Session 9b L&H Insurance in a Low Interest Rate Environment. Christian Liechti

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1 Session 9b L&H Insurance in a Low Interest Rate Environment Christian Liechti

2 L&H Insurance in a Low Interest Rate Environment SOA Annual Symposium June 2013 Macau, China Christian Liechti Swiss Re Hong Kong Agenda Interest rates on the fall Impact to life insurers How to mitigate interest rate exposure What lies ahead? 1

3 Nominal and real interest rates in decline Over the last years nominal interest rates have been trending downwards. However the real interest rates have also been trended downward in the last few decades Nominal and real 10y government bond yields for the US and the UK from 1900 to present Hong Kong is no exception HKD pegged to the USD and with constant flow of funds into the country nominal interest rates decreased over the past decade Hong Kong's Government Bond Yield for 10 Year present 2

4 How are (life) insures affected by interest rates? (I) Premium rates: Since investment income is shared with the policyholder for a lot of life insurance products, the premium fall with higher interest rates and vice versa Premiums required to fund a 100k endowment benefit with a 20y policy under different interest rate assumptions How are (life) insures affected by interest rates? (II) Demand: in general lower interest rates, lower demand as this for example the case for UK annuity business during the low interest years after 2008 Balance sheet: In a perfect word with perfect Assets Liability match, the value of a company will not change with moving interest rates. However there are limitations to this due to duration mismatches, due to the lack of long-term assets to back up long-term liabilities different valuation of assets and liabilities, e.g. under US GAAP assets are mostly marked to market and liabilities are book value Investment income: Falling interest rates translate into lower investment returns and therefore lower profitability Policyholder behaviour: may be sensitive to changes in interest rates and other economic developments as well as psychological factors, which can undermine the insurer's cash flow projections 3

5 Who cares about Interest Rate? Google searches between 2004 present: Life insurance Interest Rate Value of (life) insurers decreases in low interest rates environment Declining interest rates generally result in higher prices and lower demands for life insurance products, lower investment income and often decrease the economic value of life insurance companies As a consequence, equity analyst tend to reduce their projections of life insurers earnings as interest rates fall Insurers price-tobook values and long term interest rates 4

6 Importance of investment income for life insurance products Comparison of sources of profit for typical life risk (protection) and savings products: Main source of profit for the risk product is the u/w margin, with investment income adding only little to the to the overall earnings Main source of earnings in a savings product is investment income, with u/w margin is making only a minimal contribution. Obviously, the endowment insurance earnings pattern is linked to financial market performance and is hence much volatile. Bulk of life insurance premiums stems from savings products About 15% (USD 375bn) of the USD 2,500 bn in global l life insurance premiums are protection ti premiums Largest source of premium income of primary insurers is savings business and an even greater portion of assets is related to savings business The bulk of life insurance profits and risks are also related to savings business, thereby making them very sensitive to interest rate risk 5

7 Profitability of savings business is impacted asymmetrically by interest rate moves Protection Products Savings Products Interest rates decrease increase decrease Increase Demand Demand fll falls as Demand rises as Demand rises if Demand fll falls if the price for protection increases the price for protection decreases guarantees are adjusted with time lag guarantees are adjusted with time lag Policyholder behaviour Profitability Lower number of laps, driven by higher market price and higher risk charge at age of surrender Likely minor negative impact No major impact on lapses as lower market price are (partially) offset by higher risk charges Likely minor positive impact Low lapses, as policyholder tend to keep in the money interest rate option and might increase premium payment if allowed Profitability falls due to lower investment margin. Falls sharply once investment return falls short of guarantee Higher number of lapses can be mitigated if attractive bonuses are credited and/or high surrender charges Profitability increases modestly, since insurer participates only to some degree in investment return in excess of guarantee Reported interest rate sensitivies - Europe Life EV / EVM Interest Rates 1% Increase 1% Decrease Group Equit y Solvency Ratio (pt) Life EV / EVM Group Equit y Solvency Ratio (pt) Lapse Rates 10% Increase Life EV / EVM Aviva -4% -6% 2% n.a. n.a. -7% n.a. L&G -3% 1% n.a. 3% -1% n.a. n.a. Prudential -3% -14% n.a. 2% 14% n.a. n.a. Aegon -1% -15% n.a. 0% 13% n.a. n.a. Allianz 7% -9% 21% -14% 9% -22% n.a. Axa 5% -14% 7% -12% 15% -15% n.a. Generali 8% -11% 5% -15% 11% -23% -2% Talanx 16% n.a. n.a. -38% n.a. n.a. -8% Zurich 3% -16% 3% -2% 17% -11% -4% Source: Company financial statements and Swiss Re calculations For most insurance companies, EV and solvency react positively to a modest increase in interest rate IFRS equity shows negative sensitivity due to the accounting mismatch in most markets 6

