1. Implications of a
Lower Interest Rate Environment
Presentation to Bryan Boudreau
SOA Spring Meeting – Washington, D.C. Managing Director - Senior Risk Officer
May 30, 2003 Cross Shore Capital Management, LLC
Overview
• Current Environment
• Why Are Rates So Low ?
• Implications for Investors
• Investor Response
2
1
3. Why Are Interest Rates So Low ?
• Decline in inflation
– Fed policy has been credible, effective
– Strong dollar (until very recently)
– Imported deflation (Japan, China)
• High rates in 80’s were aberration
– supply shocks -> inflation
– Fed policy targeting money supply
• Weak Economy
– low real interest rates
– low inflation
5
Implications For Pension Funds
• asset values have declined
• 60-70% equity
• 30-40% short duration bonds
• liability values have increased significantly
• 10-15 year duration
• net result is big drop in funded status
• typical fund has moved from over to underfunded
• contribution holidays ending
• pension expense increasing
6
3
4. Implications For Insurers
• non-participating products
– structured settlements, payout annuities, GICs
– generally no options
– tend to be duration matched
• but temptation to mismatch long is much greater
– credit duration may be an issue
7
Implications For Insurers
• “participating” products
– rate (or dividend) reset products
– fixed annuities, UL,
– generally have embedded interest rate
options
8
4
5. Implications For Insurers
• Interest rate floors
– minimum credited rates (3%, 4%, or higher);
– may impact GMDB, DMIB rollups
– also need to earn “DAC amortization”
– liabilities extend as rates drop
• long call option
• extreme case is perpetuity
– companies with longer asset portfolios better
protected
– duration extension for yield (and match)
9
Implications For Insurers
• What If Interest Rates Rise ?
– long duration bonds drop in price
– book value out is equivalent to put option
10
5
6. Implications for Equity Investors
• Equity P/E’s tend to Rise
– DDM models
– but decoupling in extreme scenarios
• Prospective Equity Returns May Decline
– same risk premium, lower yield
– decrease in profit growth/pricing power
– increased probability of deflation
• 2% dividends
• 2-3% real earnings growth
• 2% inflation = 6-7% return
– assumes fair valuations
– premium to bonds may be lower than historically
11
How Are Institutions Responding ?
• Revisiting asset allocation studies
– new asset assumptions
• equity premiums
• interest rates
• correlations
– more sophisticated modeling
• stochastic modeling
• asset/liability focus
• source of bond returns
– curve
– credit
– call
– liquidity
12
6
7. How Are Institutions Responding ?
• What are asset allocation studies indicating ?
– longer duration
– generally less equity
– generally more credit and alternative assets
– but models are highly dependent on assumptions and economic
path
13
Are Low Rates Here to Stay ?
• Arguments For
– history
– inflation under control
– structural overhang on economy
– imported deflation from emerging economies
– Japan scenario
– pension supply/demand imbalance
• Arguments Against
– economy will reaccelerate
– weaker dollar will ignite inflation
14
7
8. Low Interest Rate Environment
Case Study
Japanese Insurance Industry
SOA Spring Meeting
Washington, DC
May 30, 2003
Session 79 PD
Presenters:
Koji Kondo, Ph.D.
Actuarial Assistant
New York Life Insurance Company
and
Pin Chung, ASA, MAAA
Actuary and Director
American Re-Insurance Company
1
9. Introduction
• Purpose of this presentation.
• Overview of Japanese economy:
Ø Sketch economic situations (Bubble and Post-Bubble) in Japan since
Mid-1980s.
Ø Present how and why Japan faces a low interest rate environment.
• Overview of Japanese insurance industry:
Ø Sketch the last 10 years of Japanese insurance industry.
Ø Present some statistics.
• Some issues:
Ø Discuss some of the issues important to Japanese insurance industry.
• Conclusions.
3
Overview of Japanese Economy
• Bubble Era and Post Bubble Era
• Government Sector:
– Fiscal Policy
– Monetary Policy
– Exchange Rates
• Private Sector
• Bad Loans
• Aging Society and Social Security
4
2
10. Bubble Economy
• Bubble is defined as the deviation from theoretical
prices of assets (intrinsic values or fundamentals).
