Archive for the ‘Asset Liability Management’ category

Open or Closed?

July 9, 2013

Moorad Choudry provides a good description of how banks think about ALM in a new article in The Actuary, Asset/liability management: solid as a rock?.  

But he misses one very important point that to RISKVIEWS explains the difference between banks and insurer/pension plans with regard to ALM.  That difference is the title of this piece.

The bank ALM model assumes that the bank will remain Open.  Therefore, the bank always has the option to obtain the funds that are needed to pay near term liabilities.  Unless the unfortunate occurrence of a liquidity problem.  The second part of this story is that banks do not mark their banking book of assets to market.  The banking book supports their “maturity transformation” business.  By keeping from that MTM step the bank keeps its large mismatch “off the books”.  This position has been the case, according to Choudry, since the the first banks.

Insurer and Pension ALM assumes that the company/fund becomes Closed and no longer has any access to new funds.  The new idea, that is a part of IFRS accounting that an insurer will mark everything to market is entirely consistent with the assumption that the company is assumed to be Closed.

That Closed company assumption along with the approach to ALM that insurers now use crept into insurance practice in the past 40 years with application of ideas that were no more than 75 years old.  One source speaks of these ideas as Anglo-American practices.  And in the discussions of Solvency II, one of the thorny topics goes back to this assumption since the German life insurance industry tends to favor an Open company approach.

The insurance company adoption of Closed company ALM started after some insurers suddenly went into the maturity transformation business in a big way only to learn that there was a definite limit to the amount of maturity transformation that could be done by an insurer relative to the capital and operations of the insurer.  Some insurers, notably The Equitable, experienced very large losses and had their business severely disrupted.  Almost 20 years later, as if to prove the necessity of the Closed company approach, General American also experienced massive losses when most funds were withdrawn from their maturity transformation business.

Looking at the ALM topic in this manner allows one to see the real and fundamental difference between the two approaches and in a non-pejorative manner.

In one sense, the insurers seem to be much too restrictive, too risk adverse, in their approach to ALM by adopting a full Closed.  Of course, insurers are not all planning on Closing,  on going out of business.  So preparing for this risk as if they were seems like extreme over caution.

On the other hand, banks, over the centuries have been subject to numerous runs and mass failures.  The Open company approach leaves a bank subject to a large contagion risk.  Once one bank has a problem, all banks may become subject to excessive withdrawals and all but the most secure banks that had been run with an Open company approach will experience severe trouble which could lead to a cascade of failures.  That is the reason why one of the fundamental functions of the Central Banks is to provide emergency liquidity to banks that are fundamentally sound.

If insurers shifted to an Open company approach to ALM, then insurers would also be subject to the same sort of fragility as the banks.  Insurers are in a different business from banks, usually providing longer term promises that require a much higher degree of confidence in their ability to be able to fulfill those promises under extremely stressful circumstances.  If insurers were operated with the same degree of fragility as banks, it is quite possible that their business model would fail completely.

Very High cost for Asset Allocation Advice

May 10, 2012

Most investors in hedge funds must be looking at them totally marginally.  Certainly that is the way that hedge fund managers would suggest.

What that means is the ther investor should not look at the details of what the hedge fund is doing, it should only look at the returns.  Those returns should be looked upon as a unit.

Certainly that is the only way to think of it that matches up with the compensation for hedge fund managers.  They get paid their 2 and 20 based solely upon their performance.

But think for a moment about how an investor probably looks at the rest of their portfolio.  They look at the portfolio as a whole, across all asset classes.  The investor will often make their first investment decision regarding their asset allocation.

While hedge fund managers have argued for treating their funds as one or even several asset classes, they are almost always made up of investments, long and short, in other asset classes.  So if you are an investor who already has positions in many asset classes, the hedge fund is merely a series of moves to modify the investors asset mix.

So for example, if the hedge fund is a simple leveraged stock fund, the hedge fund manager is lowering the investor’s bond holdings and increasing the stock holdings.

