A panel of senior insurance Asset-Liability Management (ALM) professionals from a range of UK-based life insurance firms joined Milliman in mid-October 2022 to exchange views on various current themes in ALM and capital management, against a challenging and fast-changing economic backdrop.

This discussion was conducted under the Chatham House rule (comments are anonymous and non-attributable) and below we summarise key points from the hour-long call. We’d like to thank all those who took part for their time.

Participants

Joe Cannavan – Head of Capital Management at Royal London
Paul Downey – Chief Actuary at Liverpool Victoria (LV=)
Paul Fulcher – Group Capital Management and Investment Executive at Just
Andrew Hague – Head of Financial Risk and Chief Actuary (Life) at NFU Mutual
Ben Paterson – Head of Front Office ALM at Canada Life
Christopher Wright – Group ALM Director at Legal & General

Moderated by Russell Ward, Matthew Ford and Florin Ginghină of Milliman

Notes

Obviously interest rates and inflation, having been very low for many years, are now at the forefront of people’s minds. With any luck, inflation will come down in the medium term, though who can say. Interest rate pathways are now even more uncertain due to recent political and market developments, and there’s greater volatility at the long end of the yield curve than we’ve seen in several decades. What are your thoughts?

Participants were in general agreement that we are seeing a significant paradigm shift in the wider macroeconomic environment. It was noted by one attendee that for the entirety of their 30+-year career to date until recently, 10-year gilt yields have been on a fairly linear downward trajectory. Now a whole range of factors and relationships that insurers (and capital/ALM functions, in particular) have become used to working with are changing, for example:

• Correlations between equity returns and those on gilts becoming positive.
• Derivatives going against firms such that they are now posting collateral.

However, it was also noted that in some senses, the environment into which we are moving could be much like that which prevailed prior to the global financial crisis in 2008 (GFC). If gilt yields remain at around 4% to 6% and inflation falls back below that, are we not looking at something like the “Goldilocks economy” of 1995 to 2007? Is it the case that we’ve gotten used to the historically abnormal world of ultralow interest rates, negative real yields, etc., and are simply panicking about a return to normality?

Another participant responded to this point that the destination is not a problem for insurers—they know how to deal with low interest rates, they know how to deal with high interest rates—but that the challenge lies in dealing with the speed of transition. Recent experience in relation to dynamic hedging was discussed and it was noted that current events have shown the value of such programmes in providing a framework and associated processes to manage derivative positions on a timely basis. It was noted such approaches may have eased the challenges faced by some defined benefit (DB) pension schemes recently. However, dynamic hedging isn’t a silver bullet for every situation, as markets have recently displayed extreme swings in both directions during short periods of time. That situation can result in increased trading costs as triggers are breached in both directions while the net movement, viewed over a slightly longer period, can be modest—of course, we can only know that the triggers are false alarms with the benefit of hindsight. Despite these complexities regarding dynamic hedging, limited liquidity in the current sterling swaption market means firms may have little choice but to dynamically manage hedging positions.

Recalling similar periods of political and market volatility, we know that the Prudential Regulation Authority (PRA) were proactively contacting firms for updates. Have you had any emails from the PRA?

Attendees noted that the PRA had (perhaps quite presciently in hindsight) contacted firms in February regarding their liquidity positions, though it was generally agreed that the current environment had not, at least to the participants’ knowledge, resulted in significant liquidity issues for UK life insurance firms as they have already given considerable thought to the management of liquidity risk, in contrast to recent experience among some pension funds. It was noted that, with interest rate movements now being far greater, the impact of convexity was a far more significant factor in assessing impacts and a key factor in explaining differences between outcomes and simpler extrapolations.¹

We also discussed the potential of firms moving to capitalise on opportunities presented by convexity and rates/inflation volatility, though the general mood was that firms are currently occupied with dealing with the threats presented in these areas. However, once the initial shock has been dealt with, are firms well-positioned to take advantage of the current climate? Frequency of rebalancing, management information (MI) , governance and cost of trading were all raised as factors in this assessment. While difficult to imagine in the near term, the prospect of interest rates and inflation moving downwards again was discussed, and there was some debate over the severity of potential losses if this were to occur.

Returning to an earlier comment, are we heading into another stable regime, but a regime that looks more like that of a couple of decades ago, and our current situation is just a violent transition from one state to the other? We have some way to go yet in terms of rates up or inflation down to get us to positive real yields across the term structure, but is the funnel of uncertainty at least starting to narrow?

Our panel members were generally in agreement with this sentiment. One speaker mooted that moving to a 2%-3% base rate, 5% gilt yields and positive real yields across the whole curve is not just sustainable, but less unusual than the past 15 or so years. However, in order to get to this point, the base rate may need to go much higher in the short to medium term so that inflation expectations are driven out of the system.

Another concurred but added that the level of change in the last 12 months has been outside the level of some 1-in-200 stresses. This is a testament to the difficulty of predicting such things, but perhaps also a signal that insurers may need to be even more open-minded regarding the use of even relatively distant history to inform the features of their stress and scenario tests. Other participants were in agreement with this, with one suggesting that, when looking at single risk factors, insurers should consider movements potentially well beyond the bounds of the capital model in light of the increased uncertainty at present.