• Some examples:
– Tulip bubble (Netherlands, 1636);
– South Sea bubble (England, 1720);
– Stock market boom (U.S., 1929).
• Example:
If dividend is expected to grow by g%, using a simple growth
model, then P = R/(i- g):
where P = price, R = dividend, i = interest rate,
g = growth rate.
P is the price based on its fundamentals, the actual price
deviates from P is the bubble. 5
Bubble Economy (continued)
• Bubble in Japan
– After 1985, Group of Five (“G5”) intervened in foreign
exchange markets. ¥? ? Economy into a recession.
– In a recessionary economy, stock prices kept rising.
– After a recovery from the recession, stock prices rose even
faster.
– In 1987, the crash in NY stock market affected the Japanese
markets, but the impacts were minimal. The market quickly
recovered.
– Real estate prices also increased dramatically (e.g., 21% in
1987).
6
3
11. Bubble Economy (continued)
– Price of commercial land was four times
as high in 1990 as in 1985.
ØForeign companies’ advance to Japan.
ØIncrease in demand for housing by baby
boomers.
ØSpeculation.
7
Bubble Economy (continued)
• To stabilize U.S. dollar, Japan implemented a low
interest rate policy (to coordinate policies with G5):
– Official discount rate ? from 5% (1986) to 2.5% (1988).
– Interest rates ? ? asset prices ? to almost double.
• The asset price increase between 1985 and 1987 may be explained
by simple growth model.
– Speculation increased asset prices even further.
• The asset price increase between 1988 and 1990 can not be
theoretically explained, and is considered a bubble.
8
4
12. Bubble Economy (continued)
• In 1990 (after the First Gulf War) Bank of Japan
(“BOJ”) increased official discount rate to prevent
inflation (Fear of inflation was due to increase in
oil price):
– Official discount rate ? ? theoretical asset prices ? .
– Actual asset prices deviated further from theoretical
asset prices.
– Investors’ anxiety accumulated and finally the bubble
burst in 1991.
9
Bubble Economy (continued)
• The bubble was created by investors’ skewed
optimistic expectations:
– Optimistic expectation that asset values will increase
(decrease) in the near future will actually increase
(decrease) asset prices (self- fulfilling prophecy).
• The bubble economy also created a boom in Japan
and made people more optimistic about the future:
– The real growth rates were:
3.1%, 4.8%, 6.0%, 4.4%, and 5.5% between 1986 and
1990.
10
5
13. Bubble Economy (continued)
• Consumption:
– The Life Cycle Hypothesis:
• Current consumption depends on current
income, savings, and future income.
– Increase in asset prices had positive effects on
current income, future income, and current
consumption.
– Asset prices? ? consumption ? .
11
Bubble Economy (continued)
• Investments:
– Interest rates? ? capital costs? ? investments? .
– Low capital costs made investments more profitable.
ØInvestments in private sector ? by 12.3% (1989) and
11.3% (1990).
– Interest rates? ? asset prices? ? investments? .
ØEasier for companies to finance by stocks, convertible
bonds, and warrants, therefore investments are induced.
12
6
14. Bubble Economy (continued)
• High investments ? aggregate demand. At the same
time, net exports were expanding.
– Aggregate demand increased income and high income
resulted in greater consumption.
• In a booming economy, a tight monetary policy is
usually introduced to cool down the economy.
• However, Japan was forced to keep a low interest
rate policy to support stability of U.S. dollar.
13
Bubble Economy (continued)
• In 1989, tight monetary policy by increasing interest rates.
• Implemented a series of policies to lower and stabilize real
estate prices.
• Stock prices (Nikkei Average) dropped after hitting its peak
(¥38,915) in December 1989.
• The process started to work in a reverse way:
Investors expect asset prices ? ? actual asset prices ?
? investors expect asset prices ? ? actual asset prices ?
? and so on (“vicious cycle”).
14
7
15. Nikkei Average
45,000
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
1981 1984 1987 1990 1993 1996 1999 2001
15
Bubble Economy (continued)
• What happened in Japan during 1990s was opposite
of what happened during the bubble era.
