Presentation is loading. Please wait.

Presentation is loading. Please wait.

DISTRIBUTERS’ SUMMIT Niagara Falls, ON, Canada June 8, 2012 Professor Bernie Wolf, PhD Schulich School of Business York University 1.

Similar presentations


Presentation on theme: "DISTRIBUTERS’ SUMMIT Niagara Falls, ON, Canada June 8, 2012 Professor Bernie Wolf, PhD Schulich School of Business York University 1."— Presentation transcript:

1 DISTRIBUTERS’ SUMMIT Niagara Falls, ON, Canada June 8, 2012 Professor Bernie Wolf, PhD Schulich School of Business York University 1

2 THE RISKS OF A LOW INTEREST RATE ENVIRONMENT: Challenges for the Managing General Agency (MGA) Sector 2

3 Importance of Interest Rates I Why focus on interest rates? The key idea is that a yield bearing asset, with a fixed interest rate, changes in value as interest rates change. When interest rates rise (fall), the asset declines (increases) correspondingly in value. In insurance parlance, interest rates determine the annuity payouts. 3

4 Importance of Interest Rates II For example, a perpetual bond with a $1K principal, yielding 2% or $20 annually, would fall to approximately half the value, if interest rates increased to 4%. Similarly, with interest rates at 10%, the bond would be worth only $200 because a new bond would be yielding five times as much. 4

5 Interest Rates Are Historically Low Interest rates have remained at historically low levels even since before the financial crisis, but recently have dropped to the lowest levels in decades because the aftermath of the financial crisis continues, especially in the form of high unemployment! 5

6 Interest Rate Risk With the U.S. Federal Reserve indicating it may not raise rates until late 2014, there are serious implications for life product guarantees. What does this low interest rate environment mean for the industry, and how will companies have to rethink pricing as a consequence? 6

7 Interest Rate Setting I Short term interest rates are by and large set by central banks. In Canada, it is the Bank of Canada (BOC). In England, it is the Bank of England. In the Euro Area, it is the European Central Bank. In the US, it is the Federal Reserve. 7

8 Interest Rate Setting II In some cases, central banks overtly try to influence longer term interest rates and the overall yield curve. For example, the Fed has applied “Operation Twist.” As part of “Quantitative Easing (QE),” the Fed has purchased mortgage backed securities and long term bonds in order to reduce longer term rates when it could no longer reduce short term rates since negative nominal rates are problematic. A reversal of QE will mean higher longer term rates. 8

9 Historic 10 year US Treasury Bond Rates Year Rate (%) [ all double digit years*] Current 1.47 [Easy to see that rates are at historically low Levels] *[highest rates in 1981: 13.92%] 9

10 June 1, year Bond Yields and +/- German Bunds I % % Points Switzerland Japan Denmark Germany [Bunds] US [T- bonds] UK [Gilts] Canada

11 June 1, year Bond Yields and +/- German Bunds II % % Points France Australia Belgium Italy Spain Ireland Greece

12 Interest Rate Setting III Generally, interest rates are set to keep inflation at bay since price stability is generally a central bank’s chief function, though the Fed also has an full employment mandate. The BOC recently affirmed its inflation target as 2%, within a control range of 1% to 3%, based on the 12 month rate change [going forward] of the “headline” Consumer Price Index [CPI] inflation. However, operationally, to avoid being clouded by changes in volatile items, the BOC concentrates on “core” inflation, which filters out volatile items such as gasoline prices. 12

13 Interest Rate Setting IV A key part of the BOC's strategy is to keep inflationary expectations in line with the targets because expectations feed into wage demands and pricing. There is a “normal” bank rate range associated with the BOC inflation target and we are well below that norm. 13

14 Interest Rate Setting V The BOC looks at current inflation and forecasts it into the future looking at capacity utilization, unemployment rates, discouraged unemployed that are not in the labour force, and the component of unemployment that is due to the degree of mismatch between the types of jobs available in a region and the qualifications of the job-seekers. 14

15 Interest Rate Setting VI Another consideration needs to be how Canada’s interest rates compare to those elsewhere in the world since higher interest rates relative to other countries tend to push up the value of the Canadian dollar, which discourages exports. Commodity prices are an additional factor that links inflation and the exchange rate. Also, the BOC needs to monitor economic conditions in other countries, particularly important export customers since exports are a vital part of our GDP. 15

16 Interest Rate Setting VII As well, geopolitical events related to levels of economic confidence, such as in the Southern tier of the Euro zone, need to be weighed in. Finally, a precipitous large increase in interest rates could cause financial panic at worst, or financial discomfort at the very least, among those who are overly leveraged and dependent upon low interest rates to meet their obligations. 16

