Mercer Capital's Atlantic Coast Bank Watch | August 2013
2013-ca-ann-mtg-session94
1. Session 94 PD, Marketing & Distribution
Implications of a Low Interest Rate Environment
Moderator:
Jeffrey D. Koll, FSA, MAAA
Presenters:
Joseph R. Dziwura
Jeffrey D. Koll, FSA, MAAA
Yidong (Winter) Liu, FSA, MAAA
2. 1
Marketing and Distribution
Implications of a Low Interest RateImplications of a Low Interest Rate
Environment
Session 94 – October 22, 2013
Agenda
Introductions Jeffrey Koll, AVP & Life Product Actuary
Unum & Colonial Life
Joseph Dziwura, Senior Managing Director
Market Risk, TIAA-CREF
Winter Liu, Principal
Oliver Wyman
Opening Remarks Jeff
Presentations Joe, WinterPresentations Joe, Winter
Q&A All
3. 2
10 Year Treasury Rate
100 Year History (1912 to 2012)
Low Interest Rate Environment
Rates below 2% only twice in 100 year history
(1941 for 4 months; 2012 for 8 months)
• Significant asset or reserve accumulation
Product Characteristics
Insurance Products Impacted by Low Interest Rates
• Long term coverage periods
• Guaranteed benefits
• High product persistency
• Annuities
Specific Product Categories
4
• Long Term Care
• Individual Disability
• Cash Value Life
• Individual Critical Illness/Cancer
• Others?
4. 3
• Valuation Interest Rates
Regulatory Requirements
Other Implications of Low Interest Rates
• Non-forfeiture Interest Rates
• Potential 7702 issues
• CA interpretation of new rate
• Company owns investment risk
Product Risk Structure
5
• No Product Levers
• Policyholders owns the investment risk
• How and when do policyholders become aware?
• What is policyholder behavior?
• How and when does the sales agent become aware?
WORKSITE DISTRIBUTION MODEL
Worksite
Company
Group
Decision
Maker
Company
Sales Rep
Employee
Employee
Family
Broker Enrollment
Company
6
6. 5
Overview
Accommodative Federal Reserve Policy lowers interest rates through important
channels:
The Federal Reserve’s ongoing purchases of Treasury and agency mortgage-backed The Federal Reserve s ongoing purchases of Treasury and agency mortgage-backed
securities (MBS) has led to a Federal Reserve balance sheet that is now over $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.
– 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.
9
– After selling assets to the Federal Reserve, investors 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.
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.
Overview
Accommodative policy removes interest rate and duration risk including prepayment
risk and market volatility from the economy:
The Federal Reserve asset purchase program was designed to remove risk from the private The Federal Reserve asset purchase program was designed to remove risk from the private
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.
10
– Market expectations concerning the total amount of risk and the composition of securities that will be
removed from the 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, e.g., asset price “frothiness”. 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.
7. 6
14 0
16.0
18.0
1871 - 2012
US 10‐Year Treasury = α + β1*(BE Infl) + β4* (ED12) – β2*(European Financial CDS) – β3* (Net Fed Purchases) + ε
U.S. and Japan 10-Year Government Bond Yields (1871 – 2013)
10-Year Yield (n) = Inflation Expectations (pe) + Expected Real Short Rate (r) + Term Premium (T)
2.0
4.0
6.0
8.0
10.0
12.0
14.0
Percent
BE Infl = Breakeven Inflation Expectations; ED12 = Eurodollar Futures
11
0.0
2.0
U.S. 10-Year Yield Japan 10-Year Yield
Note: Monthly data; averages of business days. Japan yields: 1965 ‐ 2013.
