Inflation and Its Impact on Life Insurance Companies June, 2011

Transcription

1 Inflation and Its Impact on Life Insurance Companies June, 2011

2 Inflation creates another source of uncertainty for life companies Inflation can touch nearly every aspect of life company operations: Assets Liabilities Operating costs Inflation often, but not always equates with interest rate increases The timing and magnitude of the near-term relationship between inflation and rates will matter tremendously Inflation in other markets especially equity markets could help de-value expensive equity market guarantees sold in the pre-crisis era Life insurers will have to take a broad look at their ALM strategies to manage through the uncertainty Just as the crisis has renewed demand for equity market guarantees at higher prices, an inflationary period should ignite demand for new products to protect against inflation risk 2

3 Inflation touches most aspects of the balance sheet Assets Rise in rates would harm most bond portfolios, though ALM is critical component Modest inflation may help equities increasing fee income vs. a sharper rise that could hurt markets and fees Liabilities Higher rates would be very helpful for virtually all long-dated guarantees This is especially true for some more recent product types with long durations o UL with secondary guarantees o VAs with living benefits Higher maintenance costs crimp value Customer behavior How will lapse unfold? Disintermediation risk in general account products High lapse could be a bailout for some guarantees 3

4 Inflation is typically predictive of future rate moves, but with a lag and a less than perfect correlation 15.00% 14.00% 13.00% US Inflation Rate Historically the lag between a shift of inflation and the shift in interest rates has been ~ 19 months. This lag has decreased in recent years (to less than 6 months) due to tighter monetary policy. Very High/Hyper-Inflation: Above 12% 12.00% 11.00% 10.00% 9.00% 10-Year Treasury Rate High Inflation: 8% - 12% 8.00% Rates 7.00% 6.00% Correlation: 59% 5.00% 4.00% Normal Inflation: 1.75% - 8.0% 3.00% 2.00% 1.00% 0.00% Low Inflation: 0% % -1.00% -2.00% Deflation: Below 0% 4 Source: US Bureau of Labor Statistics and Board of Governors of the Federal Reserve System. Note that historical data is not necessarily predictive

5 Historically, markets tend to be positively correlated with inflation at levels below 4.5% and negatively correlated at levels above 4.5% Deflation Japan in the 1990 s Japan: Current 3.50% Low economic growth and poor real estate and equity returns Average guarantees to policy holders declined slower than returns on asset classes High solvency ratios suffered due to high lapse rates and low revenues Government agencies helped re-capitalize books of failing companies Outside companies bought weakened insurers and seized market share (e.g. AIG) 37, , , , , , , Nikkei (Equity Market) Inflation Rate % 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% -0.50% -1.00% -1.50% Inflation US in the 1970 s US: Current 5 Ratio of assets to liabilities dropped sharply Stocks underperformed during initial period of inflation, the best time to own life insurance shares is following the initial adjustment to a high bond yield world Post-inflation, insurers with stronger balance sheets were able to take advantage of weakened competitors Source: Boston Consulting Group. Collateral Damage: Industry Focus. July $14,000 $12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $ Inflation Rate DJ Avg 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00%

6 EEV reporting provides a first pass guide to exposure Embedded value interest rate sensitivities to 100 bps shocks for US businesses of select carriers* Company (US business) EEV 2010 Increase Interest Rates 100 bps Decrease Interest Rates 100 bps AXA 6,795 euro million 392 6% (795) 12% Aegon 14,726 euro million 589 4% (736) -5% Prudential UK 5,566 euro million 4,799 GBP million (171) (148) -3% % Allianz 4,427 euro million (81) -2% (57) -1% Business mix will be a key determinant of exposure More elaborate sensitivity testing is needed to capture the nuances of an inflationary event, such as timing, magnitude and consumer behavior * Company EEV for AXA, Prudential UK and Allianz reflects US business. Company EEV for Aegon reflects Americas business 6

7 Consumer behavior will play a huge role in how an inflationary episode unfolds 2.50 UL Secondary Guarantees UL Secondary Guarantees in Billions ($) VA with GLB VA with Living Benefits in Billions ($) * - Lapse rates are more susceptible to general economic conditions than inflation particularly, though there is clearly a disintermediation risk tied to rate rises A rise in rates could help tremendously with some of the long-term guarantees that were sold in the last decade Life Insurance Lapse Rates - Source: Bernstein Research Life Insurance: Whither interest rates and will sentiment continue to trump economics (ACLI and the Federal Reserve) UL with secondary guarantees and VA with living benefits - Source: LIMRA s U.S. Individual Life Insurance Sales Survey and LIMRA estimates 7

8 DRAFT What can a life company do to be ready? Balance sheet Scenario testing of ALM and war gaming for extreme events Write the play book for the next crisis now When to hedge? When to unwind? When to start/stop selling certain products? How to communicate with constituents? Where is the portfolio now? How long should it be gapped, if it is? How well is convexity understood? Efficiency to avoid cost inflation Customers Do you have product designs for inflationary circumstances Floating rate? Indexed and how to hedge? Shorter duration Which channels and how to train/educate? Crediting policy Where is the desired spot on the map? How quickly to move if the market goes away from you? Retention Is there a dedicated unit? How effective/how could it ramp? 8