Changes in ALM under LAGIC Gerard Callaghan Peter Baker 2014 Deloitte Actuaries & Consultants Limited This presentation has been prepared for the Actuaries Institute 2014 Financial Services Forum. The Institute Council wishes it to be understood that opinions put forward herein are not necessarily those of the Institute and the Council is not responsible for those opinions.
Agenda - Impact of LAGIC changes on Life Insurer Capital Slides 3-7 - Target surplus setting Slides 8-10 - How to manage the resulting volatility Slides 11-13
LAGIC has made capital requirements more risk sensitive - Now risk based rather than scenario based - Key impacts on Capital (old vs new): - Asset risk charges are higher - Explicit stresses on inflation (liabilities) and infrastructure (assets) Prudential Capital Requirement PCA Asset Risk Charge Insurance risk charge Aggregation Benefit Supervisory Adjustment Combined Stress Scenario Adjustment Single Scenario - Net DTA must be written off - Less diversified insurers suffer small amount of diversification benefits - Some insurance stresses now not so conservative as scenarios implied - Explicit operational risk charge Operational Risk Charge Asset Concentration Risk Charge Individual charges less AB plus Adjustments APL - Liability cliff sudden impact of Policy Liability exceeding TV - Asset cliff sudden impact of PH assets running out.
Decreasing volatility - Insurance risk some stresses less conservative - Diversification helps to smooth capital Capital requirements are more volatile Increasing volatility - Larger asset stresses now applied - Explicit CPI stress (liabilities) and infrastructure stress introduced - Illiquidity premium Risky annuity book illiquidity premium Capital Requirement - Annuities, 80% FI risky assets, 20% Equities, plus illiquidity prem Capital 14.00 12.00 10.00 8.00 6.00 4.00 2.00 0.00 Mar-07 Aug-07 Jan-08 Jun-08 Nov-08 Apr-09 Sep-09 Feb-10 Jul-10 Dec-10 May-11 Oct-11 Mar-12 Aug-12 Jan-13 Jun-13 Nov-13 Old New FI book stronger stresses Capital Requirement - Risk, 100% FI Axis Title 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 Standard Deviation Mar-07 Aug-07 Jan-08 Jun-08 Nov-08 Apr-09 Sep-09 Feb-10 Jul-10 Dec-10 May-11 Oct-11 Mar-12 Aug-12 Jan-13 Jun-13 Nov-13 Risk 100% FI Old New Annuities w/illiq prem 80% risky FI, 20% Eq Old New Old New Last 4 years 0.35 0.75 0.11 0.39 Last 2 years 0.11 0.22 0.07 0.32 More volatility under both scenarios. Risk scenario: 30% CGS, 60% CGS indexed bonds, 10% corporate debt (AA rating). Ca 3yr effective duration. Annuities scenario: 10% CGS indexed bonds, 70% corporate debt (AA rating), 20% equities. Source: Deloitte analysis.
Volatility from new risks : Solvency 2 example Liabilities are discounted using Swap (LIBOR) based rates Inflation (RPI / LPI) and interest rate swap cash flows use are discounted using Overnight Index Swap (OIS) rates (i.e SONIA) when marking to market Historically SONIA and LIBOR were almost identical This changed dramatically during the GFC meaning liabilities did not move similarly to assets as was expected Could something similar happen in stressed conditions in Australia? Liabilities discounted at Commonwealth government bond yields Swaps pricing based on BBSW and discounted using OIS rates?