So if an investor with a 70% 30% Stock bond mix changes their portfolio to 65%, 25%, 10% giving 10% to a hedge fund manager who varies runs a leveraged stock fund that varies from all cash to 4/3 leveraged position in stocks, then they have totally turned their asset mix over to the hedge fund manager.

When the hedge fund is fully levered in stocks then their portfolio is 65% long Stocks, 25% long bonds, plus 40% long stocks and 30% short bonds.  Their net position is 105% stocks with  5% short bonds.  But that is not quite right.  If you only get 80% of your performance, your position is 97% stocks and 1% bonds.  That is right, it is less than 100%.  Only it is really worse than that.  That is the allocation when performance is good.  When the stock market goes really poorly, you get the performance of the 105%/(5%) fund. 

Other funds go long and short large and small stocks.  The same sort of simple arithmetic applies there. 

It is really hard to imagine that anyone who thinks that there is any merit whatsoever to asset allocation would participate in this game.  Because they will no longer have any say in their asset allocation.  What you have done is to switch to being a market timer.  In the levered stock example, you now have a portfolio that is 65% long stocks and 35% market timing.  

So in most cases, what is really happening is that by investing in a hedge fund, the investor is largely abandoning most basic investment principles and shifting a major part of their portfolio asset allocation to a market timer. 

At a very large fee.

ERM in a Low Interest Rate Environment

June 14, 2011

(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.

Managed Risk Taking

May 12, 2010

Is your ALM system a risk management system or is ALM a process at your firm for managed risk taking?

It appears that banks and insurers both use the term ALM to refer to the process that they use with interest rate change risk.  But in general, banks are using ALM as a part of a managed risk taking system, while insurers are most often using ALM as a risk management system.

The difference is in the acceptable targets.  Insurers most often have a target for matching of assets and liabilities to within a 0.50 tolerance in difference in duration for example.  The tolerance is most often justified as a practical consideration, allowing the managers of the ALM system to avoid making too many expensive small moves and to gently steer the portfolio into the matched situation.

Banks will have a much larger mismatch allowance.  A part of the basic business of banks is to borrow funds short term and to lend them long term.  There is a significant duration mismatch embedded into their business model.  The ALM managers are there to make sure that the interest rate risk does not grow beyond those tolerances.  The bank should be setting the limit for mismatch to a level of loss that they can afford.

It is fascinating that for the most part, insurers who are generally buy and hold risk takers are unwilling to take advantage of the generally upward sloping yield curve in anywhere near the level that banks are.  Insurers tend to look at their risks as good risks and bad risks and to avoid any exposure to the bad risks if possible.  Interest rate change risk is seen as a bad risk, probably because (a) there us no underwriting, no selection involved and (b) the risk is totally uncontrollable.

Insurers like risks where they can develop an expertise of underwriting the risk, selecting the better risks over the worse risks.  Interest rate risk, at least within economies has no specific risk component.  If there was underwriting involved, that underwriting would be trying to figure out the forces that drive interest rates up and down.  And that is very difficult to do.

The interest rate change risk is totally uncontrollable because there is no claims management.  There is a major subjective, personal element in the form of the central bankers setting the rates at the short end.  The rates at the long end are driven by both supply and demand as well as by inflation assumptions.  So to get interest rates risht, one would need to read the minds of the central bankers, predict the need for funding and the amount of capital available at various rate levels for various terms as well as the expectations of the market for inflation.  Good luck.

There is another difference between banks and insurers that perhaps explains the difference in strategies.  THe banks are usually able to get their money on a short term basis, paying the low short term interest rates.  Insurers, on the other hand usually get their funds for a longer term.  They may not always need to promise a long term interest rate, but they usually want to keep their customers for the long term, so they want to make plans to pay interest rates at a level consistent with long term.

And if you follow yield curves over time, you will notice that the steepest and most reliable part of the yield curve is at the very short end of the curve.  At the middle of the curve, there is not always an upward slant that is large enough to justify the risk of a significant mismatch, not is it reliable enough to build your business off of it.

So maybe the two segments have it right for their situations.  Banks can have their managed risk taking system while insurers need their risk management system.