Source: Robert Shiller, Federal Reserve and Bloomberg
5.00%
6.00%
U.S. Government Yield Curve
2.00%
3.00%
4.00%
Post‐Crisis Yield Curve
Pre‐Crisis Yield Curve
Expected Yield Curve
12
0.00%
1.00%
1 M 3 M 6 M 1 Y 2 Y 3 Y 5 Y 7 Y 10 Y 30 Y
Septeber 2013 July 2007 Implied Forward Rate December 2015
Source: Bloomberg
9. 8
8 00
10.00
Decomposition of 10-Year U.S. Government Bond Yield (1990 – 2013)
The Term Premium
2.00
4.00
6.00
8.00
Percent
10‐Year U.S. Government Bond Yield
15
‐2.00
0.00
1990
1991
1991
1992
1993
1994
1994
1995
1996
1996
1997
1998
1998
1999
2000
2001
2001
2002
2003
2003
2004
2005
2005
2006
2007
2008
2008
2009
2010
2010
2011
2012
2012
Source: Internal calculations and Three‐Factor Yield Curve Model, Federal Reserve Board (Kim and Wright 2005)
Term Premium:
a. Risk Premium
b. Convexity Premium
Volatility
Asset Returns (January 2011 – September 2013)
40.00%
50.00%
“Portfolio Channel”
0.00%
10.00%
20.00%
30.00%
16Source: Bloomberg and Federal Reserve System
‐10.00%
10. 9
Corporate Spreads (January 2005 – September 2013)
700
800
Spread=f(default probability,expectedrecoveryrate,liquidity,interestrates)
AAAS d 00142 000917*GDPG th 0 000292 * VIX 0148 *10 Y
0
100
200
300
400
500
600
BasisPoints
AAA Spread = 0.0142‐0.00917 * GDP Growth + 0.000292 * VIX ‐0.148 * 10‐Year
Treasury + 0.0791 * Term Spread
BBB Spread = 0.0264‐0.132 * GDP Growth + 0.000453 * VIX ‐0.206 * 10‐Year
Treasury + 0.0891 * Term Spread
17Source: Bloomberg
0
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
3/3/2013
5/3/2013
7/3/2013
9/3/2013
AAA BBB
Potential GDP and Actual GDP (March 1950 – March 2017)
$16,000
$18,000
$20,000
ons)
RealGDP = Y = C + I + G + NX
Potential GDP = ProductivityLabor
MV= PY= Nominal GDP
Inflation = f(Inflation Expectations, Output Gap)
Specific Inflation Equation
Core PCE (t‐1)
Core PCE (t‐2)
$6,000
$8,000
$10,000
$12,000
$14,000
hained2005Dollars(Billio
RealGDP PotentialGDP
MV = PY = Nominal GDP
where
M = Money and Credit
V = Velocity
P = Prices
Output Gap
Core PCE (t 2)
Inflationary Expectations
Unemployment GAP (t‐1)
Relative Import Inflation (t‐2)
18Source: Congressional Budget Office
$2,000
$4,000
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
Ch
11. 10
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 Fixed-Income Investment 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
19
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 option adjusted duration (OAD) is 7.5 and the liability option adjusted duration
(OAD) is 9.6; returns are generally higher for liabilities than for assets. Liabilities appear to be more highly
20
correlated with the yield curve and fixed‐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.
12. 11
Directed by the board and senior
management, including
Risk‐Based holistic ALM decision
making and mitigation/hedging and
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
delineation of scope and
frequency with formal policy
documentation
Integrate information from
models and historical data
with defined parameters
and analytical methods
contingency planning utilizing the
results of the complete balance
sheet in strategic and/or tactical
actions including derivative
strategies (e.g., swaptions and caps)
to minimize the duration gap
Provide forward‐looking
assessment and monitoring and
reporting of results, impacts, and
exposure changes
2121
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 (ALM)
Holistic analytical balance sheet results and synthetic derivative strategies need to be
evaluated under a variety of yield curve environments.
A t t d i d f l i t t t i f ibl i f b f t i
Summary: Impact of Long Term, Low Interest Rates on
Balance Sheets
– A protracted period of low interest rates is a feasible scenario for a number of countries.
However, it may not be the most likely scenario.
A sustained low interest rate environment will have a negative impact on life insurance
balance sheets.
– There is also 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-
22
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.
14. 13
Low rates impact insurers in multiple ways
Lower investment
income
Magnify tail risk
Lapse supported
products
Encourage “bad”
behaviors
Lower surrenders for
“negative spread” products
Steeper mortality
slope for life business;
stronger mortality
improvement for
longevity business
negative spread
liabilities
Higher renewal deposits
Heightened interest
rate shock risk
Companies have been tweaking every available parameter -
what else can be done?
