(Excerpts from presenation at Riskminds USA)
A discussion of how the current low interest rate environment impacts choices for (1) interest rate risk, (2) other risks and (3) Enterprise Risk Management. How an insurer might react to low interest rates depends to a large extent on risk taking strategy and their point of view about interest rate risk. There are four primary strategies for interest rate risk:
- Minimize Risk
- The Classic ALM approach is designed to minimize risk. Duration mismatch is a measure of the degree to which you failed to achieve risk minimization. Most ALM programs allow for an acceptable level of mismatch which might be an operational risk acceptance or it might be an option to take some interest rate risk tactically. Risk is evaluated compared to Zero (matched position).
- Accumulate Risk
- The classic approach of banks to interest rate risk is to accumulate it. The Japan carry trade is an interest rate accumulation trade. Life Insurers usually Accumulate Mortality Risk. Non-Life Insurers usually Accumulate attritional Risks Accumulation of risk usually means that there is no limit to the amount of the risk that may be taken if it is priced right. Risk is evaluated compared to expected cost using Utility theory – accept risk if expected value >0.
- Manage Risk
- The New ERM approach to Risk is to Manage Risk by looking at Risk vs. Reward for the portfolio of risks including diversification effects. Taking a Strategic or Tactical approach to making choices - Return Targets “Over the Cycle” or “Every Year”. Risk is evaluate with an Economic Capital model. Risk means increase in total enterprise Economic Capital.
- Diversify Risk
- Many firms pay attention to diversification, but few make it the cornerstone to their ERM. Firms focused on diversification will accumulate a risk as long as it does not come to dominate their risk profile and if it is expected to be profitable, often taking a purely Tactical approach to which risks that they will accumulate. They may not even have a chosen Long Term Strategic view of most risks. They evaluate each risk in comparison to other risks of the enterprise. The target is to have no single large risk concentration.
There are two aspects of Point of View that you need to be clear about:
Long Term Strategic vs. Short Term Tactical
You might ignore both and imply avoid a risk
You might ignore Strategic and take risks tactically that might not make sense in the long run
You might Strategically decide to take a risk and ignore Tactical which means you take the risk no matter the environment
You might pay attention to both and always take the risk but vary the amount of the risk
Going Concern vs. Going out of Business
Classic ALM (and Economic Capital models) use a “going out of business” model
But the “Going Concern” model is much more complicated and requires assumptions about future business and should include a going out of business assumption
With these questions resolved a company can go about setting their strategy for interest rate risk taking in a low interest environment. To do that they may want to look at three scenarios:
·Scenario 1 – Interest Rates stay low
·Scenario 2 – Interest Rates increase slowly
·Scenario 3 – Interest Rates increase quickly For each scenario, look at the implications for both interest rate risk as well as all of the other aspects of their risk profile and their business strategy. If a scenario shows results that are unacceptable, then the planners and risk managers need to develop strategies to avoid or mitigate the projected problem, should that scenario come to pass as well as triggers for initiating those activities should the scenario appear imminent.