As the crisis unwinds, it is almost certain that there will be a more deleveraged financial system and a substantially different regulatory environment. In the near- to medium-term, it is likely that the global economy will remain volatile, with accompanying uncertainty in the equity and credit markets. With all of this in mind, what should insurers focus on in this changing environment? Which changes to Asset/Liability Management (ALM) and Enterprise Risk Management (ERM) can help companies ride out the current crisis and even come out of it even stronger?
First and foremost, insurers need to take a longer term view of their business and investment portfolios. If they establish a more top-down view of balance sheet risks and develop risk management approaches that allow them to more successfully withstand volatile markets, then they should be able to effectively manage their risks in changing economic cycles.
The life industry's portfolios in particular have changed significantly in the past few decades. As Figure 1 shows, they are much more complicated than they used to be. Assets include structured classes and both callable and embedded options. Liabilities include some embedded options that policyholders' have an economic incentive to exercise, and others (e.g. contingent on mortality/longevity events) which they cannot.
Historically, life insurance used a simple, protection-oriented business model. Liabilities were valued with traditional actuarial approaches and insurers generally allocated their assets conservatively in simple fixed income classes. In recent years, however, wealth accumulation products such as variable and fixed deferred annuities have gained popularity as baby boomers plan for retirement. More and more insurers are offering guarantees (which represent short positions) on top of more dynamic wealth accumulation or life protection products. In addition, more and more companies have allocated assets to structured classes such as CDOs or CMBS. Furthermore, some large variable annuity writers' hedging programs have totally re-shaped their balance sheets.
Generally speaking, there are three categories of insurers:
Some large insurers have diversified business portfolios that are a combination of the categories described above.
The distinctive nature of individual companies puts them at different competitive advantage/disadvantage depending on market cycles. Clearly, the extreme bear market in late 2008 - which was characterized by a plunging stock market, sky-rocketing equity volatility, and low interest rates - has substantially hurt embedded option carriers. GMxBs of variable annuities often have roll-up, ratchet or step-up features, which negatively affect insurers when equity markets fall. Separate account carriers also suffered, though to a lesser extent than embedded option carriers, because their incomes declined as a result of lower account values.
Other than suffering declines in the value of their investment portfolios, most general account carriers have weathered the crisis reasonably well thanks to their relative isolation from the volatility of the financial market. In contrast, many embedded options carriers are de-risking their products and some are even considering exiting their current business (e.g. variable annuities).
It is increasingly clear that insurers will continue to significantly restructure both the assets and liabilities on their balance sheets. It also is likely that there will be industry consolidation once a recovery begins apace. However, insurers cannot afford to misinterpret the current situation as a solely temporary one or the result of a market overreaction. Management needs to think broadly about how the industry is changing and develop clear strategies to ride out future economic cycles.
How can insurers ensure they will be adequately capitalized in a less leveraged financial world? If high inflation and interest rates return, how should insurers mitigate the disintermediation risk and how will policyholder behavior change?
History can teach us a great deal about managing economic cycles. As figure 2 shows, the U.S. economy has experienced seven recessions in the past 40 years. Although circumstances have varied leading up to each recession, downturns generally correspond to distortions in:
Declining yet already low interest rates have been the rule since 2001. However, this has been an aberration - albeit a fairly lengthy one - that has corresponded to unusually low rates of inflation (other than in equities and real estate).
The converse of the past decade was the inflationary mid-1970s to mid-1980s, which saw interest rates top 20 percent, and substantially affect the insurance industry. Life policy surrenders and policy loans increased to higher than anticipated levels, which resulted in disintermediation risks for insurers. Many of them had to liquidate their assets in order to pay off cash withdrawals from the general accounts. As noted in one recent report published by Bridgewater Associates [1], in the early 1980s, policy lending had reached 9.3%25. In the same period, policy surrenders had reached 12.3%25 (compared with 6.7%25 in 2007). When interest rates fell in the late 1980s and guaranteed crediting interest rates on policies were higher than what companies made on investments, cash inflows into insurance companies immediately caused capital challenges and rating downgrades.
What relevance does this have to current conditions? Many economists believe that there is a good chance high inflation and interest rates will return in near- to medium-term. They base their views in large part on the Federal Reserve's aggressive policy of increasing the US dollar supply. For example, in March 2009, the Fed announced a plan to buy $1 trillion in debt (including up to $300 billion in longer-term Treasury securities and an additional $750 billion of mortgage-backed securities) in order to unfreeze the credit markets in the midst of financial crisis. This aggressive policy could undermine dollar values, which in turn could drive up interest rates - although no one can predict with certainty if and when this will occur.
[1] "The Coming Insurance Industry Crisis", Bridgewater Associates, Inc, March 2009
In addition, substantially increasing government spending (and the deficit), as well as the United States' international trade deficit, might further shake investor confidence in the dollar's long-term value - all of which compounds the risk of inflation and rising interest rates. Conversely, if high unemployment and lower wages persist, and both consumers and business continue to cut expenditures, then a deflationary spiral is possible. The latter scenario would be especially pernicious because, in light of the fact money market rates are already close to zero, policymakers do not have the flexibility to lower rates to stimulate demand.
