SESSION 3 ASSET LIABILITY MANAGEMENT: BERNANKE S MAGIC 8-BALL SAYS AN INTEREST RATE

Transcription

1 2013 ANNUAL SPRING INVESTMENT FORUM American College of Investment Counsel Chicago, IL SESSION 3 ASSET LIABILITY MANAGEMENT: BERNANKE S MAGIC 8-BALL SAYS AN INTEREST RATE INCREASE IS UNLIKELY April 25, :30 a.m. 12:30 p.m Mark A. Sternberg Schiff Hardin LLP (Moderator) Steven J. Karasick Allstate Investments, LLC Harry Norman, Jr Hartford Investment Management Company Bradley S. Ritter Delaware Investments Advisors

2 ACIC 2013 Spring Investment Forum ASSET LIABILITY MANAGEMENT: BERNANKE S MAGIC 8-BALL SAYS AN INTEREST RATE INCREASE IS UNLIKELY Chicago Illinois April 25, 2013 Moderator: Mark A. Sternberg Partner, Schiff Hardin LLP Panelists: Harry Norman, CFA, FSA - Head of ALM, The Hartford Bradley S. Ritter, CFA - Senior Vice President, Head of Private Placements Group, Delaware Investments Steve Karasick - Senior Portfolio Manager and Head of Derivatives Trading, Allstate Investments

3 ACIC Presentation Asset / Liability Management Harry Norman April 25, 2013

4 Asset / Liability Management Prudent management of interest rate risk is a critical function for all financial institutions Asset / Liability Management (ALM) is the unit that coordinates management of interest rate risk At The Hartford, the ALM team reports to the Chief Risk Officer Key risk metrics used in ALM are duration and DV01 Duration is the price sensitivity of a financial instrument to changes in rates DV01 is the change in market value for a 1 basis point change in rates An institution s risk position can be expressed as the net DV01 Compare duration of asset vs. liabilities; difference is net DV01 For instance, if XYZ is long $10 mm DV01: If rates go down 1 basis point >> gain of $10 million If rates go up 1 basis point >> loss of $10 million 2 13H000

5 ALM is broader than just interest rate risk ALM can be defined as the ongoing process of formulating, implementing, monitoring, and revising strategies related to assets and liabilities to achieve an organization s financial objectives, given the organization s risk tolerances and other constraints* Financial Objectives Earnings Capital Management Multiple Accounting Frameworks GAAP / Statutory / Economic Risk Tolerances Duration, Convexity Earnings / Surplus Volatility Portfolio Quality, Diversification 3 13H000

6 5/1/1994 2/1/ /1/1995 8/1/1996 5/1/1997 2/1/ /1/1998 8/1/1999 5/1/2000 2/1/ /1/2001 8/1/2002 5/1/2003 2/1/ /1/2004 8/1/2005 5/1/2006 2/1/ /1/2007 8/1/2008 5/1/2009 2/1/ /1/2010 8/1/2011 5/1/2012 2/1/2013 Current low rate environment will challenge earnings yr Treasury Yields Jan March 2013 Interest Rates are at historic lows Rates have declined 320bps since mid IG Corporate Spreads Credit spreads have tightened considerably since A Spread (vs. TSY) BBB Spread (vs. TSY) All in yields are at historical lows All In Yields A BBB BB '95-' '00-' '05-' H000

7 Integrated risk management processes help ensure corporate objectives are met Insurance pricing requires assumptions Premium payment Investment return Claim payment Risk management monitors and evaluates experience relative to assumptions Underwriting experience Mortality studies Investment returns Portfolio risk and capital consumption Earnings forecast Duration management is key to mitigating interest rate risk Invest premium dollars to match anticipated liability claim payment pattern Continually monitor duration of portfolio relative to liabilities 5 13H000

8 Interest rate risk varies by insurance product Life products Longer contractual life Single premium vs. recurring premium Reinvestment risk Minimum rate guarantees Product guarantees Guaranteed Minimum Death Benefits (GMDB), Withdrawal Benefits (GMWB) P&C products Shorter contractual life Annual premium collection period Generally, short time between premium receipt and claim occurrence Workers compensation has longer claim payment horizon 6 13H000

9 Potential risk management strategies Revisit pricing rate assumptions Analyze profitability across multiple rate environments Set lower return assumptions Reduce minimum guarantees Regulatory minimums Increase fees for product guarantees Policyholders value guarantees Hedging costs are higher Revisit desired liability portfolio Reduce / discontinue sales of product lines Strategic dispositions 7 13H000

10 Search for Yield! Brad Ritter, CFA Senior Vice President, Head of Private Placements Delaware Investments April 25, 2013

11 Search for Yield! High Level Themes/Strategies From the Insurance/Product Perspective: Lower guaranteed crediting rates Lower earned rate assumptions on new insurance products Use forward contracts to protect against sustained low rates Invest in longer duration bonds to maintain duration match and increase yield Consider unwinding low rate hedges to realize capital gains Encourage the investment side of the house to find more yield! 2

12 Search for Yield! Prime Directive: Never Compromise Underwriting for Yield! First Corollary to Prime Directive for Private Placements: That also applies to document terms and covenants! So what WON T we do? We won t buy a credit today we wouldn t have bought 5 years ago. We won t go long just to go long E.g., not buying 30-year technology issuers or retailers. We won t sacrifice on key covenants: Priority debt; Make-whole; (Anti-)Cookson We won t move down the capital structure just to pick up yield. 3

13 Search for Yield! Given those constraints, what WILL we do? More Privates! Still getting good value relative to publics, so increase allocations to privates For credits we like, go as long as reasonably makes sense If you like a credit for 10 years, consider a 12 or 15 year tranche for the extra yield. Consider deals with structural premiums: Credit tenant leases Pick-up versus public bonds of the same issuer (e.g., WAG, HD) Project finance Solar farms; Chicago Parking Meters Tax credits NAIC 3 Foreign currency swaps Consider new jurisdictions South Africa; Turkey Consider new asset classes with private characteristics Military housing Secondary trading Orphans Portfolio Rebalancing Opportunistic 4

14 Search for Yield! Alternatives Private Equity and Hedge Funds Different analysis since alternatives go into surplus, not the product lines. Much smaller portion of the overall portfolio. Labor intensive That said, we are exploring ways to grow the alternative portfolio: Low correlation to product line liabilities (e.g., oil and gas funds) Minimize J-Curve Secondary funds Pharma royalty Focus on current income Mezzanine funds Loan funds Leverage off of existing relationships Co-investment 5

15 ACIC Presentation Asset / Liability Management Steve Karasick April 25, 2013

16 ACIC Spring Forum Asset Liability Management Insurance Companies may use derivatives in three ways: 1. Income generation. For example, selling covered calls against an asset 2. Replication. For example, pairing a treasury note and a credit default swap to create a synthetic corporate bond 3. Hedging. For example, buying options to hedge the payout of a variable annuity contract The majority of derivatives use is for hedging. 2

17 ACIC Spring Forum Asset Liability Management Contracts issued by life insurance companies have features and characteristics that produce cash flows that are very difficult to match using traditional fixed income investments. A generic fixed annuity may have: A guaranteed minimum crediting rate The owner s right to walk away from the policy Just these two features expose life insurance companies to risk if either rates fall (the crediting rate has a minimum) or if rates rise (owners can walk away exactly when fixed income assets fall in value). Some annuities contain very complex ultimate payouts that are linked to the performance of equities. As such, derivatives play a key role in Asset Liability Management. Derivatives allow the ALM/Portfolio manager to hedge the residual risks created by the policies issued that cannot be captured by the cash investment portfolio. 3