8 How to mitigate interest rate exposure risk? (I) Matching the duration of assets and liabilities But lack of long term assets complicates insurers' ALM Technical provisions of insurance companies vs. outstanding government bonds How to mitigate interest rate exposure risk? (II) Hedging policyholder behaviour risk However, adequate modelling is challenge due to policyholders may not react completely rationally to moves in interest rates, since they are not aware of the economic value of their options, are not aware that they could exercise them, or simply because of inertia policyholder behaviour may be driven by factors other than interest rates, e.g. developments in housing markets, concerns about insurers solvency, or liquidity needs of policyholder are important di drivers of fthe behaviour incomplete information may mislead insurers about policy behaviour. Due to a lack of adequate historic data for modelling, it is difficult to analyse. Further policy behaviour might also change in the future as financial literacy improves 7

9 Mitigate policyholder risk through product design New product features should be designed to effectively manage financial, life and policyholder behaviour risk. Balance between policyholder options and insurers hedgeability should be given Among savings products, there are a variety of design features than can reduce sensitivity to changes in interest rates: level of guarantee: the lower, the less likely market will breach flexibility of guarantee: flexible upwards and downward duration of guarantee: annual vs. lifetime guarantee surrender features right to increase payments/sum insured Balancing the cost and benefits of insurance options and guarantees Of course the policyholders and the sales force would like to have interest rates guarantees as high and as for many years as possible and would also like to have generous surrender options etc. such options and features come with a cost, is the policyholder prepared to bear them? Challenge is to strike the balance between the benefits of embedded options and their cost to make the savings product more attractive to the customer Example: in a simple guarantee product, with no mortality protection or other options, the cost of a fixed-interest rate guarantee increases disproportionally with the maturity Approximate cost of guarantees at different levels and maturities 8

10 What lies ahead? A Japan-style life insurance industry crisis? (I) In today's low interest rate environment, there are concerns that the global life insurance industry will suffer the same as Japanese life insurers in the late 1990s A quick look back: losses in foreing currency holdings led to crazy sales of insurance products with aggressive investment practices Life insurers clung to high guarantees despites falling bond yields and deteriorating stock markets Loss of credibility triggered a spike in surrenders Interest rates for the valuation of new policies from 1970 to present How does it go on? A Japan-style life insurance industry crisis? (II) Japanese life insurance breakdown in Japan was the result of an accumulation of many negative trends, including a decline in interest rates Measures have been taken: strengthening accounting rules and assessing policy risk lowering guarantee levels Japan illustrates, life insurers can operate successfully in low interest rate environment Today's global l life insurers are generally in better shape than Japanese insurers were in the 1990s 9

11 Three scenarios for the future and their impact in life insurance 1) A gradual cycle of rising and falling interest rates ideal scenario - demand and profitability may fluctuate with interest rates, but better and worse years offset each other over time. No pressure to adjust pricing and guarantees. Policy behaviour is unlikely to deviate strongly form underwriting assumptions and can be managed. 2) A prolonged period of low interest rates Life insurers with long-term rigid interest rate guarantees suffer as investment fall short. Policies stay longer than expected on their books. Overall demand in life insurance will be low. 3) An inflation spike leads to a surge in nominal bond yield Would be very stressful for life insurers geared towards interest rates savings business. High lapses expected, resulting in losses in production costs as well as fixed-income assets at a loss. Protection products would not be affected significantly How dangerous is the Interest Rate Spike? 10

12 Increase in lapses after interest rate spike in the region (I) Market Japan China Hong Kong Product Single Premium Participating Single Premium WoL Endowment & WoL Non Investment linked Product features that increase exposure to lapse after interest rate spike: Inflexible interest rate guarantee No market value adjustment to surrender values Limited or no surrender charge Limited it or no tax benefit Overall exposure to interest rate spike High Medium Low interest rate exposure Increase in lapses after interest rate spike in the region (II) Japan Single Premium WoL portfolio sold via banks is most vulnerable in interest rate scenario 10y interest rates is near all-time low despite aggressive governmental stimulus package and monetary policy. China Interest rate spike would be mainly a concern for life insurers with long term portfolio 80% of China individual long term product sales is participating Level of policy annual bonus has material impact on the consumer willingness to purchase insurance an maintain the policy, especially for the bank channel Probability of interest rate spiking in China is low Hong Kong About 35% of total premium in 2011 was single premium non investment linked products Most sold through agents Most long term products have fixed interest rates guarantees and no market value adjustment to surrender values, which will increase lapse rates during interest rate spike Low risk of interest spike due to peg to USD 11

13 Questions? Thank You 12

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