Asset Liability Management in a Low Interest Rate Environment

Transcription

1 Asset Liability Management in a Low Interest Rate Environment ASHK Evening Talk 25 February 2004 Robert Chen

2 Agenda Introduction: Interest Rates Overseas Experience: UK and US Use of ALM Scenario testing Stochastic investigations Pricing Product Guarantees Challenges in carrying out ALM Conclusion

3 The higher a people s intelligence and moral strength, the lower the rate of interest. -- Eugen von Böhm Barwerk (19 th Century)

4 Economic Determinants of Interest Rates Monetary policy International interest rates Productivity of capital goods Demand for money Interest Rates Time preference of savers Liquidity preference Market expectations of inflation Market expectations interest rates

5 Jan-96 Jan-98 Jan-00 Jan-02 Jan-94 Jan-92 History of Interest Rates 10-Year Government Bond Yields Jan-62 Jan-64 Jan-66 Jan-68 Jan-70 Jan-72 Jan-74 Jan-76 Jan-78 Jan-80 Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Month US Japan Hong Kong %

6 Interest Rate Trends How will interest rates move in future? One way of telling: Yield curve US$ and HK$ Yield Curves at 31 October % 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% US$ HK$

7 Interest Rate Trends Forward rates show that the market expects interest rates to rise. But will it? Yield curve represents only a consensus of market opinions, i.e. expected value. Actual future interest rates will be affected by the impact of future unanticipated shocks. This is not the only way that the rates will turn out. Need a coherent economic model to generate future interest rate scenarios.

8 If interest rates rise Problems for life insurers Par products become less attractive Non-par products become even less attractive Result in lapses which reduce future profits If assets are invested in fixed interest, losses on sales of assets to meet surrender benefits For par products, pressure to increase dividend payments: problem of How much to set aside for the future, and How to explain that to policy holders. Funds flow out of savings products and into unit linked products / mutual funds

9 If interest rates rise Responses Flexible surrender values: better match with value of underlying assets. Shorten policy terms of non-par products. Follow a clearly stated bonus policy. Clear communication with policy holders.

10 If interest rates fall even further Problems for life insurers Current problems compounded More severe costs of investment guarantees on both NP and WP. Valuation interest rates fall -> further strain on free assets Par products What level of dividends to declare? How much smoothing reserve can we release? Do we declare zero interest dividends? Illustrations and competitive bonus vs Policyholders reasonable expectations. Non Par products If assets need to be turned over, they will now earn a lower yield. Options and guarantees They can potentially carry significant cost.

11 If interest rates fall even further Product features that can carry significant interest rate risk: Mostly exposed to low interest rates. If earned rates fall below that assumed in pricing, the accumulation of assets with interest will not be adequate to meet benefit payments. Long term non-par products Only profitable if experience is better than pricing assumption Guaranteed annuity options Guaranteed crediting rates

12 If interest rates fall even further Responses Hedge risks Derivatives Reinsurance Result in more certain profits, not higher profits. Cheaper to hedge when interest rates are high Better practise to identify and quantify risks at product design stage and price them into the premium rates. Asset strategy and new business product mix appropriate to the low interest rate environment.

13 Overseas Experience - UK Recent difficulties caused by Fall in equity values Fall in interest rates Guarantee on guaranteed annuity options Swaptions to hedge interest rate risks Cutting bonus rates Policyholder Reasonable Expectation Issues Management of bonus rates using asset shares Limited by policyholders reasonable expectations Current payout still around 115% - 130% of asset shares

14 Overseas Experience - UK Long-term non-participating products e.g. conventional term assurance products Priced on high investment yield assumptions Poor investment yields on renewal premiums Tighter regulatory environment Response to the investment environment Examines impact of changes in yield curves Examines realistic solvency as well as statutory solvency

15 Overseas Experience - UK Annuities Removed obligation to take out life annuity by age 75 Due to poor annuity rates High income bonds Supported by equity values Threatened by lower equity values

16 Overseas Experience - US Interest rates at their lowest level in 50 years. Interest guarantees becoming exposed Result of early lock-in of benefits State regulated minimum crediting rates Often determined from moving average of rates Remains higher than current yields Companies reactions Pulling out of the market Hedging current guarantees

17 Overseas Experience - US Calls on bonds Increased calls on bonds as interest rates fall. Unable to find new bonds with similar level of yield. Realising gains on bonds Companies may sell some bonds to realise the capital gains. This would boost earned rates in the short term. Accounting treatment (IMR) does not allow the full realisation of gains to emerge.

