DURATION MATCHING DISCUSSION PAPER

Transcription

1 0 RATE APPLICATION DURATION MATCHING DISCUSSION PAPER In the most recent PUB Order / from December 0, it was ordered that: MPI shall submit a discussion paper of the duration matching of its claims liabilities and investments as part of the next GRA. This paper will: ) provide a background on how the Corporation s interest rate risk has evolved over time; ) provide analysis on the financial impact of the duration matching strategy; ) discuss the Corporation s ability to withstand interest rate risk; ) discuss the upcoming ALM study; ) provide recommendations and conclusions.. Background on Interest Rate Risk The Corporation uses duration matching in order to manage the interest rate risk associated with the Corporation s assets and liabilities. Section. of MPI s Investment Policy Statement states the following: Interest rate risk is managed by maintaining the combined Macaulay duration of the floating rate note, cash, marketable and non-marketable bond components with ±.0 years of the actuarially determined duration of the Corporation s claims liabilities. Interest rate risk, as defined by PWC is the risk of economic loss resulting from market changes in interest rates and the impact on interest rate sensitive assets and liabilities. Interest rate risk arises due to the volatility and uncertainty of future interest rates. The timeline below indicates how the Corporation s interest rate risk exposure has changed over time. 000 Prior to accounting changes in 00, the Corporation s interest rate risk exposure was minimal. In the June, 000 Investment Policy Statement, a sub-section on interest rate risk was added to Section regarding investment risks. This sub-section stated that the duration of the nominal bonds was to be within. years of the duration of the Corporation s liabilities. Currently, the accounting treatment of the fixed income portfolio has a significant impact on the interest rate risk of the Corporation for rate setting purposes. However, prior to 00/0, the fixed income portfolio was held at book value on the financial statements. As a result, the impact of interest rate movements on the market value of the fixed income portfolio did not flow through net income unless a bond was sold. Page

2 0 RATE APPLICATION 0 0 The book yield of the fixed income portfolio was used to determine the discount rate for the claim liabilities, since the assets supporting the liabilities were held at book value. The book yield of an asset is generally stable and predictable (e.g. MUSH bonds are currently held at book value/yield). Therefore, stable asset yields produced stable claims discount rates and insulated net income from significant changes in market rates. 00 The Corporation s interest rate risk exposure on the financial statements changed in fiscal year 00/0 with the implementation of fair value accounting. Under fair value accounting, marketable bonds were reported at market value instead of at book value. As a result, fluctuating interest rates impacted the value of marketable bonds, which flowed though net income. Since the claims discount rate is based on the fixed income yield for accounting purposes, the change to fair market accounting also impacted how the claims discount rate was calculated. Instead of using the book yield for marketable bonds, the market yield was used in the claims discount rate. With (most) assets held at market value, the actuary is now required to closely monitor and update the discount rate based on monthly fluctuations in market yields. This potential for significant changes in market yield rates also meant that mismatches in duration between the fixed income portfolio and liabilities could have a significant impact on net income. 0 In 0, there were two significant changes to section. on interest rate risk in the Investment Policy Statement. First, the liability duration used to calculate the bandwidth was changed from the total liability duration of the Corporation to claims duration. Second, the duration bandwidth in section. of the Investment Policy Statement was increased from +/-. years to +/-.0 years, which increased the Corporation s exposure to interest rate risk. Summary Prior to the 00/0 fiscal year, the fixed income portfolio was held at book value on the financial statements and the claims discount rate was based on book yield. As a result, changing interest rates did not have a significant impact on net income. With the introduction of fair market value accounting in 00/0, the fixed income portfolio was held at market value and the claims discount rate was based on market yield. This increased the Corporation s interest rate risk. Then, in 0 the duration bandwidth in section. was increased to +/- years increasing the Corporation s exposure to interest rate risk. The book yields and discount rates changed slowly as they were only impacted when the fixed income portfolio turned over due to maturities and sales. Page