– Pessimistic about the future and the pessimism reflected in
the economy.
• Early 1990s, growth of consumption and investments
by private sector ? :
– Consumption increased by only 1.2%, 1.7%, and 1.5%.
– Investments decreased by 7.2%, 10.5%, and 2.8%.
• The real growth rate: 0.4%, 0.5%, and 0.6% from
1992 to 1994.
16
8
16. Bubble Economy (continued)
• In 1995, a sign of recovery was seen:
– Consumption for durable goods (automobiles and
electronic goods) increased.
– Consumption grew: 3.1% (1995) and 2.8% (1996).
– Investments recovered to: 5.7% (1995) and 6.4%
(1996).
– Due to large deficits and banking crisis, the
economy entered into another recession.
17
Government - Fiscal Policies
• Since 1973 (the first oil crisis), the goal was:
– to reduce budget deficits and reduce dependency on
government (deficit) bonds.
• Reduced fiscal spending throughout 70s and 80s.
• During the bubble era, tax revenue ? :
– 8.1% (1989) and 9.4% (1990).
• Early 90s, achieved the goal:
– by cutting spending and increasing tax revenues.
• Due to a large current account surplus, U.S.
pressured Japan to increase fiscal spending.
18
9
17. Government - Fiscal Policies (continued)
• Since 1992, implemented a series of expansionary
fiscal policies (over 70 ¥trillion between 1992 and
1996), including tax cut:
– The policies did not work effectively:
• the bubble was large scale and lasted very long;
• it took the economy a long time to readjust;
• if consumers expect a future tax increase to cover the
deficits, they would not increase consumption.
Therefore, fiscal policy does not stimulate the economy
(“Ricardian Equivalence”).
19
Government - Fiscal Policies (continued)
• However, it is generally accepted that the
economy would have been even worse had the
government not increased fiscal spending for the
last ten years.
20
10
18. Government Policy - Exchange Rate
• Governments cannot control foreign currency markets
=> cannot implement explicit foreign currency policies
=> can influence exchange rates by intervention.
• Monetary policy also influence exchange rates
=> usually monetary policy is not used to influence
exchange rates.
• Late 80s, Japan pursued an expansionary monetary
policy (a low interest rate policy) to support stability
of U.S. dollar.
21
Government Policy - Exchange Rate
(continued)
• Early 90s, yen appreciated and strong yen had negative
impacts on the economy (due to a tight monetary
policy and large current account surplus):
– In August 1993, $ ? to ¥100 for the first time.
– In April 1995, dollars hit ¥80.
– Strong yen ? exports, ? imports, and ? economic
growth.
22
11
19. Bad Loans
• Since 1983, Japan discussed with U.S. the
deregulation of financial industry.
• In 1994, the deregulation of interest rates was
completed.
• After the deregulation, banks needed to:
– improve asset management abilities,
– improve rating skills, and
– learn risk-hedging skills.
• However, banks heavily used land collaterals for
their loans.
23
Bad Loans (continued)
• During the bubble era, high land prices made it
easier for banks to make loans with land collaterals.
• In 1989, the government changed land laws and
introduced new real estate taxes to stop the land
price rise.
• Loans with land collaterals decreased dramatically.
• Raising interest rates and regulations on lands
caused a crash in asset prices (both stock and real
estate), and left banking industry with bad loans.
24
12
20. Bad Loans (continued)
• The real estate prices and stock prices stayed at a
low level, and optimistic views finally faded.
• In 1994, several banks went into bankruptcy. This
was a blow to the myth that banks never bankrupt.
• In 1997, Japan was on the brink of financial crisis.
25
Bad Loans (continued)
• Low interest rate era started in 1993.
• Discount rates: 2.5% in 1993, then 0.5% in 1995.
• Interest rate on one-year savings account:
• 8% (1993), 0.5% (1995), and 0.3% (1997).
• Banks increased revenues under low interest rates.
• Revenues for financial institutions:
• 4 ¥trillion (1995) and 7 ¥trillion (1997).
