risk from the privatep p g g p
sector portfolio of private investors. For example, Treasury and agency MBS purchases
remove duration risk, thereby lowering long-term interest rates and reducing private sector
borrowing costs. Agency MBS purchases also remove prepayment risk in the market
lowering MBS yields and mortgage rates supporting the housing market and refinancing.
– The major impact of monthly purchases on interest rates comes from the expectations of the
total “stock” of risk – e.g., duration risk -- that will be removed from the private sector and
the length of time the Federal Reserve will hold this risk. Market expectations concerning
the total amount of risk and the composition of securities that will be removed from the
9
market will evolve over time with incoming information on the real economy – inflation and
unemployment and other considerations.
– Accommodative policies and sustained low interest rates could lead to excessive risk taking
in some financial markets. Continued slack in the economy along with low inflation
suggests accommodative policy is warranted. Dialing back accommodation poses its own
risk to growth, price stability and financial conditions.
1871 - 2012
14 0
16.0
18.0
US 10‐Year Treasury = α + β1*(BE Infl) – β2*(European Financial CDS) – β3* (Net Fed Purchases) – β4* (ED12) + ε
BE Infl = Breakeven Inflation Expectations; ED12 = Eurodollar Futures
U.S. and Japan 10-Year Government Bond Yields (1871 – 2012)
2 0
4.0
6.0
8.0
10.0
12.0
14.0
Percent
10
Note: Monthly data; averages of business days. Japan yields: 1965 ‐ 2012.
Source: Robert Shiller, Federal Reserve and Bloomberg
0.0
2.0
1871.011878.061885.111893.041900.091908.021915.071922.121930.051937.101945.031952.081960.011967.061974.111982.041989.091997.022004.072011.12
U.S. 10-Year Yield Japan 10-Year Yield
10-Year Yield (n) = Expected Real Short Rate (r) + Inflation Expectations (pe) + Term Premium (T)
7. 6
5 00%
6.00%
U.S. Government Yield Curve
Pre‐Crisis Yield Curve
2.00%
3.00%
4.00%
5.00%
Expected Yield Curve
11
0.00%
1.00%
1 M 3 M 6 M 1 Y 2 Y 3 Y 5 Y 7 Y 10 Y 30 Y
March 2013 July 2007 Implied Forward Rate December 2015
Post‐Crisis Yield Curve
Source: Bloomberg
10-Year Government Bond Yields (January 2005 – March 2013)
5
6
United States
Germany
2
3
4
Percent
Germany
Japan
12Source: Bloomberg
0
1
1/3/2005
3/3/2005
5/3/2005
7/3/2005
9/3/2005
11/3/2005
1/3/2006
3/3/2006
5/3/2006
7/3/2006
9/3/2006
11/3/2006
1/3/2007
3/3/2007
5/3/2007
7/3/2007
9/3/2007
11/3/2007
1/3/2008
3/3/2008
5/3/2008
7/3/2008
9/3/2008
11/3/2008
1/3/2009
3/3/2009
5/3/2009
7/3/2009
9/3/2009
11/3/2009
1/3/2010
3/3/2010
5/3/2010
7/3/2010
9/3/2010
11/3/2010
1/3/2011
3/3/2011
5/3/2011
7/3/2011
9/3/2011
11/3/2011
1/3/2012
3/3/2012
5/3/2012
7/3/2012
9/3/2012
11/3/2012
1/3/2013
8. 7
Corporate Spreads (January 2005 – March 2013)
700
800
Spreads = α - β1* GDP Growth + β2*VIX - β3*10-Year Treasury + β4*Term Premium + ε
Spreads = f(default probability, expected recovery rate,
liquidity, interest rates)
200
300
400
500
600
BasisPoints
13Source: Bloomberg
0
100
1/3/2005
3/3/2005
5/3/2005
7/3/2005
9/3/2005
11/3/2005
1/3/2006
3/3/2006
5/3/2006
7/3/2006
9/3/2006
11/3/2006
1/3/2007
3/3/2007
5/3/2007
7/3/2007
9/3/2007
11/3/2007
1/3/2008
3/3/2008
5/3/2008
7/3/2008
9/3/2008
11/3/2008
1/3/2009
3/3/2009
5/3/2009
7/3/2009
9/3/2009
11/3/2009
1/3/2010
3/3/2010
5/3/2010
7/3/2010
9/3/2010
11/3/2010
1/3/2011
3/3/2011
5/3/2011
7/3/2011
9/3/2011
11/3/2011
1/3/2012
3/3/2012
5/3/2012
7/3/2012
9/3/2012
11/3/2012
1/3/2013
AAA BBB
Potential GDP and Actual GDP (March 1950 – March 2017)
$16,000
$18,000
s)
Real GDP = Y = C + I + G + NX
C= Consumption
$8,000
$10,000
$12,000
$14,000
ained2005Dollars(Billions
Output Gap
I = Investment
G = Government Spending
NX = Net Exports
Potential GDP = ∆Productivity + ∆Labor
MV = PY = Nominal GDP
M = Money and Credit
V = Velocity of Money and Credit
P Prices
14Source: Congressional Budget Office
$2,000
$4,000
$6,000
Mar-50
Mar-52
Mar-54
Mar-56
Mar-58
Mar-60
Mar-62
Mar-64
Mar-66
Mar-68
Mar-70
Mar-72
Mar-74
Mar-76
Mar-78
Mar-80
Mar-82
Mar-84
Mar-86
Mar-88
Mar-90
Mar-92
Mar-94
Mar-96
Mar-98
Mar-00
Mar-02
Mar-04
Mar-06
Mar-08
Mar-10
Mar-12
Mar-14
Mar-16
Cha
Real GDP Potential GDP
P = Prices
Inflation = f(Inflation Expectations, Output Gap)
9. 8
Assets that utilize leverage and a minimal amount
of general account proceeds currently held
(e.g. credit default swaps and replication, spread lending activity)
Levers and Strategies for Higher Net Excess Yields:
Levels of Increasing Risk
Assets with relatively higher
risk of credit issues and
default
(e.g. BB and B rated corporate securities)
Assets with longer‐dated
duration and maturities or
negative convexity profiles
(e.g. municipal bonds, Agency CMOs)
Leverage
Duration/
Convexity
Credit Risk
15
Assets for which secondary
market is limited or funding /
balance sheet is provided
(e.g. private placements, commercial
mortgage loans, negative basis packages)
Assets that are lower in
the capital structure
(e.g. subordinated corporate debt,
mezzanine CLO tranches)
Assets with securitized cashflows
(e.g. Non‐Agency RMBS, CMBS, ABS, senior CLO
tranches, insurance‐linked securitizations)
Illiquidity
Capital
Structure
Structural
Complexity
Note: Net excess yield is defined as current asset yield less the average liability minimum interest rate guarantee.