3 0 RATE APPLICATION 0 0. Financial Impact of Interest Rate Risk The financial impact of the duration bandwidth of +/- years in a rising and falling interest rate environment is quantified in this section.. Assumptions for the Scenarios The financial model was used to determine the Corporation s risk exposure to parallel shifts in the yield curve. The 0 GRA base scenario was used for all inputs except for interest rates, the duration gap assumption and marketable bond spreads. Changes in interest rates were assumed to occur in 0/.. Rising Interest Rate Scenario This scenario assumes that the Government of Canada year bond yield increased by.0% from % to % in one year. A.0% increase is realistic because a 0.% increase occurred from December, 0 to December, 0. The impact on Basic net income is shown in the table below. Scenario (+.0% increase) Impact on Basic Net Difference Relative to -.0 Duration Gap Income ($millions) Duration Scenario If the fixed income duration is years lower than the claims duration (a duration gap of -.0) the impact on Basic net income is estimated to be $. million. If the duration gap is -.0 years, the impact on Basic net income is $. million, which is $. million lower compared to when the duration gap is -.0. If the duration gap is 0.0, intuitively the impact of interest rates changes to net income should be close to $0 instead of $. million as shown in the table above. To explain, the claims duration used to calculate the financial statement impact from changes in interest rates is different than the duration used by the bond manager to manage the fixed income portfolio. In the calculation of claim liabilities the actuary must include a margin for adverse deviation. Adding this margin does not change actual economic cash flows. However, it has the effect of increasing the duration of claim liabilities. For example, the claim liabilities had a duration of. years as of February 0. With the margin for adverse deviation the claim liabilities had a duration of. years. When interest rates rise, the market value of bonds and the present value of the claims liabilities both decrease. The combined net impact is dependent on the duration gap. In general, a negative duration gap (asset duration is less than claims duration) indicates that net income will increase with rising interest rates. A positive duration gap (asset duration is greater than claims duration) indicates that net income will decrease with rising interest rates. The margin is applied by deducting the assumed margin percentage from the expected investment return (i.e. the discount rate assumption). Page

4 0 RATE APPLICATION 0 The bond manager is managing to a claims duration (. years) with a +/- year bandwidth that is different than the claims duration that flows through to the financial statement (. years). When calculating the impact of changes of interest rates on net income, the effective bandwidth is -. years / +. years instead of -.0 year / +.0 years, since the effective bandwidth is adjusted for the 0. year margin for adverse deviation. Despite this difference, the Corporation determined that duration matching (or cash flow matching) the asset portfolio to the claim liabilities with the margin for adverse deviation was not appropriate. The Corporation s asset and liability matching strategy should be reflective of actual expected investment returns and actual claim cash flows, not amounts with actuarial margins.. Falling Interest Rate Scenario This scenario assumes that interest rates decrease by.0% from % to %. In this scenario, the difference between a duration gap of -.0 years and -.0 years is estimated to be ($.) million. Scenario (-.0% decrease from %) Impact on Basic Net Duration Gap Income ($millions) Difference Relative to -.0 Duration Scenario -.0 (.) (0.) (.) 0.0 (0.) (.).0 (.) (.0).0.0 (.) This impact of decreasing the duration gap from -.0 to -.0 is significantly larger when interest rates decrease ($. in Scenario ) compared to when interest rates increase ($. million in Scenario ). Scenarios and were run assuming a.% base forecast (Q 0/ actual rate) instead of a.0% base forecast. In these scenarios, by decreasing the duration gap from -.0 to -.0 years, the impact on basic net income is ($.) million when interest rates increase, and $. million when interest rates decrease. These results are not shown because decreasing the GoC year bond rate by.0% from.% is lower than the lowest month-end GoC year bond rate of.%. Page

