Transcript Interest Rate Risk in a Low Interest Environment:

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DISTRIBUTERS’ SUMMIT
Niagara Falls, ON, Canada
June 8, 2012
Professor Bernie Wolf, PhD
Schulich School of Business
York University
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THE RISKS OF A LOW
INTEREST RATE
ENVIRONMENT:
Challenges for the
Managing General Agency
(MGA) Sector
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Importance of Interest Rates I
• Why focus on interest rates?
The key idea is that a yield bearing asset, with a
fixed interest rate, changes in value as interest
rates change. When interest rates rise (fall), the
asset declines (increases) correspondingly in
value.
In insurance parlance, interest rates determine the
annuity payouts.
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Importance of Interest Rates II
• For example, a perpetual bond with a $1K
principal, yielding 2% or $20 annually,
would fall to approximately half the value, if
interest rates increased to 4%. Similarly,
with interest rates at 10%, the bond would
be worth only $200 because a new bond
would be yielding five times as much.
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Interest Rates Are Historically Low
• Interest rates have remained at
historically low levels even since
before the financial crisis, but recently
have dropped to the lowest levels in
decades because the aftermath of the
financial crisis continues, especially in
the form of high unemployment!
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Interest Rate Risk
• With the U.S. Federal Reserve indicating
it may not raise rates until late 2014,
there are serious implications for life
product guarantees.
• What does this low interest rate
environment mean for the industry, and
how will companies have to rethink
pricing as a consequence?
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Interest Rate Setting I
• Short term interest rates are by and large set by
central banks. In Canada, it is the Bank of
Canada (BOC). In England, it is the Bank of
England. In the Euro Area, it is the European
Central Bank. In the US, it is the Federal
Reserve.
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Interest Rate Setting II
• In some cases, central banks overtly try to
influence longer term interest rates and the
overall yield curve. For example, the Fed has
applied “Operation Twist.” As part of “Quantitative
Easing (QE),” the Fed has purchased mortgage
backed securities and long term bonds in order to
reduce longer term rates when it could no longer
reduce short term rates since negative nominal
rates are problematic . A reversal of QE will
mean higher longer term rates.
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Historic 10 year US Treasury Bond Rates
• Year
•
•
•
•
•
•
•
•
•
Rate (%)
1962-69
4.85
1970-79
7.50
1980-89
10.59 [1980-85 all double digit years*]
1990-99
6.66
2000-09
4.44
2010
3.22
2011
2.78
Current
1.47 [Easy to see that rates are
at historically low Levels]
*[highest rates in 1981: 13.92%]
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June 1, 2012 -- 10 year Bond Yields and
+/- German Bunds I
•
• Switzerland
%
0.53
• Japan
0.81
• Denmark
0.97
• Germany [Bunds] 1.17
• US [T- bonds]
1.47
• UK [Gilts]
1.54
• Canada
1.64
% Points
-0.64
-0.35
-0.20
----+0.30
+0.37
+0.47
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June 1, 2012 -- 10 year Bond Yields and
+/- German Bunds II
•
• France
• Australia
• Belgium
• Italy
• Spain
• Ireland
• Greece
%
% Points
2.25
2.78
2.94
5.87
6.52
7.44
30.54
+1.08
+1.61
+1.78
+4.70
+5.35
+5.97
+29.37
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Interest Rate Setting III
• Generally, interest rates are set to keep inflation
at bay since price stability is generally a central
bank’s chief function, though the Fed also has an
full employment mandate.
• The BOC recently affirmed its inflation target as
2%, within a control range of 1% to 3%, based on
the 12 month rate change [going forward] of the
“headline” Consumer Price Index [CPI] inflation.
However, operationally, to avoid being clouded by
changes in volatile items, the BOC concentrates
on “core” inflation, which filters out volatile items
such as gasoline prices.
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Interest Rate Setting IV
• A key part of the BOC's strategy is to keep
inflationary expectations in line with the targets
because expectations feed into wage demands
and pricing.
• There is a “normal” bank rate range associated
with the BOC inflation target and we are well
below that norm.
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Interest Rate Setting V
• The BOC looks at current inflation and
forecasts it into the future looking at
capacity utilization, unemployment rates,
discouraged unemployed that are not in the
labour force, and the component of
unemployment that is due to the degree of
mismatch between the types of jobs
available in a region and the qualifications
of the job-seekers.
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Interest Rate Setting VI
• Another consideration needs to be how Canada’s
interest rates compare to those elsewhere in the
world since higher interest rates relative to other
countries tend to push up the value of the
Canadian dollar, which discourages exports.
• Commodity prices are an additional factor that
links inflation and the exchange rate.
• Also, the BOC needs to monitor economic
conditions in other countries, particularly
important export customers since exports are a
vital part of our GDP.
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Interest Rate Setting VII
• As well, geopolitical events related to levels
of economic confidence, such as in the
Southern tier of the Euro zone, need to be
weighed in.