Pre Crisis Mid Crisis Post Crisis Difference between LIBOR & SONIA almost zero % 15 October 2008 SONIA vs LIBOR 5.1 4.9 4.7 4.5 4.3 4.1 3.9 3.7 3.5 29 Oct 2013 SONIA vs LIBOR 5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 % Sonia Terms (yrs) Libor Sonia Terms (yrs) Libor Difference Difference Difference Difference almost zero Difference LIBOR - SONIA % 1.2 1 0.8 0.6 0.4 0.2 0 % Difference LIBOR - SONIA 1.2 1 0.8 0.6 0.4 0.2 0 Terms Terms
Yieldds (%) 9 8 7 6 5 4 3 2 1 0 Australian 5 year swap spreads 01/03/2004 01/11/2004 01/07/2005 01/03/2006 01/11/2006 01/07/2007 01/03/2008 01/11/2008 01/07/2009 01/03/2010 01/11/2010 01/07/2011 01/03/2012 01/11/2012 01/07/2013 01/03/2014 140 120 100 Government yield Swap rate Swap Spread 80 60 40 20 0 Swap Spread (bp) Yieldds (%) 8 7 6 5 4 3 2 1 0 Australian 10 year swap spreads 01/03/2004 01/11/2004 01/07/2005 01/03/2006 01/11/2006 01/07/2007 01/03/2008 01/11/2008 01/07/2009 01/03/2010 01/11/2010 01/07/2011 01/03/2012 01/11/2012 01/07/2013 01/03/2014 120 100 Government yield Swap rate Swap Spread 80 60 40 20 0 Swap Spread (bp)
How to manage a volatile capital position? Accept a certain level of volatility through risk appetite and set commensurate target surplus? Actively seek to reduce volatility tighter hedging programs (e.g. inflation), asset allocation? A bit of both?
Formalisation of Target surplus setting ICAAP has formalised the process of target surplus calculation: What do we need target surplus for? New business Change in market conditions more so than before Change in risk from assumption changes Considerations to include Board s risk appetite framework Sensitivities of PCR calculation Business plan considerations Access to capital / shareholder preferences Desired credit rating Source: Ian Laughlin, FSAA presentation, 6 June 2013 http://www.apra.gov.au/speeches/documents/fsaa-presentation-3-june-2013-ian-laughlin-for-publication.pdf
Approaches to Target surplus setting How is it typically done? Par funds in run-off need for derisking Advantages Disadvantages Market popularity LAGIC approach, but with stronger shocks Stress and scenario testing approach Clear, objective calculation Aligned with LAGIC/ICAAP Can be built on existing LAGIC calcs Aligned with ICAAP Easy to explain to management More volatile Need to watch out for cliffs Technical to explain movements to management Still less common, but gaining popularity Subjective Less popular to the extent required under ICAAP High level allocation Stable Easily understood Can lead to higher amount of excess assets inefficient Popular amongst wellcapitalised companies Combined approaches (high level plus LAGIC) Best of both worlds Additional work Popular amongst larger sophisticated companies
How to Improve target surplus setting Review of risk appetite how close to PCR are companies willing to get given increased volatility over a longer time horizon? More detailed approaches for ICAAP and target surplus setting using stress and scenario testing over a longer time horizon? Averaging target surplus across multiple periods to smooth volatility? Shareholder communication!
Actively managing the volatility Closer A/L matching specifically around duration, inflation linked cash flows, and risk of assets Working with banks to refine hedges Asset allocation changes asset teams to consider post-capital returns before changing asset allocations Push for diversification ; review product and asset allocation? Governance and organisational structure Closer interaction between pricing and ALM teams Reward behaviour which controls volatility within risk appetite
Asset allocation and hedge effectiveness Example product : Disability Income Contract Features : CPI linked monthly payments to policyholder till recovery or death Economics Best Estimate Liability = Assets $100m Duration Inflation Sensitivity Hedging Strategy Interest rate swaps + Equity CPI swap + 5 year AA Fixed Interest 5 years $0.05m per bp Approximate Capital Charges $40m equity + $6.25m inflation = $46.25m $4.6m credit risk Interest rate swaps hedge duration risk Equities provide real returns to match CPI linkage Very large equity capital requirement Large inflation risk requirement Fixed interest hedges duration risk CPI swaps hedge inflation mismatch Only credit risk capital charge Demand for CPI Swaps is increasing Closer attention to interest rate matching Groups need to understand the LAGIC impacts for trade off decisions on asset mix and return on capital
Actively managing the volatility Economic capital regimes (e.g. in the UK) have resulted in much closer links between ALM functions and pricing functions because capital is costly! Pricing Aim to maximise returns on economic capital ALM Governance & Management Information Reporting Decisions on what CPI and Interest rate hedges should be used follow from this» removal of unrewarded risks e.g. inflation and rates Asset Mgt
Catalysts for further change to ALM Large superannuation lump sums are accumulating Aging population & increasing life expectancy Increasing shift towards purchasing annuity type products? Demand for hedges (interest and CPI linked) increases Development of swaps such as CPI, Limited CPI with caps and floors e.g. in UK Banks structuring derivatives to hedge longevity e.g. longevity swaps