Risk-free interest rate workshop

1. Risk-free interest rate workshop Brian Kipps

2. Swaps vs. Bonds: Theoretical considerations • In evaluating an ideal “risk free” yield curve one should consider the characteristics required from such a curve: • Observable Transparent, quoted in the open market, easily validated • Objective No bias in the curve or data used in constructing the curve. Typically this is achieved in cases where there are a significant amount of contributors • No/low credit risk Projected cashflows should be discounted at a rate which implies that there is certainty on the occurrence of such cashflow • Liquidity across term structure Liquidity indicates the reliability of the observed prices/rates and whether observed rates are achievable. In the valuation of long-term liabilities it is important that there is liquidity across the term structure of the yield curve due to the sensitivity of long-dated cashflows to interest rates. • Arm’s length requirement Typically used in defining a fair value: should indicate the price or value at which such valued cashflows could be bought/sold in the financial markets.

3. Swaps vs. Bonds: Theoretical considerations (cont) • But let’s be clear: there is no true risk free curve – governments default despite the ability to print cash and raise taxes (that is why SA local currency debt is only A- on international scale), and collateralised swap transactions can lose money if a bank defaults and you can’t close out the transaction quickly enough and collateral proves insufficient (jump risk) • What we really need is a practical approach to the risk free rate and to move on to some of the more important stuff

4. Swaps vs. Bonds: Practical implications • Using a specific risk free curve in the insurance industry could have significant implications for local financial markets: • Government relies on the bond market for funding, especially in the back end which is where long term insurers invest although bank support through B3 as well as real money investors will arguably absorb the supply should the swap curve be preferred • Corporates and banks rely on the swap market for funding and risk transfer through the derivatives market, again long term insurers play an important role here • And since neither curve is truly risk free, why do something that has wider unintended consequences on the real economy? • First prize is that insurers are allowed to use either the swap curve or the bond curve in valuing different tranches of business as this will ensure minimal impact on or disruption to the financial markets • There may need to be rules to prevent abuse of this e.g. upfront election per tranche of business (not unlike an accounting election), and capital implications for assuming bond/swap basis risk in risk management activities

5. Swaps vs. Bonds: Practical implications (cont) • It is also very important to consider the illiquidity premium as part of our risk free rate discussion • Remember a bond is funded (your money is at risk), whilst a swap is unfunded (no cash put down) and collateralised under CSA • A bond (adjusted for credit risk) is comparable to a bank deposit (adjusted for a bank’s credit risk), and not a swap • Bank deposits pay significantly over Jibar to attract term funding, the majority of which is compensation for illiquidity (banks need to pay investors a premium to lock up their funding so they have a stable deposit base to on-lend to corporates) • A bank raising funding through senior debt (marked against government bonds), or through institutional deposits (marked against Jibar) is generally ambivalent between the two sources – they are priced to be largely equivalent, and in fact a bank will generally swap its senior debt funding into Jibar once it is raised anyway • What this means is that there is a big market force (bank funding) ensuring that the government bond and (credit adjusted) deposit markets are kept in line • Supply and demand dynamics of the two markets means this does not always hold, but there is a link between the two of them

6. Swaps vs. Bonds: Practical implications (cont) • In the event that a single risk free curve is forced upon the insurance industry, then in our opinion the swap curve is preferable: • Closer to credit risk free: CSAs internationally moving to zero threshold, cash collateralised • Convergence of banking and insurance: if we want to reduce regulatory inconsistencies, then we need to adopt the swap curve – why should a 5yr amortising deposit have a different value to a 5yr term certain annuity? • For the economy: supports corporates looking to fix their funding, whilst B3 and real money investors will continue to support government funding efforts • For fixed income liabilities: Interest rate risk is an unrewarded risk; credit risk is a rewarded risk. Swaps allow flexibility to hedge interest rate risk, but optimise allocation to credit risky assets – beneficial to policyholder returns and/or shareholder ROE • For hedging of investment guarantees: Some exposures cannot be hedged on the bond curve – no swaptions, zero coupon instruments, and funding implications would force you into a rolling bond forward strategy which is expensive (which will impact policyholder pricing and benefit provision) and is dependent on the bond-repo market at every roll date • Arms length: if the intention is to create a market consistent liability, the market consists of other life companies and banks (which use the swap curve) – not the government

7. Illiquidity premium Total risk premium Total return on asset Total risk premium Profits demanded by investors. Excess risk premium Compensation for firm-specific credit risk. Idiosyncratic default risk premium Compensation for non firm-specific credit risk. Systemic default risk premium Compensation for potential lack of liquidity. Illiquidity premium Bond or swap rate. Risk free return • Illiquidity premium = compensation for locking your money in for a long period of time • For an annuitant, he is lending his money to the life company for a long period of time and deserves compensation for this – this can be achieved by investing his money in matching assets which earn an illiquidity premium e.g. long-dated bonds, loans • An illiquidity premium is merely one constituent of the overall risk premium defined as the total return on an asset in excess of the risk free return • Credit spreads are generally defined as the spread over risk-free on a credit risky asset. Credit spreads are not in their entirety compensation for expected loss – they also compensate the investor for illiquidity, profit (to cover CoC)

8. Illiquidity premium (cont) • So how do we approximate this illiquidity premium, since on its own it is not easily observable... • Ideally the illiquidity premium is calculated from the market, not from the assets you hold – this is old school actuarial thinking • A practical suggestion: • If using the swap curve, look at bank funding rates and adjust for bank’s credit risk • If using government curve, apply something similar to current matching premium calculation but calculated on a universe of applicable bonds, not just the ones you happen to hold, and adjusted using expected loss rather than random number like 25% • One of the problems with the current matching premium approach is that because it assumes one risk free (swap) curve, it also captures bond/swap basis in the matching premium if you invest in bonds • This has nothing to do with illiquidity • To avoid this, either disallow these assets from the matching premium calculation (not ideal), or strip out the bond/swap basis from the matching premium AND hold capital against the basis risk • Does this really need to be prescribed, or just some principles agreed?

9. Extrapolation methodologies • In valuing long dated liabilities it is inevitable that these will extend beyond the observable part of the yield curve (roughly 30yrs) • The key principles that should be applied in extrapolating a yield curve are: • Where there is useful data, use it (e.g. back-end of observable curve) • Ideally no complicated theoretical model which is hard to understand and creates unnecessary “noise” in capital calculations and earnings • Convergence to an ultimate forward rate is a sensible approach although care should be taken not to put too much reliance on a few points on the observable yield curve: could lead to market distortions • Ideally the extrapolated part of the curve needs to be linked to the observable yield curve and updated dynamically • Ideal outcome would be for insurers to apply discretion as long as methodologies are consistently applied, sensible, and (potentially) disclosed