5 0 RATE APPLICATION. Explanation of Results In Scenario and, there were disproportionate results when changing the duration gap from -.0 to -.0: a smaller absolute impact on net income when interest rates increase by % ($. million) and a larger absolute impact when interest rates decrease by % ($. million). As shown in the table below, in Scenario the claims discount rate increases by 0.0% and the marketable bond yield increases by 0.% when moving from a duration gap of -.0 to -.0. In Scenario, the claims discount rate increases only by 0.0% while the marketable bond yield increases by 0.%. Since the claims discount rate changes by different amounts when interest rates change +/- %, this causes basic net income to react differently. These disproportionate impacts can be explained by the margin for adverse deviation. When interest rates fall from % to %, the margin for adverse deviation has a greater impact when calculating the claims liability discount rate compared to when interest rates rise from % to %. Scenario and Results Duration Gap (Years) Claims Discount Rate Marketable Bond Yield Marketable Bond Duration (Years) 0 Base -.0.0%.%. Scenario : Interest -.0.%.%. Rates Increase by % -.0.%.0%. Scenario : Interest Rates Decrease by -.0.%.%. % -.0.0%.%. Difference Scenario : Interest Rates Increase by % Scenario : Interest Rates Increase by % % 0.% %.0% % -0.% % -0.%. Summary: These scenarios indicate that there is a significant downside risk to the Corporation ($.) million to having a larger duration bandwidth without a proportionate upside benefit ($. million) when interest rates increase. Page

6 0 RATE APPLICATION The Corporation s Ability to Withstand Interest Rate Risk The Corporation s ability to withstand interest rate risk has decreased over the past few years due to: ) recent changes to the financial forecast; and ) the risk of forecasting interest rates.. Changes to the Financial Forecast The Corporation has made continuous improvements in recent years to bring its financial forecast to a best estimate basis. For example, prior to 00, the equity return assumption in the model was the forecasted yield of the Government of Canada year bond rate. However, this assumption was not justified based on historical equity returns data relative to fixed income yields. As a result, the forecasted equity return was increased to the forecasted yield on the Government of Canada year bond plus.% in 00. A second example relates to claim liabilities. Between the 00/0 and 0/ fiscal years, the Corporation reduced claims liabilities by over $00 million relative to existing booked values. These reductions stemmed mainly from improved best estimate assumptions for long term injury claims. The favourable claims impacts during this period largely masked the impact of a declining interest rate environment that was occurring at the same time as the Corporation maintained a negative duration gap. The cumulative impact of these changes to forecast assumptions has reduced the Corporation s ability to withstand volatility in net income. This is in conjunction with the Corporation s overall interest rate risk exposure increasing since the introduction of fair value accounting in 00/0.. The Risk of Forecasting Interest Rates As discussed throughout the 0 GRA, there is significant rate-setting risk to the Corporation if the forecasted interest rates from the five major banks and Global Insight did not materialize. The interest rates at the time of last year s rate submission were near historical lows. The market yield on the Government of Canada (GoC) year bond hit a low of.0% as of April 0, 0. If inflation is expected to be % during the next years, then year bonds purchased on this date would have a negative yield of -0.% on an annual basis over this period. When interest rates are this low relative to expected inflation, it is reasonable to assume the probability of interest rates increasing is much higher than the probability of these rates falling. As a result, all forecasters assumed rising interest rates, and at the time, the only question that was being asked was how fast interest rates would rise. The interest rate environment has changed over the last year, where the probability of interest rates falling or rising is likely closer to being equal. In one month from December 0 to January 0, the yield on the GoC year bond fell by 0.% from.% to.%. This relatively large drop within a month is in the opposite direction compared to The equity risk premium was increased from zero to.% in 00 Independent of interest rate changes. The Corporation does not anticipate any significant reductions to claims liabilities in the foreseeable future (excluding reductions from interest rates). Since October 0, there has been a net change in claim liabilities (exclusive of interest rate impacts) of approximately $ million relative to book values. Page

7 0 RATE APPLICATION Global Insight s forecasted interest rate of.% for Q 0 (January 0 forecast). If the 0 GRA has a base forecast that assumes interest rates will increase, and interest rates fall, the downside risk of having a year negative duration gap is significant. Assuming a scenario with a negative duration gap of -.0 years, if interest rates were forecasted to increase by 0.0%, it would increase net income by approximately $ million compared to the scenario where the duration gap was zero. However, if actual interest rates decreased by 0.0% over the year, this would decrease actual net income by approximately $ million. In this scenario, the impact on net income over one year is a combined $ million difference in forecasted versus actual net income. Page