26
13
21. Discount Rates of U.S. and Japan
16
14
12
10
Japan
%
8
US
6
4
2
0
J-80 J-82 J-84 J-86 J-88 J-90 J-92 J-94 J-96 J-98 J-00
27
Bad Loans (continued)
• Good quality banks attempted to clean up bad loans.
• Banks possessed too many bad loans could not benefit
from the low interest rate environment.
• Stabilization of financial system:
– Swift clean- up of bad loans.
– Encouragement of information disclosure.
– Introduction of objective management indices such as capital
ratios.
– Introduction of Pay off System (similar to FDIC: Max of
$100,000 will be insured).
28
14
22. Bad Loans (continued)
• In 1998, announced the “Japanese Big Bang” plan:
– following the English Big Bang under Thatcher
Administration in 1986.
• The goal:
– to revitalize Tokyo financial markets by introducing a
large scale of deregulation in financial industry.
• The deregulation started in 2001.
• The deregulation was aimed for financial industry
but is expected to have positive effects on the entire
economy.
29
Private Sector
• Private sector was too optimistic during the bubble
era.
• The adjustment process was too slow due to fixed
labor cost:
– Labor costs were fixed for most of Japanese companies,
which accounted for a large part of costs (extremely rare
to lay off people);
– Under the recessionary economy, many companies
suffered from losses because they could not flexibly
manage labor costs.
• Other factors.
30
15
23. Aging Society and Social Security
• The ratio of most productive age (20-64 years old)
and those over 65 years old:
• 4.4:1 in 1998, 2.5:1 (2010) and 2:1 (2020) (predicted);
• due to longevity and low birth rate.
• Average number of children per women in her life:
• 4.32 in 1949, 1.39 in 1997;
• due to more women in work force and marrying later.
• Life expectancy:
• 50 years (men) and 54 (women) in 1947;
• 77.2 years (men) and 83.8 (women) in 1997.
31
Aging Society and Social Security
(continued)
• An increase in annuity benefits and medical expenses
are expected.
• Social security benefits increased from 6.3 ¥trillion
(1973) to 64.7 ¥trillion (1995):
– this increased from 6.5% (1973) to 17.0% (1995) of GNP.
• The government faces difficulties in supporting social
security system.
• The private sector, especially insurance industry, is
expected to compliment the social security system.
32
16
24. Population Projection (in 1,000)
140,000
Total
120,000 0 to 14 years old
100,000 15 to 64 years old
65+ years old
80,000
60,000
40,000
20,000
0
2000 2010 2020 2030 2040 2050
33
Overview of Japanese Insurance Industry
• Life Insurance Products
• Annuity Products
• Asset Management
• Failure in ALM
• Product Development
• Changes in Asset Management
• Marketing and Sales Channel
• IT System and Customer Segmentation
34
17
25. Overview of Insurance Products
• Overall, new sales of products (measured
by premium income) decreased in a
recessionary economy since 1997.
• Japanese version of 401(k) does not
attract a lot of policyholders; a temporary
trend is policyholders shift funds from
group annuity to individual annuity.
35
Premium Income (¥billion)
350,000
Individual Iife
300,000 Individual Annuities
250,000 Group Life
Group Annuuities
200,000
Others
150,000 Total
100,000
50,000
0
92
93
99
00
01
94
95
96
97
98
19
19
19
20
20
19
19
19
19
19
36
18
28. Life Insurance Products
• Products:
• Pure Endowment (until 1960s).
• Pure Endowment with Term Life (1960s to 1980s).
• Whole Life with Term as rider (end of 1980s to 2000).
• Fixed Universal Life (2000 to present).
• Many factors affected life insurance products:
• Changes in family structure
? nucleus family.
• Changes in consumer behaviors
? recognition of mortality vs. survival risk
? separation of savings from insurance.
41
Individual Life Products
• Prior to 1980
– Main products were whole life insurance and pure
endowment.
• The market was very much saturated. (Over 80% of population had
insurance products.)
• During 1980s
– Competition intensified by:
• offering high guaranteed rates;
• lowering premiums;
• introducing term-life insurance as rider.