18 Overseas Experience In summary: how are they dealing with it? Internal management: stochastic modelling of assets and liabilities to investigate Adequacy of capital Appropriateness of investment strategy Proper allowance for cost of guarantees in pricing. Transfer of risk: Hedging Over-the-counter or tailor-made derivative contracts Reinsurance

19 The Role of ALM Gives quantifiable feedback on the appropriateness of Investment strategy asset mix Product strategy cost of guarantee features Under the current environment, what types of investigations to carry out? Scenario testing (simple gives how much ) Stochastic testing (more complex also gives how likely ) Allows company to: Assess possible cost of existing benefits Ensure future new business allows a fair price to be charged for guarantees Stop selling products for which a fair price can not be charged

20 Scenario Testing Testing financial outcomes under what-if scenarios. Allows the investigation to focus on the more interesting cases. Easy to do, does not require detailed modelling of assets. Gives a useful picture of likely impact of interest rate movements, I.e. gives how much answers. A useful first step.

21 Scenario Testing Example: Solvency Testing Free Asset Ratio 60% 50% 40% 30% 20% 10% 0% -10% -20%

22 Stochastic Investigations One step further from scenario testing Scenarios are now generated using an economic model. The severity of the scenario is consistent with the frequency of such scenarios. Gives answers to how likely as well as how much. Able to use this to perform valuations and assess likelihood of outcomes. Applications: Investment strategy evaluation Economic capital assessment Realistic valuation of liabilities / IAS Pricing of product features / guarantees

23 Stochastic Investigations Requirements of an economic model Depends on purpose of investigation Some common requirements are: Arbitrage-free Market consistent Does not produce negative interest rates Consistent with economic theory

24 Investment Strategy Assessment Example 1 Investment Strategy Assessment

25 Current Strategy - Results 60% Free Asset Ratio 50% 40% 30% 20% 10% 0% -10% -20%

26 Current Strategy - Analysis Free asset ratio = 10% Probability of insolvency = 12% Higher than objective of 5% What can we do? Change the investment strategy Change the product strategy (pricing, bonus strategy, product mix) Hold more capital (or ensure access to capital if required) Capital injection Financing reinsurance Raise subordinated debt Lines of credit

27 Switching to a More Conservative Strategy 60% Free Asset Ratio 50% 40% 30% 20% 10% 0% -10% -20%

28 Inject More Capital Free Asset Ratio 60% 50% 40% 30% 20% 10% 0% -10% -20%

29 Comparing Alternative Strategies

30 Comparing Alternative Strategies

31 Pricing of Product Guarantees Example 2 Pricing of product features / guarantees

32 Pricing of Product Guarantees The issue Deterministic projection on best estimate assumptions show no cost. Significant cost could emerge if returns reduce. Need to know market value of cost of guarantees. The solution Stochastic investigation. Uncovers the distribution of costs of guarantees. Extra requirements of economic model Market consistent Arbitrage free (Some statistical models may not be suitable)

33 Emerging Cost of Guarantees

34 Deflated Cost of Guarantees

35 Cost of Guarantees (After 5,000 Simulations) Age at Entry Mean Standard Deviation

36 Challenges in carrying out ALM Choice scenarios Appropriate deterministic scenarios Stochastic economic scenario generator Changes in projection models, to allow for Management decisions Policyholder behaviour Ensuring the model and the results are reliable System and assumptions Obtaining buy-in from managers on reasonableness of assumptions and results Analysing information produced Large volumes of results produced Need for appropriate reporting measures to be developed and understood

37 Conclusion Key issues to address in low interest rate environment Ensure viability of the operation Fair price to charge for guarantees Assess cost of hedging Actuary s role Monitor company s current and ongoing solvency (understand threats) Keep abreast of latest technical developments Apply appropriate techniques to ensure due allowance for risks Educate the board in the importance and implications of the economic environment