The authors cannot predict the future, but effective risk management is not about predicting the future as much as it is about preparing for what is possible. Insurers, especially general account carriers, have to be aware of and prepare for uncertainty about inflation, deflation, and interest rate movement.
The equity market has gone through many cycles in the past 40 years. In general, equity cycles switch more frequently than credit cycles, are more seriously affected by crises (especially crises of confidence), and often bottom out swiftly. As shown in figure 3, the U.S. stock market - thanks in large part to technological developments - experienced unprecedented growth starting in the mid-1990s. However, this growth was interrupted by three serious crashes resulting from the Asian financial crisis of 1998, the bursting of the internet bubble in 2001, and the bursting of the credit bubble last year.
Embedded in these market cycles has been a number of volatility cycles (see figure 4). Between 2004 and late 2007, volatility was relatively low, but it soared to an extraordinarily high level in the middle of last year's financial panic. For embedded option carriers who offered short positions such as GMxBs on variable annuities, increased volatility substantially hurt their bottom line and capital strength. In light of ongoing volatility, the GMxB business faces an uncertain future as guarantees have created extreme stress on insurers' balance sheets.
In order to avoid or at least better manage future volatility, insurers need to give serious thought to the following questions:
Life insurance companies, which by their nature are supposed to endure, will inevitable face many severe economic shocks such as the inflation of the 1970s and the systemic shock of 2008. Insurers' risk appetites are generally high when the economy peaks, and are much lower when the economy contracts. However, this tends to result in a reactive rather than proactive approach to managing economic cycles. As figure 5 shows, management would be better served by taking a long-term perspective and dynamically managing the business throughout economic cycles.
Initially, it is good practice to anticipate the scenarios that could unfold in the next cycle and what action is needed to both protect the company's balance sheet and ease future earning volatility. For example, when interest rates are low, management should consider what may happen if they rise. Purchasing interest rate caps when interest rates are low is economically advantageous and is clearly a strategically sound way to protect a company. Furthermore, when interest rates are high, companies could purchase interest floors when their market price is low. Interest rate floors would have offered inexpensive protection 20 years ago, and it is possible that interest rate caps offer inexpensive protection today.
Dynamic risk management also can include adjusting risk and product design pricing. At the bottom of an economic cycle, when policyholders' risk aversion is high and there is increased demand for guarantees, insurers that maintain high ratings have the ability to charge higher prices for the long-term risks (e.g., long-term disability) they offer. Management should have a clear understanding of policyholders' economic incentives and how they may exercise guarantees. For example, in anticipation of higher future interest rates, companies may offer products with higher or longer surrender charges on their UL products. Furthermore, some existing variable annuity guarantees, such as roll-ups, step-ups and ratchets, are clearly at odds with dynamic cycle management; accordingly insurers should determine if they can continue to offer them.
Another way for individual companies to manage economic cycles is by purchasing contingent capital as a supplement to economic capital [2]. As one example, in the midst of the financial crisis, many variable annuity writers started macro-hedging programs to avoid further losses and protect their balance sheets from equity market declines.
Finally, management should have a clear view of and strategies for determining which risks on their balance sheets it needs to transfer or exit, and when to do so. For example, at the bottom of an equity market cycle, it is probably unwise to exit the variable business and expand the general account business. As another example, when they face considerable equity or credit market uncertainty, companies should consider expanding into less capital intensive businesses and take on risk (e.g., mortality) that is less correlated to the markets.
In conclusion, insurers need to take a long-term view of their business and investment portfolios. If they establish a more top-down view of balance sheet risks and develop risk management approaches that allow them to more successfully withstand volatile markets, then they should be able to effectively manage their risks in changing economic cycles.
[2] "The Coming Insurance Industry Crisis", Bridgewater Associates, Inc, March 2009 See Rubin and Shi, " Contingent Capital: Stepping into Strategic Capital Planning", August 2008, PwC American Insurance Digest
As importantly, effective risk management is not about predicting the future as much as it is about preparing for what is possible. Because very few things in this world are certain, a wide range of plausible "what ifs" and potential responses to them deserve careful consideration. In his book The Black Swan, Nassim Taleb talked about two different worlds, Mediocrastan and Extremistan. Risk management typically operates under the assumption that we live in Mediocrastan, where investment returns and deviations are based on the standard normal distribution. Managing for the long-term requires us to manage as if we are in Extremistan. When market interest rates were 10%25, the interest rate scenario of sustained rates below 1%25 was in Extremistan, not Mediocrastan. In today's environment rates above 10%25
Accordingly, while history never repeats itself exactly, it is prudent to examine long-term investment trends - as well as the micro-trends inside long-term trends - when considering what may happen in the future. While such an approach will not immediately reverse the damage the recent financial crisis has caused to many insurers' balance sheets, it can help strengthen ALM practices and prevent similar stresses from recurring in the future.