Assumptions Embedded in Risk Analysis

April 28, 2010

The picture below from Dour VanDemeter’s blog gives an interesting take on the embedded assumptions in various approaches to risk analysis and risk treatment.

But what I take from this is a realization that many firms have activity in one or two or three of those boxes, but the only box that does not assume away a major part of reality is generally empty.

In reality, most financial firms do experience market, credit and liability risks all at the same time and most firms do expect to be continuing to receive future cashflows both from past activities and from future activities.

But most firms have chosen to measure and manage their risk by assuming that one or two or even three of those things are not a concern.  By selectively putting on blinders to major aspects of their risks – first blinding their right eye, then their left, then by not looking up and finally not looking down.

Some of these processes were designed that way in earlier times when computational power would not have allowed anything more.  For many firms their affairs are so very complicated and their future is so uncertain that it is simply impractical to incorporate everything into one all encompassing risk assessment and treatment framework.

At least that is the story that folks are most likely to use.

But the fact that their activity is too complicated for them to model does not seem to send them any flashing red signal that it is possible that they really do not understand their risk.

So look at Doug’s picture and see which are the embedded assumptions in each calculation – the ones I am thinking of are the labels on the OTHER rows and columns.

For Credit VaR – the embedded assumption is that there is no Market Risk and that there is no new assets or liabilities (business is in sell-off mode)

For Interest risk VaR – the embedded assumption is that there is no credit risk nor new assets or liabilities (business is in sell-off mode)

For ALM – the embedded assumption is that there is no credit risk and business is in run-off mode.

Those are the real embedded assumptions.  We should own up to them.

Making Better Decisions using ERM

April 21, 2010

Max Rudolph provided a lecture on ERM for the University of Waterloo and the Waterloo Research institute in Insurance, Securities and Quantitative finance (WatRISQ).

Key Points:

ERM’s Role in Strategic Planning

  • Understanding the Risk Profile
  • Solutions are Unique
  • Using Quantitative and Qualitative Tools

ERM is Not:

  • A Checklist Exercize
  • A Rating Agency Exercize
  • Just About Risk Mitigation

Have You ever heard of the Financial Crisis?

And Much more…

Max Rudolph

Any Road Will Do

February 20, 2010

Is what the Cheshire Cat told Alice.  Since she did not know where she was going.

And unfortunately, that is where the European Bank Supervisors seem to be regarding Risk Management.  They just published a short paper entitled “High level principles for risk management”, which despite the lofty title gives very little clear guidance at a high level.   I will instead point you to something along the same lines that WAS well written that DOES represent actual principles of risk management.  I refer you to the BIS report in Interest Rate Risk Management from 1997.  Their 11 top principles are listed below.

A. The role of the board and senior management

Principle 1: In order to carry out its responsibilities, the board of directors in a bank should approve interest rate risk management policies and procedures, and should be informed regularly of the interest rate risk exposure of the bank.

Principle 2: Senior management must ensure that the structure of the bank’s business and the level of interest rate risk it assumes are effectively managed, that appropriate policies and procedures are established to control and limit these risks, and that resources are available for evaluating and controlling interest rate risk.
Principle 3: Banks should have a risk management function with clearly defined duties that reports risk exposures directly to senior management and the board of directors and is sufficiently independent from the business lines of the bank. Larger or more
complex banks should have units responsible for the design and administration of the bank’s interest rate risk management system.

B. Policies and procedures

Principle 4: It is essential that banks’ interest rate risk policies and procedures be clearly defined and consistent with the nature and complexity of their activities. These policies should address the bank’s exposures on a consolidated basis and, as appropriate, also at the level of individual affiliates.

Principle 5: It is important that banks identify the risks inherent in new products and activities and ensure these are subject to adequate procedures and controls before being introduced or undertaken. Major hedging or risk management initiatives should be approved in advance by the board or its appropriate delegated committee.

C. Measurement and monitoring system

Principle 6: It is essential that banks have interest rate risk measurement systems that capture all material sources of interest rate risk and that assess the effect of interest rate changes in ways which are consistent with the scope of their activities. The assumptions underlying the system should be clearly understood by risk managers and bank management.
Principle 7: Banks must establish and enforce operating limits and other practices that maintain exposures within levels consistent with their internal policies.