• During 1990s
– Under a low-growth economy:
• forced to reduce guaranteed rates.
42
21
29. Annuity Products
• Prior to 1990, annuities were not popular.
• During 1990s, sales of annuities did not decrease as
drastically as individual life products.
• Individual annuity products (as savings product) face
competition from savings accounts.
• Competition for group annuity products also
intensified within and outside the industry.
• Flight to quality:
– The customers are becoming more concerned with the rating
and quality of the insurance company.
43
Life Insurance in Force Amount
(¥trillion)
2,500
Individual Iife
2,000 Individual Annuities
Group Life
1,500 Total
1,000
500
0
1992 1994 1996 1998 2000
44
22
30. Individual Life in Force (¥trillion)
1,500
1,400
1,300
1,200
1,100
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
45
Individual Annuity in Force (¥trillion)
100
80
60
40
20
0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
46
23
31. Group Life in Force (¥trillion)
600
500
400
300
200
100
0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
47
Asset Management
• Total assets of insurance industry increased
by almost 20% every year during 1980s.
• During 1990s, total assets grew by only
single digit (about 5%).
48
24
32. Asset Management (continued)
• Prior to 1975
– Lending loans to corporations (60% of total assets.)
• Late 70s
– Investments in domestic securities.
• Since mid 80s
– Investments in equities and foreign securities increased.
– Interest rate differential between U.S. and Japan
increased. This trend continued until 1989.
– The losses from foreign currency > the gains from
interest rate differential.
49
Asset Management (continued)
Exchange Rates between Dollar and Yen
300
250
200
150
100
50
0
J-80 J-82 J-84 J-86 J-88 J-90 J-92 J-94 J-96 J-98 J-00
50
25
33. Asset Management (continued)
• Current trend of asset allocation strategy:
– The weight of asset allocation has been
shifting from equities and foreign securities to
domestic corporate and public bonds.
– Low demand for borrowing loans and direct
financing by issuing corporate bonds.
51
Failure in ALM
• Asset maturities < Liability maturities creates:
– (i) investment risk and (ii) re-investment risk.
• Late 1980s and early 1990s, guaranteed rates as
high as 5% to 6%.
• Early 90s, still optimistic about the future.
• Insurance companies have a difficulty to meet
guaranteed rates promised to policyholders.
52
26
34. Average Yield on Total Asset
(General Account)
5
4
3
%
2
1
0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
53
Failure in ALM (continued)
• What could have been done and what has been
proposed?
1. Matching maturities of assets to maturities of
liabilities:
– The most conservative method.
• If one could match both maturities, one could reduce
interest rate risk.
– Not realistic.
• It was almost impossible to find assets with maturities
as long as 20 to 30 years in Japan.
54
27
35. Failure in ALM (continued)
2. Controlling maturity of assets:
– Also unrealistic.
• Due to the fact that predicting long-term
interest rates is almost impossible.
– The capital markets were not as fully
developed in Japan as in the U.S. and Europe.
55
Failure in ALM (continued)
3. Reducing guaranteed rates:
– An option in the future.
– Will increase policyholders’ financial burden.
– Will lose competitiveness in the market place.
– May hurt company’s reputations and may trigger
policy cancellation.
– Under current regulations, reducing guaranteed
rates is not permitted. The issue has been
discussed in the Diet (parliament).
56
28
36. Failure in ALM (continued)
4. Making maturity of liabilities more flexible:
– Promised too high and too long-term guaranteed
rates .
– Could have shortened term of guaranteed rates
even if the interest rates were high (or low).
• Did not have products at hand that allowed them to
promise shorter-term returns.
– Needed more product variety, i.e., flexibility.
57
Changes in Asset Management
• Lending loans to corporations
– Until the middle of 1980s, the main part of
asset management.
• Equities
– Accounted for 20%, and reached 30% of total
assets during 1980s.
• Government bonds and foreign bonds
– During 1990s.
58
29
40. Product Development
• Separation of savings from insurance:
– Whole life and term life products for insurance.
– Savings accounts.
