Low interest rates the new normal?

Transcription

1 Low interest rates the new normal? Actuarial Club of Southwest and Southeastern Actuaries Conference Francisco Orduña, FSA, MAAA Marshall Lin, FSA, MAAA, CFA 17 November 2016 The better the question. The better the answer. The better the world works.

2 Ernst & Young LLP disclaimer The views expressed by the presenters are not necessarily those of Ernst & Young LLP. This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice. Page 1

3 Key questions What is the current interest rate environment and its outlook in the United States? How do low interest rates impact the life insurance industry? What are the common interest rate assumptions adopted by life insurers? How do commonly used economic scenario generators (ESGs) cope with the current low interest rate environment, and what are their limitations? What alternatives can practitioners explore? Page 2

4 Historical perspective of US interest rates The current environment, with near-zero, short-term rates since 2009, is unprecedented in the history of US interest rates. 18 Federal funds effective overnight rate (%) Fed rate increase soft landing Fed tightening OC bankruptcy QE1 Nov 2008 QE3 Nov Source: Board of Governors of the Federal Reserve System QE2 Nov 2010 Page 3

5 Low interest rate environment Factors influencing interest rates: Equilibrium, market expectation Inflation expectation Central bank s monetary policy Current environment: Monetary policy, quantitative easing Conditions in the global economy Deflationary concerns Other headwinds, such as low oil prices How long do we expect the rates to remain low? US Treasury securities 10-year constant maturity rates (%) Source: Board of Governors of the Federal Reserve System Page 4

6 Comparison to global economic market These global factors also influence interest rates: Integration and harmonization of global markets Central bank influence Currency consideration: no arbitrage Narrowed spread post-2014 Page 5

7 Negative interest rates in global markets Bond duration Switzerland Germany Negative Positive Japan Sweden Netherlands France Spain Italy United Kingdom United States * Source: quartz.com, as of July 6, 2016 The Federal Reserve is now requiring systematically important financial institutions (SIFIs) to use negative short-term interest rates in stress testing. Page 6

8 Jun 07 Dec 07 Jun 08 Dec 08 Jun 09 Dec 09 Jun 10 Dec 10 Jun 11 Dec 11 Jun 12 Dec 12 Jun 13 Dec 13 Jun 14 Dec 14 Credit Spread Interest rates since the financial crisis Long-term interest rates declined with 10-year Treasury rate just under 2.3%. The yield curve continued to be positively sloped with some steepening around the 5-year tenor. 5.00% 4.50% 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% The A and BBB credit spreads have since stabilized post the financial crisis. This, combined with the low Treasury rates, means yields have stayed low for these asset classes insurance companies typically invest in. Implied credit spread - A-rated Additional spread for BBB-rated bond over A-rated Page 7

9 Life insurers main perceived economic risks Prolonged low interest rates and a rapid increase in interest rates are among the top three challenges identified by surveyed companies. Prolonged low interest rates Adverse equity market movements Rapid increase in interest rates Widening credit spreads Other Source: EY proprietary survey Number of companies Page 8

10 US life insurance industry average portfolio rates The persistent low interest rates are hitting life insurance companies bottom line, and portfolio rates are expected to continue declining as existing assets mature and proceeds get reinvested in low yield instruments. 6.0% 5.8% 5.7% 5.6% 5.7% 5.8% Investment Yields 5.6% 5.4% 5.2% 5.4% 5.1% 5.2% 5.1% 5.0% 4.8% 4.9% 4.9% 4.8% 4.6% 4.4% 4.2% Source: EY proprietary survey 2016 Page 9

11 Rising interest rates Also a risk for life insurance products An industry survey showed the products companies considered most at risk in a rapidly rising interest rate environment. The main risks included disintermediation, products where the sales focus is on credited rates and products with asset mismatches. 90% 80% Products considered most vulnerable to an interest rate spike 79% 70% 60% 50% 53% 40% 30% 20% 10% 26% 21% 11% 0% Fixed deferred annuity Universal Life Variable annuity Whole life Variable life insurance Source: SOA July 2014, survey published in Transition to a High Interest Rate Environment Research Page 10