Principle 8: Banks should measure their vulnerability to loss under stressful market conditions – including the breakdown of key assumptions – and consider those results when establishing and reviewing their policies and limits for interest rate risk.

Principle 9Banks must have adequate information systems for monitoring and reporting interest rate exposures to senior management and boards of directors on a timely basis.

D. Independent controls

Principle 10: Banks must have adequate internal controls for their interest rate risk management process and should evaluate the adequacy and integrity of those controls periodically. Individuals responsible for evaluating control procedures must be independent of the function they are assigned to review.

Principle 11: Banks should periodically conduct an independent review of the adequacy and integrity of their risk management processes. Such reviews should be available to relevant supervisory authorities.

These principles are so universal that you will find that if you simply substitute the name of any other risk for the words “interest rate” in the sentences above, you will still have an excellent list of risk management principles.  In fact, just substitute the words “Bank”  or even “Insurer” for interest rate above and you now have a complete and coherent set of PRINCIPLES FOR RISK MANAGEMENT.

The most puzzling thing to me is that this BIS report has long been superseded by something with wording much more like the meandering and fuzzy report of the CEBS.  Don’t take my word for it, the newest version of this BIS interest rate risk management paper is available on their website.  Compare the wording of that report to these crystal clear principles and let me know where you see any improvements.

Does Bloomberg Understand Anything about Risk Management?

December 18, 2009

On December 18, Bloomberg posted a story about losses on interest rate swaps at Harvard.   The story says that in 2004, Harvard entered into long term swaps to lock in future rates for planned borrowing.  That seems like ok risk management.  But as it happened, interests did not rise, they fell.  So the hedge was not needed.  They type of hedging strategy that they chose had no initial cost.  The cost of risk management was incurred only if the hedged event did not happen.   If interest rated did risk, then the swaps would have resulted in a gain so that Harvard’s costs were limited to a predetermined amount.  If Interest rates fell, then Harvard would pay on the swaps, but save on the interest costs, bring the sum of interest paid on their borrowing and the swap payments to a fixed predetermined total in all cases.

However, Bloomberg chooses to say is this way:

Harvard was betting in 2004 that interest rates would rise by the time it needed to borrow.

The bulk of the story is about how Harvard lost their “bet” and how much money that they lost because they lost the “bet” when interest rates fell, and Harvard had to postpone their planned borrowing.

No wonder it is difficult for firms to disclose any information about actual risk management actions and plans.  If a reasonable, but not perfect risk management action is seen as a “bet”, rather than a move to stablize interest costs.

Every risk management action will have a cost.  Harvard’s real bad move, similar to the one by Soc Gen in January 2008, the choice to lock in losses, and at the worst time.  Interest rates cannot go below zero, so there is absolutely no reason to get out of those swaps, unless their cashflow was so, so poor that they had no way to pay the monthly interrest swap amount (even though they somehow had the cash to settle all of the swaps, presumably paying the present value of the long term swap amounts as viewed at a time ov very low interest rates).

Their other bad move was to fail to hedge the possibility that they would not even do the project and therefore not need the hedge.  To identify how to hedge that situation, they would have had to do some scenario testing of scenarios of extreme losses in their endownment that would have resulted in the situation that they now find themselves.  That analysis should have resulted in some far out of the money hedges on the investments in Harvard’s portfolio.  And the fact that much of their portfolio may be unhedegable should have been a warning about the wisdom of making forward committments like the swaps that presume that the endownment will not tank.

Seeing how wrongheaded the coverage of the transactions was, Harvard probably felt that they had long term reputational risk from paying the monthly payments.

Alternately, if as the article says, the swap markets are so much more liquid at periods for up to 3 years, they why didn’t they enter into trades to reverse the first 3 years of the payments?

No matter what the market says right this minute, I find it hard to believe that interest rates for Harvard will never again reach 4.72% that the swaps were locking in as the rate.

But that is not the point.  The point is that Bloomberg reports Risk Management as a “bet” implying that lack of risk management is not a “bet”.