8 0 RATE APPLICATION Upcoming ALM Study PUB Order No. / (page ) stated: MPI shall have the composition of its investment portfolio reviewed by an external expert consultant, with a view to determining whether the current asset mix should continue, or should be revised. The Corporation s last asset/liability study was completed in March 00. The Corporation is in the process of completing a Request for Proposal for an ALM consultant. It is expected that this ALM will be completed by the end of 0. PWC Presentation PWC was requested by the Corporation to research how other companies (pension plans, life insurance companies, property and casualty companies, etc) approach the issue of asset liability matching. They produced a presentation titled Interest Rate Risk Management Canadian Landscape. This presentation is included as Attachment C to the Investment Income Document. The main finding of the research is that most firms surveyed use cash flow matching instead of duration matching. Cash Flow Matching Cash flow matching is an alternative solution to manage the Corporation s interest rate risk. Cash flow matching occurs when the cash flows from assets are managed to match the timing of the liability cash flows, in order to pay the liabilities as they come due. The main advantage of cash flow matching over duration matching is that cash flow matching eliminates interest rate risk from any type of yield curve shift. Cash flow matching is more popular among insurance companies for this reason. The main disadvantage to cash flow matching is that the expected return of a portfolio designed for cash flow matching is likely lower when compared to a portfolio designed for duration matching. Conclusion #: That the ALM consultant will be requested to study the Corporation s current duration matching strategy, and analyze cash flow matching in Phase of the ALM study. The goal of Phase will be for the consultant to recommend an appropriate interest risk mitigation strategy to MPI. The goal of Phase of the ALM study will be to recommend an appropriate asset allocation for the investment portfolio based on the decision from Phase. Conclusion #: The duration bandwidth (i.e. the gap between the duration of the Corporation s assets and liabilities) as specified in section. of the Investment Policy Statement be changed to +/-.0 years. This is a temporary measure to reduce interest rate risk and forecasting risk due to the duration gap until the ALM study is completed. This change in bandwidth would reduce the interest rate risk of the Corporation by approximately $ million from a 0 basis point decline in interest rates. A duration matching strategy is susceptible to interest rate risk since duration matching only provides protection against parallel yield curve shifts. Duration matching does not protect the Corporation from interest rate risk when the non-parallel yield curve shifts and twists occur. Page

9 0 RATE APPLICATION 0 0. Summary. The interest rate risk of the Corporation is significant with a larger duration bandwidth. Two scenarios were presented in the paper that analyzed the impact of changing interest rates by +/-.0% in one year from.0%. Changing the duration gap from -.0 to -.0 years reduced the positive impact on Basic net income from $. million to $. million when interest rates increased by.0%. This $. million difference represents an opportunity cost of reducing the duration gap from -.0 to -.0 when interest rates rise. However, if interest rates fell by.0%, changing the duration gap from -.0 to -.0 years improved the impact on Basic net income by $. million from ($.) million to ($0.) million. Therefore, in this second scenario, moving to a +/-.0 year bandwidth mitigates the net income loss by $. million. These impacts indicate that there is a significant downside risk to the Corporation ($.) million to having a larger duration bandwidth without a proportionate upside benefit ($. million) when interest rates increase.. There is increased forecasting and rate-setting risk with a duration bandwidth of +/- years. Assume interest rates were forecasted to rise by 0.% in one year with a forecasted duration gap of -.0 years. Instead, actual interest rates declined by 0.0%. The estimated variance of actual net income to budgeted net income is $ million. This interest rate risk exposure has financial, economic and forecasting consequences for the Corporation.. An asset-liability study is expected to be completed by the end of 0. The ALM consultant will be requested to make a recommendation regarding the optimum strategy to manage the interest rate risk of the Corporation.. As an intermediate step to reduce the interest rate, forecasting and rate-setting risks of the Corporation, the duration bandwidth in section. of the IPS was decreased from +/-.0 years to +/-.0 year. Page