17 Interest Rate Setting VIII The BOC has repeatedly said that interest rates would rise from current levels since a overnight rate of 1.00% is so low compared to earlier periods. The question is just when do the rates rise and by how much at a time? [The prime rate offered by Canadian commercial banks, corresponding to the overnight rate is currently 3.00%.] 17

18 Governor Mark Carney’s Own Words I The outlook for global economic growth has weakened in recent weeks. Some of the risks around the European crisis are materializing and risks remain skewed to the downside. This is leading to a sharp deterioration in global financial conditions. While the U.S. economy continues to expand at a modest pace, economic activity in emerging- market economies is slowing a bit faster and a bit more broadly than had been expected. More modest global momentum and heightened financial risk aversion have reduced commodity prices. 18

19 Governor Mark Carney’s Own Words II Although economic growth in Canada was slightly slower than expected in the first quarter, underlying economic momentum appears largely consistent with expectations. However, the composition of growth is less balanced. In particular, housing activity has been stronger than expected, and households continue to add to their debt burden in an environment of modest income growth. Despite external events, business and household confidence has held up and domestic financial conditions remain very stimulative. The contribution of government spending to growth is expected to be quite modest over the projection horizon, in line with recent federal and provincial budgets. The recovery in net exports is likely to remain weak in light of modest external demand and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar. 19

20 Governor Mark Carney’s Own Words III The Canadian economy continues to operate with a small degree of excess capacity. Total CPI inflation is expected to fall below 2 per cent in the short term, as a result of lower gasoline prices, while core inflation is expected to remain around 2 per cent. Reflecting all of these factors, the Bank has decided to maintain the target for the overnight rate at 1 per cent. To the extent that the economic expansion continues and the current excess supply in the economy is gradually absorbed, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate, consistent with achieving the 2 per cent inflation target over the medium term. The timing and degree of any such withdrawal will be weighed carefully against domestic and global economic developments. 20

21 Short Term Vs. Long Tern Interest Rates Most insurance products depend upon long term interest rates rather than short term rates. Essentially long term rates can be viewed as the market’s expectation of short term interest rates over time plus a term premium. Currently, as we have already seen, 10 year rates in the US, Germany and Canada are extremely low, particularly German bunds which are seen as a “safe haven” within the Euro zone. 21

22 Impact of Low Interest Rates 1. Obviously, clients find it much more difficult to accept fees of say 2% when gross returns are 3% than when they are 6%. 2. Universal life polices, where interest rates determine how long the insurance will be in effect, may end prematurely [my own bad experience!]. 22

23 Implications for the Insurance Industry I Low interest rates provide the following difficulties: 1. Insurance companies suffer financial hardships when they have guaranteed minimum payout rates during a previous higher interest rate era without locking in high rates on their own assets. For example, low interest rates have forced one insurance company to reduce features offered on its guaranteed minimum withdrawal benefit products. Starting April 30, 2012, the company reduced its income payout percentage on a segregated fund that features a cashable lifetime annuity, by 75 basis points, depending on the age the client begins making withdrawals. 23

24 Implications for the Insurance Industry II 2. Low interest rates make annuity payouts seem small. Hence, clients shy away from them. To compensate, insurance companies may have to offer higher payouts, thereby squeezing their profit margins. 3. ETFs, etc., may provide increased competition for life products from insurance companies. 24

25 Implications for the Insurance Industry II 4. Insurance companies have to offer products with variable payouts to minimize the risk for the companies and for the client. The products may also have the effect of squeezing profits. 5. Insurance companies have to add “bells and whistles” to make annuities more appealing to clients where extreme flexibility make high fees seemingly more tolerable. 25

26 Implications for the Insurance Industry III 6. With insurance companies and brokers being pressed, the material in the sandwich gets to be squeezed, in this case, the MGAs! 26

27 Conclusions: Some Advice I 1. For clients unwilling to accept annuities based on low interest rates, and consequently low payouts, insurance companies need to structure products that are flexible and, which at the same time, protect both the client and the companies from adverse interest rate changes. 2. Make insurance products more attractive by providing features desired by the clients. 3. Avoid the tendency to make products opaque to the point that when the policy terms become clearer, the client is unhappy. Transparency goes a long way. 27

28 Conclusions: Some Advice II 4. Make sure that insurance company based life products are competitive with alternatives such as ETFs. 5. MGAs need to provide feedback to the insurance companies as to how to structure products. 28

29 THANK YOU! Let’s have some Q & A! 29


Download ppt "DISTRIBUTERS’ SUMMIT Niagara Falls, ON, Canada June 8, 2012 Professor Bernie Wolf, PhD Schulich School of Business York University 1."

Similar presentations


Ads by Google