Companies are doing all they can to meet profitability targets
i. Reduce credited rates, index caps
ii Reduce dividendsii. Reduce dividends
iii. Increase COIs, fees
iv. Reduce commissions
v. Modify ALM and hedging strategy
What else is there to tweak?
Prolonged low interest rate environment and volatile equity markets
helped shift consumer mentality
i. Focus turned from wealth accumulation to income protection
ii. Consumers may be willing to compromise
Revisit marketability?
15. 14
Product development trend
Longevity Variableg y
annuity annuity
Fixed indexed
it
Indexed
U i l Lifannuity Universal Life
Product development
Longevity annuity
Deferred payout annuity – is it time for survivorship to shine?
How to make it more attractive than SPIA
i M k it “d f d”i. Make it “deferred”
ii. Make it “flexible premium”
iii. Throw in tax advantage (“QLAC”)
iv. Handout death benefits
v. Combo it
Challenges
i. Death benefit vs. payout ratio
ii. High rating requirement SPIAg g q
iii. Investment management
Deferral phase Payout phase
Payout phase
Contribution phase
SPIA
Longevity annuity
16. 15
Product development
Variable annuity
The pursuit of “holy grail” Lessons from 2008-2009
experience
i Riders more expensiveIncome
security
(“downside”)
Control
over
assets
Affordability
?
i. Riders more expensive
than previously thought
ii. Consumers may be
ready for some trade-off
New development
i. Embedded longevity
iWealth
accumulation
(“upside”)
annuity
ii. Volatility managed funds
Product development
Fixed indexed annuity
Traditional FDA going through a tough ride; companies have been:
i. Closing out holes
ii. Lowering minimum guarantee
iii. Lowering distribution cost
iv. Adding MVAiv. Adding MVA
Fixed indexed annuity boom
60%
70%
80%
90%
100%
Total
12%
6%
52%
Immediate
MVA
Indexed
6%
22%
22%
9%
8%
35%
10%
8%
46%
11%
7%
47%
Ann
0%
10%
20%
30%
40%
50%
2008 Q4 2009 Q4 2010 Q4 2011 Q4 2012Q4
PercentofT
30%
52%
Book
Value50%
22%
48%
35%
37%
46%
36%
47%
nuityType
Source: LIMRA
17. 16
Product development
Fixed indexed annuity
Low rate environment impacts FIA less than FDA
i. FIA has longer average duration
ii. Low short rate and equity volatility help lower option cost
D i t k lth l ti (“ id ”) i t ti Designs to make wealth accumulation (“upside”) more interesting
i. Rainbow index, commodity index
ii. Registered FIAs with floor under zero
iii. Index “Craps”
Sales driven by guaranteed life withdrawal benefit (“GLWB”) riders
i. Over 85% of new sales offer GLWB
ii. Design similar to VA GLWB, a separate benefit base (“BB”) grows at
a fixed rate; %age of BB can be withdrawn every year for life even if
AV is exhausted
iii. Is FIA the new VA?
New twist on GLWB
i. Stacked BB growth rate: index + fixed spread
ii. GLWB on traditional FDA
Product development
Indexed UL
Indexed UL (“IUL”) has exploded in popularity
i. A recent industry survey showed IUL accounts for 40% of all UL
sales
Current IUL index caps typically >10% Current IUL index caps typically >10%
Product Current indexed cap Guaranteed indexed cap
Indexed annuity #1 3% 3%
Indexed annuity #2 3% 1%
Indexed annuity #3 3.25% 1%
Indexed life #1 10% 2.75%
i. For IUL, still a large gap between current and guaranteed cap
ii. More sources of profit relative to FIA
Indexed life #2 12% 4%
Indexed life #3 13% 3%
18. 17
Profitability metrics
Why is target IRR still 10-12% now that interest rates are so
low?
Alternative profitability metrics to give considerations to interestAlternative profitability metrics to give considerations to interest
rate environment
i. Spread-based IRR
ii. Cost of funds ROE
Questions