12 Low interest rate insurer mitigation reactions In-force management Subsidize new crediting rates with credited rates from legacy business Increase COIs, loads, or adjust the dividend scales for life products On shore captives or off shore reinsurance Restrict level of new premiums in life insurance products Trade interest rate guarantees with LTC, critical illness or death benefit riders Product development Migrate to indexed products Reduce guaranteed crediting rates Increase secondary guarantee premiums or reduce benefits in Universal Life products Reduce or eliminate return of premium (ROP) guarantees in fixed annuities Include or refine market value adjustments in fixed annuities Reconfigure commission structures to a flatter and more tail-oriented scheme Page 11

13 Long-term interest rate assumptions There is a wide range of long-term interest rate assumptions among life insurers. This range is shifting over time, as the low interest rate environment persists. 8.0% Long term interest rate assumption comparison 2013 vs % 6.0% 5.0% 4.0% 3.0% 2016 survey responses 2013 survey responses 2.0% 1.0% 0.0% Source: EY proprietary survey 2013 and 2016 Page 12

14 Path to long-term interest rates A significant number of economists and actuaries expect that interest rates to stay low in the near future. While there is a general consensus that interest rates will eventually revert to historical levels, there are significant disagreements about when and how this will happen Path to mean reversion target 7% 6% Mean reversion point 5% 4% 3% 2% 1% Current interest rate AIRG Delayed Rise Extended Low Rates 0% Projection Year Thus, stochastic models become a crucial need for companies to understand the impact of assets and liabilities across multiple interest rate paths. Page 13

15 Key features in real-world stochastic interest rate models Mean reversion: Most common real-world interest rate stochastic models assume that interest rates will revert toward a specified rate, commonly referred to as the mean reversion target. The mean reversion target is the primary driver of best estimate measures Progression of average projected yield curves Sources of uncertainty: Instantaneous changes in interest rates are modeled through a volatility parameter and the level of interest rates in the projection. Long-term changes in interest rates are primarily impacted by the mean reversion strength and the assumed volatility level. Sources of uncertainty are the primary driver of tail-based measurements. Model Vasicek Cox-Ingersoll-Ross Black-Karasinski Stochastic differential equation dr = a b r dt + σdz dr = a b r dt + σ rdz dln(r) = a b ln(r) dt + σdz t = 0 t = 1 t = 5 t = 10 t = 20 Mean-reversion Page 14

16 Economic scenario generation in the life insurance industry The Academy s Interest Rate Generator (AIRG) is the most commonly used ESG in the industry, as it can be directly used to perform principles-based reserves (AG 43) and capital (C-3 Phase I and II) calculations. ESG used for real-world interest rates Third party 25% AIRG 47% Homegrown 28% *Based on a proprietary survey of US life insurance companies Page 15

17 Regime-switching model Overview Calibrated historical interest rates to two regimes: the current low interest rate environment and the preceding historical period Historical one-year Treasury rate 15% 10% High regime Low regime 5% 0% High regime Simulates an interest rate environment similar to the period Mean reversion point (MRP) closer to historical average Interest rates move toward MRP with high volatility and low mean reversion strength Low regime Simulates interest rates based on the postfinancial crisis environment ( ) Lower MPR and stronger mean reversion strength Interest rates move around the MRP with low volatility Page 16

18 Prolonged low interest rate environment Transition probabilities can be used to reflect different views of how long we will stay in the current low interest rate environment. Using a 15% transition probability translates to an average of 6.7 years before transitioning out of the low interest rate environment. A user can increase/decrease the transition probability to reflect a particular view of how long the current low interest rate environment will persist. 5.5% Average of simulated 7-year rates 4.5% 3.5% 0.75% 2.5% 0.76% 1.5% Transition Pr Transition Pr Transition Pr. Page 17