• Example:
– Meiji Life Insurance Company:
• Life Account L.A., like universal life
products, policyholders can choose weights
on savings and insurance according to life
style and income level.
65
Product Development (continued)
• Shift to “the Third Field”
– First field: traditional life insurance area.
– Second field: traditional property & casualty insurance.
– Third field: including everything else, e.g., medical
insurance markets.
• It is a very promising market in the future.
• Unbundling and Reconstructing risks
– Segmented markets:
Ø Cover cost of hospitals for up to five days;
Ø Cover cancer insurance;
Ø Cover medical expenses.
66
33
41. Marketing and Sales Channel
• Traditional sale force.
– Seiho Lady vs. Certified Financial Planners. (E.g.,
SONY Life).
• Initial stage of using brokers, telemarketing and
online marketing.
• Investing in and developing cross sales:
– Alliance with P&C companies and banks.
– Convenience stores (7-Eleven).
67
Investment in IT System and
Customer Segmentation
• Investing in and developing IT system:
– Stores more data;
– Analyzes the data more effectively.
• Customer Segmentation:
– Identifies policyholders’ needs;
– Provides products meet customers’ needs;
– Reduces risks.
68
34
42. Looking Forward: US Economy
• Bubble Era and Post Bubble Era?
• Monetary Policy?
• Fiscal Policy?
• Exchange Rates?
• Private Sector?
• Bad Loans?
• Aging Society and Social Security?
• Accounting System?
69
Conclusions
• Conservatism.
• Coordination.
• Data mining.
• Diversification.
• Econometric forecasting.
• Marketing strategies.
• Product development.
• Risk management.
• Social responsibility.
70
35
43. Endnotes
• Any views or opinions expressed in this presentation are
those of the individuals and not of New York Life Insurance
Company or American Re-Insurance Company.
• We appreciate the following persons for constructive inputs.
v Scott Orr (American Re-Insurance Company)
v Daniel Hui (AXA-Financial)
v Jessica Eisenberg (New York Life Insurance Company)
v Makoto Yasuanka, Yuka Yamashita and Akiji
Shimomachi (Meiji Life Insurance Company)
• You can reach us at:
Koji Kondo: koji_kondo@newyorklife.com,
kkondo@hotmail.com, and (212) 576-5012;
Pin Chung: pchung@amre.com, pjc2000_us@yahoo.com,
and (612) 799-8658.
71
Reference
• Economics
1. “Heisei Fukyo 10 Nenshi (Ten-Year History of Recession in Japan),” (1998) Kazuo
Yoshida, PHP Shinsho.
2. “Gendai Defure no Keizaigaku (Economics of Modern Deflation),” (1998)
Seiichiro Saito, PHP Shinsho.
3. “Zero Kinri no Keizaigaku (Economics of Zero Interest Rate Policy),” (2000) Kikuo
Iwata, Diamond Sha.
• Insurance
4. “ The Seiho-Daraku no Kozo (The Seiho-Process of Destruction),” (1999) Yuichi
Asamoto, Toyo Keizai.
5. “ The Seiho-Saigo no Tatakai (The Seiho-Last War),” (2000) Yuichi Asamoto, Toyo
Keizai.
72
36
44. Reference (continued)
6. “Seiho Kiki no Honshitsu (Essence of Life Insurance Crisis),” (2001) Yasuo
Kofuji, Toyo Keizai.
7. “Seimei Hoken ga Abunai (Life Insurance Crisis),” (2000) Yasuo Kofuji,
Sekai Shoin.
8. “Kensho Seiho Kiki (Survey on Insurance Crisis),” (2000) Mitsuhiro Fukao
and Japan Economic Research Center, Nihon Keizai Shimbun Sha.
9. “Seiho Kiki wa Owaranai (Insurance Crisis is not over yet),” (2002)
Mitsuhiro Fukao and Japan Economic Research Center, Toyo Keizai
Shimpo Sha.
10. “Seiho Big Bang,” (1997) Masatoshi Furuse, Toyo Keizai Shimpo Sha.
11. Abstract of Life Insurance Fact Book, (1998 – 2002) Japan Institute of Life
Insurance.
73
37