We talked about models and the importance of choosing appropriate time windows for input data sets, the difficulty of determining them and justifying their relevance. For example, it was suggested that there is a tendency to dismiss data from the 1970s due to the differences in regime between now and then—nonindependent central bank(s), globalisation in its infancy, lower debt to gross domestic product (GDP) ratios—but that it may be good practice to at least consider such data to help avoid becoming too anchored in any particular regime, as we know they can and do eventually change. Participants were in general agreement here, and it was put forward that the 1970s still provides a useful case study for double-digit inflation in the UK.

Turning to liquidity, when market stress events occur now it often seems to be liquidity that becomes the major cause for concern. Has the push, post-GFC, towards central clearing and cash-for-collateral changed the appetite for risk associated with derivatives?

Multiple participants posed distinctions between the recent experience of life insurers compared with the widely publicised and significant challenges faced by some DB pension schemes. It was felt that insurers have generally managed to secure greater flexibility to manage collateral requirements through the use of so-called “dirty credit support annexes (CSAs)”² and that this leaves them more resilient in this regard. It was put forward that the move from regulators to encourage central clearing and clean CSAs may have created a degree of systematic risk—if a bank has liquidity issues it has recourse to the central bank as a liquidity provider of last resort, whereas pension funds currently do not.

This led the conversation to liquidity stress testing frameworks, and it was agreed that, in order to use derivatives effectively, it is necessary to understand both one’s liquidity position and the negative impact that certain derivatives and hedging positions could have on this position. At that point, once these factors are sufficiently understood, one can get creative with managing liquidity. It was also noted that, as a result of the Matching Adjustment (MA), insurers may not take full rates exposure in the same way as other financial institutions.

On foreign exchange (FX) hedging, this has become more interesting of late with a weak and volatile pound, combined with a rampant dollar. We’re seeing some central banks intervene in the currency markets (notably in India and Japan). Is it going to be riskier to invest overseas given currency movements? Could we see something like the 1985 Plaza Accord (wherein the US agreed to intervene jointly with other countries to devalue the dollar)?

One participant did not feel this was likely, as the US does not seem to be as adversely affected by the strong dollar as it was in the early 1980s. If controlling inflation in the domestic economy via hawkish Federal Reserve action means a strong dollar, it seems that’s acceptable (or perhaps even desirable) for the US, at least for now.

The MA was raised again at this point, and it was noted that (especially among firms with significant Matching Adjustment portfolios) UK life insurers are quite cash flow-matched and don’t tend to use derivatives for leverage. In an ideal world, UK life insurers would love to buy and hold illiquid sterling inflation-linked bonds, but there’s a supply issue and as such many have to settle for buying similar assets denominated in other currencies and hedging the attendant additional risks. As nobody has CSAs which allow for posting of completely illiquid real estate or infrastructure assets, it was mooted that there is likely a point at which an asset mix which is too heavy on non-sterling illiquids becomes penal, especially at a time where large rate and currency movements make it possible that substantial amounts of collateral may need to be posted. It was also noted that one of the stated aims of the UK’s reform of the current Solvency II legislation is to encourage investment in sterling-denominated illiquid assets.

There has been diversification but is that a supply-and-demand point? Namely, if we increasingly domesticate demand then does supply become an issue?

One participant stated that perhaps the only wholly non-scarce asset at the moment is UK gilts, but that annuity firms’ business model does not work if only gilts are held. It was also raised that in particularly adverse circumstances, hedged non-sterling bonds backing annuity liabilities can actually have a negative value.

The necessity of having some proportion of liquid assets in a portfolio (particularly an MA portfolio) backing annuity liabilities is obvious, but the debate is over exactly what proportion this should be. It was proposed that this proportion may have become higher given the events of the last six months or so.

Another indicator of how quickly things have moved is that the 2022 Life Insurance Stress Test (LIST) exercise already looks rather out of date as it considered shocks involving falls in interest rates and longevity improvements.

Only a short amount of time left, but can we ask about the property market and related illiquids, e.g., commercial real estate loans and equity release mortgages? Are they riskier now?

Not surprisingly, participants did consider that risk around these assets was increasing from a combination of:

• Rising expectations of price volatility, with insurers being systematically short volatility due to the no negative equity guarantee (NNEG) embedded in lifetime mortgage products.
• Downward revisions to expected property price growth, where insurers’ exposures are asymmetric.

To briefly summarise, Milliman notes that:

• There was broad recognition that we are experiencing a regime change in relation to the behaviour of economic variables such as interest rates and inflation. In the longer term this may be no bad thing but the transition (and speed of it) is bringing increased volatility and uncertainty, which is likely to continue for some time yet.
• Insurers’ programmes to manage market and liquidity risks have held up well but there are some useful lessons to be taken from recent events in terms of contemplating different regimes to help expand the range of outcomes evaluated under stress and scenario tests. As Mark Twain reportedly said, “History doesn’t repeat but it does rhyme.”

¹ For example, if the duration of assets exceeds that of the liabilities then convexity provides a partial mitigation of the impact of an increase in interest rates. A simple extrapolation that considered only duration would thus tend to overstate the impact of the change.

² A credit support annex (CSA) governs the provision of collateral by the parties in a derivatives transaction. These arrangements allow for a variety of assets such as government and corporate bonds to be posted as collateral on derivative positions.