• Finally, a precipitous large increase in
interest rates could cause financial panic at
worst, or financial discomfort at the very
least, among those who are overly
leveraged and dependent upon low interest
rates to meet their obligations.
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Interest Rate Setting VIII
• The BOC has repeatedly said that interest
rates would rise from current levels since a
overnight rate of 1.00% is so low compared
to earlier periods. The question is just when
do the rates rise and by how much at a
time?
• [The prime rate offered by Canadian
commercial banks, corresponding to the
overnight rate is currently 3.00%.]
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Governor Mark Carney’s Own Words I
• The outlook for global economic growth has weakened in
recent weeks. Some of the risks around the European
crisis are materializing and risks remain skewed to the
downside. This is leading to a sharp deterioration in global
financial conditions. While the U.S. economy continues to
expand at a modest pace, economic activity in emergingmarket economies is slowing a bit faster and a bit more
broadly than had been expected. More modest global
momentum and heightened financial risk aversion have
reduced commodity prices.
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Governor Mark Carney’s Own Words II
• Although economic growth in Canada was slightly slower than
expected in the first quarter, underlying economic momentum
appears largely consistent with expectations. However, the
composition of growth is less balanced. In particular, housing
activity has been stronger than expected, and households
continue to add to their debt burden in an environment of modest
income growth. Despite external events, business and household
confidence has held up and domestic financial conditions remain
very stimulative. The contribution of government spending to
growth is expected to be quite modest over the projection horizon,
in line with recent federal and provincial budgets. The recovery in
net exports is likely to remain weak in light of modest external
demand and ongoing competitiveness challenges, including the
persistent strength of the Canadian dollar.
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Governor Mark Carney’s Own Words III
• The Canadian economy continues to operate with a small
degree of excess capacity. Total CPI inflation is expected to fall
below 2 per cent in the short term, as a result of lower gasoline
prices, while core inflation is expected to remain around 2 per
cent.
• Reflecting all of these factors, the Bank has decided to
maintain the target for the overnight rate at 1 per cent. To the
extent that the economic expansion continues and the current
excess supply in the economy is gradually absorbed, some
modest withdrawal of the present considerable monetary policy
stimulus may become appropriate, consistent with achieving
the 2 per cent inflation target over the medium term. The timing
and degree of any such withdrawal will be weighed carefully
against domestic and global economic developments.
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Short Term Vs. Long Tern Interest Rates
• Most insurance products depend upon long
term interest rates rather than short term
rates. Essentially long term rates can be
viewed as the market’s expectation of short
term interest rates over time plus a term
premium. Currently, as we have already
seen, 10 year rates in the US, Germany
and Canada are extremely low, particularly
German bunds which are seen as a “safe
haven” within the Euro zone.
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Impact of Low Interest Rates
• 1. Obviously, clients find it much more
difficult to accept fees of say 2% when
gross returns are 3% than when they are
6%.
• 2. Universal life polices, where interest
rates determine how long the insurance will
be in effect, may end prematurely [my own
bad experience!].
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Implications for the Insurance Industry I
• Low interest rates provide the following difficulties:
• 1. Insurance companies suffer financial hardships when they
have guaranteed minimum payout rates during a previous
higher interest rate era without locking in high rates on their
own assets.
For example, low interest rates have forced one insurance company to
reduce features offered on its guaranteed minimum withdrawal benefit
products.
Starting April 30, 2012, the company reduced its income payout
percentage on a segregated fund that features a cashable lifetime
annuity, by 75 basis points, depending on the age the client begins
making withdrawals.
•
•
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Implications for the Insurance Industry II
• 2. Low interest rates make annuity
payouts seem small. Hence, clients
shy away from them. To compensate,
insurance companies may have to
offer higher payouts, thereby
squeezing their profit margins.
• 3. ETFs, etc., may provide increased
competition for life products from
insurance companies.
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Implications for the Insurance Industry II
• 4. Insurance companies have to offer products
with variable payouts to minimize the risk for the
companies and for the client. The products
may also have the effect of squeezing profits.
• 5. Insurance companies have to add “bells and
whistles” to make annuities more appealing to
clients where extreme flexibility make high fees
seemingly more tolerable.
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Implications for the Insurance Industry III
• 6. With insurance companies and
brokers being pressed, the material in
the sandwich gets to be squeezed, in
this case, the MGAs!
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Conclusions: Some Advice I
• 1. For clients unwilling to accept annuities based on
low interest rates, and consequently low payouts,
insurance companies need to structure products
that are flexible and, which at the same time,
protect both the client and the companies from
adverse interest rate changes.
• 2. Make insurance products more attractive by
providing features desired by the clients.
• 3. Avoid the tendency to make products opaque to
the point that when the policy terms become
clearer, the client is unhappy. Transparency goes a
long way.
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Conclusions: Some Advice II
• 4. Make sure that insurance company
based life products are competitive with
alternatives such as ETFs.
• 5. MGAs need to provide feedback to the
insurance companies as to how to structure
products.
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THANK YOU!
Let’s have some Q & A!