Expected Return Volatilty Yield Curve Agency MBS ABS CMBS Credit Equity Liability Index
1 Yield Curve 3.1 4.1 1 ‐0.2 ‐0.6 ‐0.8 ‐0.6 ‐0.8 ‐0.7 0.8
2 Agency 3.2 4.2 ‐0.4 1 0.5 0.1 0.3 0.3 0.3 0.7
3 MBS 3.9 4.6 ‐0.4 0.2 1 0.6 0.4 0.6 0.7 0.6
Asset Liability Management (ALM): Linking USD Factor Returns,
Volatilities and Correlations across the Balance Sheet
4 ABS 3.6 4.9 ‐0.6 0 0.4 1 0.4 0.6 0.6 0.6
5 CMBS 4.8 5.1 ‐0.4 0.2 0.4 0.4 1 0.4 0.5 0.6
6 Credit 5.7 8.3 ‐0.6 0.2 0.2 0.4 0.2 1 0.7 0.7
7 Equity 7.9 16.7 ‐0.5 0.1 0.1 0.3 0.1 0.4 1 0
8 Liability Index 5.8 9.1 0.9 0.8 0.7 0.7 0.7 0.8 0.1 1
For illustrative purposes. Long‐term Expected Return and Volatility estimates (in percent). Correlations are long‐term – below diagonal, and short‐term – above diagonal.
• Assume the “portfolio” asset duration is 7.5 and the liability duration is 9.6; returns are generally higher for
liabilities than for assets. Liabilities appear to be more highly correlated with the yield curve and fixed‐
16
income assets than with equities. Bonds therefore appear to be a better hedge against changes in the value
of liabilities than do equities. We need a complete understanding of risk sensitivities and return and
correlation characteristics for both assets and liabilities, including embedded options and contingent claims
and key rate durations (KRDs) across the shape of the yield curve to assess the effectiveness of any such
matching hedge relationship, and to provide for optimal asset allocation and capital efficiency strategies.
• A regime shift ,e.g., in a flight to liquidity and quality in times of market stress or in the real economy in
terms of a reduction in aggregate demand, lowers interest rates and changes asset and liability expected
returns, volatilities and correlations in addition to the duration/ mismatch/ gap risk profile.
Source: Bloomberg and Barclays and internal calculations.
10. 9
Directed by the board and senior
t i l di
Risk‐Based decision making and
iti ti /h d i d
Be an integral part of strategic
and capital and liquidity
planning and a guide for
setting risk appetite
Scenario and Stress Testing Framework
Objective
Governance
Design
Action
Monitoring
Scenario
and Stress
Testing
Framework
management, including
delineation of scope and
frequency with formal policy
documentation
Integrate information from
models and historical data
with defined parameters
and analytical methods
mitigation/hedging and
contingency planning utilizing the
results in strategic and/or tactical
actions including derivatives
Provide forward‐looking
assessment and monitoring and
reporting of results, impacts, and
exposure changes
1717
Process
Analysis
Clear activities,
methodologies
responsibilities and
frequency for
repeatable processes
Execution of analysis and quantification
of impacts for market, credit, liquidity,
operational, capital and strategic issues,
and asset‐liability management
• The scenario of projected low interest rates may not be the most likely scenario.
Analytical balance sheet results need to be evaluated under a variety of yield curve
environments. A protracted period of low interest rates is a feasible scenario for a
number of countries
Summary: Impact of Long Term, Low Interest Rates on
Balance Sheets
number of countries.
• A sustained low interest rate environment will have a negative impact on life insurance
balance sheets. There is an asymmetrical relationship between the asset side and
liability side due to the contractual crediting rate guarantee for accumulating and pay
out annuities. The competition for assets will continue to compress spreads and keep
overall yields low.
• Protracted low interest rates will impact insurance companies by affecting re-
i t t t fi d i tf li If l i t t t t d t b
18
investment returns on fixed-income portfolios. If low interest rates are expected to be
permanent, lower interest income will significantly impact insurers with long–term
liabilities and shorter-term duration assets. To the extent that lower interest rates
reflect a lower-growth environment, returns on investment in general - and equities in
particular – would also be expected to be lower.