But, how many companies are implicitly taking a “bet” that the future will never get worse than the present by not hedging anything?

Why is that NEVER a story?

The Future of Risk Management – Conference at NYU November 2009

November 14, 2009

Some good and not so good parts to this conference.  Hosted by Courant Institute of Mathematical Sciences, it was surprisingly non-quant.  In fact several of the speakers, obviously with no idea of what the other speakers were doing said that they were going to give some relief from the quant stuff.

Sad to say, the only suggestion that anyone had to do anything “different” was to do more stress testing.  Not exactly, or even slightly, a new idea.  So if this is the future of risk management, no one should expect any significant future contributions from the field.

There was much good discussion, but almost all of it was about the past of risk management, primarily the very recent past.

Here are some comments from the presenters:

  • Banks need regulator to require Stress tests so that they will be taken seriously.
  • Most banks did stress tests that were far from extreme risk scenarios, extreme risk scenarios would not have been given any credibility by bank management.
  • VAR calculations for illiquid securities are meaningless
  • Very large positions can be illiquid because of their size, even though the underlying security is traded in a liquid market.
  • Counterparty risk should be stress tested
  • Securities that are too illiquid to be exchange traded should have higher capital charges
  • Internal risk disclosure by traders should be a key to bonus treatment.  Losses that were disclosed and that are within tolerances should be treated one way and losses from risks that were not disclosed and/or that fall outside of tolerances should be treated much more harshly for bonus calculation purposes.
  • Banks did not accurately respond to the Spring 2009 stress tests
  • Banks did not accurately self assess their own risk management practices for the SSG report.  Usually gave themselves full credit for things that they had just started or were doing in a formalistic, non-committed manner.
  • Most banks are unable or unwilling to state a risk appetite and ADHERE to it.
  • Not all risks taken are disclosed to boards.
  • For the most part, losses of banks were < Economic Capital
  • Banks made no plans for what they would do to recapitalize after a large loss.  Assumed that fresh capital would be readily available if they thought of it at all.  Did not consider that in an extreme situation that results in the losses of magnitude similar to Economic Capital, that capital might not be available at all.
  • Prior to Basel reliance on VAR for capital requirements, banks had a multitude of methods and often used more than one to assess risks.  With the advent of Basel specifications of methodology, most banks stopped doing anything other than the required calculation.
  • Stress tests were usually at 1 or at most 2 standard deviation scenarios.
  • Risk appetites need to be adjusted as markets change and need to reflect the input of various stakeholders.
  • Risk management is seen as not needed in good times and gets some of the first budget cuts in tough times.
  • After doing Stress tests need to establish a matrix of actions that are things that will be DONE if this stress happens, things to sell, changes in capital, changes in business activities, etc.
  • Market consists of three types of risk takers, Innovators, Me Too Followers and Risk Avoiders.  Innovators find good businesses through real trial and error and make good gains from new businesses, Me Too follow innovators, getting less of gains because of slower, gradual adoption of innovations, and risk avoiders are usually into these businesses too late.  All experience losses eventually.  Innovators losses are a small fraction of gains, Me Too losses are a sizable fraction and Risk Avoiders often lose money.  Innovators have all left the banks.  Banks are just the Me Too and Avoiders.
  • T-Shirt – In my models, the markets work
  • Most of the reform suggestions will have the effect of eliminating alternatives, concentrating risk and risk oversight.  Would be much safer to diversify and allow multiple options.  Two exchanges are better than one, getting rid of all the largest banks will lead to lack of diversity of size.
  • Problem with compensation is that (a) pays for trades that have not closed as if they had closed and (b) pay for luck without adjustment for possibility of failure (risk).
  • Counter-cyclical capital rules will mean that banks will have much more capital going into the next crisis, so will be able to afford to lose much more.  Why is that good?
  • Systemic risk is when market reaches equilibrium at below full production capacity.  (Isn’t that a Depression – Funny how the words change)
  • Need to pay attention to who has cash when the crisis happens.  They are the potential white knights.
  • Correlations are caused by cross holdings of market participants – Hunts held cattle and silver in 1908’s causing correlations in those otherwise unrelated markets.  Such correlations are totally unpredictable in advance.
  • National Institute of Financa proposal for a new body to capture and analyze ALL financial market data to identify interconnectedness and future systemic risks.
  • If there is better information about systemic risk, then firms will manage their own systemic risk (Wanna Bet?)
  • Proposal to tax firms based on their contribution to gross systemic risk.
  • Stress testing should focus on changes to correlations
  • Treatment of the GSE Preferred stock holders was the actual start of the panic.  Leahman a week later was actually the second shoe to drop.
  • Banks need to include variability of Vol in their VAR models.  Models that allowed Vol to vary were faster to pick up on problems of the financial markets.  (So the stampede starts a few weeks earlier.)
  • Models turn on, Brains turn off.

