Are We “Due” for an Interest Rate Risk Episode?
In the last ten years, we have had major problems from Credit, Natural Catastrophes and Equities all at least twice. Looking around at the risk exposures of insurers, it seems that we are due for a fall on Interest Rate Risk.
And things are very well positioned to make that a big time problem. Interest rates have been generally very low for much of the past decade (in fact, most observers think that low interest rates have caused many of the other problems – perhaps not the nat cats). This has challenged the minimum guaranteed rates of many insurance contracts.
Interest rate risk management has focused primarily around lobbying regulators to allow lower minimum guarantees. Active ALM is practiced by many insurers, but by no means all.
Rates cannot get much lower. The full impact of the historically low current risk free rates (are we still really using that term – can anyone really say that anything is risk free any longer?) has been shielded form some insurers by the historically high credit spreads. As the economy recovers and credit spreads contract, the rates could go slightly lower for corporate credit.
But keeping rates from exploding as the economy comes back to health will be very difficult. The sky high unemployment makes it difficult to predict that the monetary authorities will act to avoid overheating and the sharp rise of interest rates.
Calibration of ALM systems will be challenged if there is an interest rate spike. Many Economic Capital models are calibrated to show a 2% rise in interest rates as a 1/200 event. It seems highly likely that rates could rise 2% or 3% or 4% or more. How well prepared will those firms be who have been doing diciplined ALM with a model that tops out at a 2% rise? Or will the ALM actuaries be the next ones talking of a 25 standard deviation event?
Is there any way that we can justify calling the next interest rate spike a Black Swan?