19 Alternative ESG Regime-switching, key-rate Cox-Ingersoll-Ross model Regime-switching: uses a Markov chain process to model the transition between regimes Annual transition probability To low regime To high regime From low regime 85.0% 15.0% From high regime 2.1% 97.9% Key rate: models each spot rate on the curve individually: Advantage: increased flexibility, precision and control over desired outcomes Disadvantage: complexity and large number of parameters Alternatives: function-based models (i.e., Nelson-Siegel) Uses the Cox-Ingersoll-Ross (CIR) stochastic differential equation in each regime Calibrates the model with maximum likelihood estimates (MLE) based on historical Treasury rates Complies with the AIRG calibration criteria Page 18

20 Projected interest rates AIRG 18% AIRG 7-year rate projection 16% 14% 12% 10% Rates in 2045 AIRG 5% percentile 2.030% 50% percentile 3.799% 95% percentile 6.305% 95th percentile 75th percentile 25th percentile Historical Average 8% 6% 4% 2% 0% Page 19

21 Projected interest rates RSCIR 18% RSCIR 7-year rate projection 16% 14% 12% 10% Rates in 2045 AIRG 5% percentile 1.179% 50% percentile 4.679% 95% percentile 9.464% 95th percentile 75th percentile 25th percentile Historical Average 8% 6% 4% 2% 0% Page 20

22 Sample RSCIR scenario 10% 8% 1 year 7 year 20 year 6% Low regime High regime 4% 2% 0% Page 21

23 Cash flow testing Deterministic scenarios We built a deferred annuity (DA) model and ran cash flow testing projections. Minimum guarantees ranging from 1% to 4% We tested the deterministic NY7 scenarios in the DA model. CFT Results: 30-year projections, in millions $ NY7 Description Ending Surplus 1 Level Increasing 3,787 3 Up/Down 1,272 4 Pop Up 3,247 5 Decreasing (522) 6 Down/Up Pop Down (592) Page 22

24 Cash flow testing Stochastic scenarios Ending Surplus: 30-year projections, in millions $ VaR AIRG RSCIR 7.5% trans. pr. RSCIR 15% trans. pr. RSCIR 30% trans. pr. 50.0% 1, ,024 1, % 1, % 575 (166) (62) % 226 (430) (470) (557) 99.5% 102 (489) (693) (721) Compared to the AIRG, RSCIR produced results with: Higher probability of asset deficiency Increased tail risk Page 23

25 Worst scenarios AIRG Only 2 out of the 1,000 scenarios generated negative ending surplus. The worst scenarios are the ones with extremely high rates (20%+ 7-year rate) Scenarios where rates stay low are the next group of worst scenarios 7-year rate (%) Worst AIRG Scenarios #1 worst scenario #2 worst scenario #3 worst scenario #4 worst scenario #5 worst scenario Projection year Page 24

26 Worst scenarios RSCIR The worst scenarios under RSCIR captured the scenarios that companies considered to be the most significant risks: Prolonged low interest rates Rapid increase in interest rates at different projection periods 7-year rate (%) Worst RSCIR Scenarios #1 worst scenario #2 worst scenario #3 worst scenario #4 worst scenario #5 worst scenario Projection year Page 25

27 Takeaways Key questions What is the current interest rate environment and outlook? How do low interest rates impact the life insurance industry? What are the common interest rate assumptions adopted by life insurers? How do commonly used economic scenario generators (ESGs) cope with the current low interest rate environment, and what are their limitations? What alternatives can practitioners explore? Takeaways Interest rates have stayed low, and there is a lot of uncertainty on where the rates are headed. The exact impacts are company specific but low interest rates have generally been hurting the bottom line and forcing companies to rethink their investment strategy and value proposition. Companies often assume rates will revert to historical averages, but there is a wide range of assumptions on how exactly this will happen. Commonly used ESGs may not fully address the unique challenges presented by the current low interest rate environment. Practitioners need to understand the inherent assumptions underlying their tools and enhance their analyses with alternative tools, such as regimeswitching features. Page 26

28 Questions? We are interested in hearing your thoughts Marshall Lin Office: Francisco Orduña Office: Page 27

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