Are We “Due” for an Interest Rate Risk Episode?

November 11, 2009

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?

The Interest Rate Spike of the Early 1980s: An Epic Dislocation in the Life Insurance Business

September 19, 2009

From Mike Cohen

Perspective: The life insurance business was a relatively straightforward business from its inception and early growth years in the nineteenth century up until the late 1970’s.  Whole life insurance, with a fixed rate of return on its savings component in the 4% range, was sold by career agents who were ‘captive’ to (sold exclusively for) their companies. The business model clearly appeared to be sound. An inside joke at life insurance companies (insurance humor being what it is) was that “All you had to do was turn the lights on” and the business worked.

An unprecedented economic event occurred over a span of 4 1/2 years, from late 1976 until the third quarter of 1981, that changed all that. Interest rates spiked to levels never before seen in the United States. The prime rate rose from a cyclical trough of 6.25% in December, 1976 to unheard of levels of 20% or higher in April, 1980, crossed the 20% threshold again for a two month stretch in December, 1980 through February, 2001, and yet again from May through September, 2001. This shock challenged literally everything about the life insurance business:

1) Guaranteed interest rates offered by whole life products were not (at all) competitive with other investment options consumers could get. Policyholders were borrowing heavily from their policies, as the loan interest rates were well below rates they could earn on their investments.  This dynamic spawned the financial strategy known as “buy term and invest the difference”, and drove insurers to develop products that paid competitive (relative to the market) rates, such as Universal Life

2)  Bonds values were far ‘under water’ (below cost), as the rates of interest they paid were substantially below what investors could earn on other instruments. Without wanting to realize capital losses on their sale, insurers generally had little choice but to hope for a lower interest rate environment.

3) Given that cash flow was leaving companies in substantial and potentially crippling amounts, many companies made one of two disastrous choices (and often both):

– They paid their producers first year (heaped) commissions to rewrite business already on the books so it wouldn’t surrender, ruining the profitability on that business

– They sold business offering current interest rates (GICs were an egregious example) to raise cash, but they weren’t able to invest the cash at comparable rates, locking in a negative spread, and losses. This dynamic spawned the creation of a critical financial/ actuarial technique, Asset Liability Management.

As companies’ profitability reeled from these and related problems, they looked much closer looks at their profit fundamentals and sought ways to improve results. One area of many came under intense scrutiny … distribution costs. In this new environment, companies across the industry learned that an entirely new distribution model was critical for survival, let alone success.

My company at the time (a life insurer) undertook a major strategic analysis in 1983 … products, markets, distribution were the key areas, but not the only ones. I was a member of the four person team heading this critical project. Overheard in one of our working sessions:

“If we could only come up with a diamond in the rough”, said one of the other members on the project team, a close friend of mine.

“We’ve already had it, and it endured for over 100 years.”, I replied. “We now need to develop significantly different solutions, and more fundamentally focus on entirely new ways to think about our business”.

The life insurance industry had reached a dislocation. All of its strategic dynamics changed, and its companies were forced to change with it in order to survive. It took many years;  many industry observers would say more than a decade, but the industry was able to essentially reinvent itself and prosper.

Now, in 2009, the life insurance industry is in the throes of the current dislocation as is the entire financial services industry, and its companies are faced with the challenge of responding to a new set of dynamics.


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