1. Indian Actuarial Profession Serving the Cause of Public Interest
Institute of Actuaries of India
26th Indian Fellowship Seminar
Interest Rates – Where are they headed?
Interest Rate Guarantees – How to Manage them?
Presenters:
Navin Ghorawat
Rakesh Kumar
15th December, 2016
Mumbai, India
Guide: Mr. Sachin Saxena
Indian Actuarial Profession
Serving the Cause of Public Interest

2. Agenda Where are the Interest Rates Headed?
Historical Interest Rates – Range and Spread
Future of Interest Rates – Best Estimate and Alternatives
Impact of Demonetization
2. Interest Rate Guarantees and How to Manage them?
Why and how guarantees arise?
Impact of Guarantees on different Products
Management of Interest Rate Guarantees
Case Study: Japanese Life Insurance Industry

3. Historical Interest Rates - Range
Historical 10 years G-Sec rates in India
Have fallen below the 6% mark only twice in the last two decades, and close to the 5% mark only once.
The rates have been range-bound for the larger part of the last two decades.
The recent trend shows that the rates have been on a downward trend over the last couple of years, even before the recent events in the economy.

4. Historical Interest Rates - Spread
Comparative 10 years Bond Yield (India, UK,US, Japan and Brazil)
The spread between Indian yields and yields of developed economies like US and UK has widened since 2009, when it was close to 2% to over 6% by the year 2013.
This trend has now started to reverse with the developed economies finally being able to raise rates and the Indian Govt. targeting rates in the range of 4-6%.
So, we can see that the lines for US, UK and Japan, that lie below the dotted line are inching upwards on the right, while the blue line representing India is sliding downwards.
This might suggest a possibility of returning to an environment with a smaller spread.

5. Future Interest Rates – Best Estimate
Reasons for Interest Rates falling to %
Modi Govt. View: Target Inflation of 4% and Target Real Yields of %
RBI Stance: Change of Governor, Supporting Govt. view
Weather (Monsoons): Good Monsoons have lowered CPI
Fiscal Deficit and Govt. Budget – Higher tax revenues, Income Disclosure Scheme, Disinvestment Proceeds
Sluggish Growth (as the IIP suggests)
Stable Currency – India attracting capital flows as a safe haven

6. Future Interest Rates - Alternative
Reasons for Deviation from Best Estimate
Weather: Bad Monsoons can have an adverse impact on Inflation and hence rates.
Indian Govt.: Recent moves have not been as successful as hoped. Rajya Sabha minority still an issue.
US/UK Quantitative Easing: If the developed economies raise rates and the spread between Indian and US/UK yields narrows, capital will flow out from India.
Price of Crude Oil: Major drop in inflation and interest rates was due to sharp fall in Crude Oil prices. This trend has started to reverse.
Global Political Environment: Syria, Brexit, Trump, Immigrants in Europe

7. Impact of Demonetization
Accelerated Fall in Interest Rates due to increased money in banks.
Increased Transparency and Move to Financial Savings leading to greater exposure to debt and equity markets.
Reduction in Economic Activity: Negative Wealth Effect and decrease in currency in circulation.
Massive Fiscal Gains: Higher tax revenues to significantly reduce fiscal deficit
Undisclosed notes to reduce RBI liabilities and will be eventually available to be distributed as dividend to Govt.
Increase in Demand for Govt. Papers: Higher demand of Govt. bonds from Banking sector as deposits pick up.
RBI to be more accommodative: Dealing with uncertain times, some moves might be perfected by trial. E.g. 100% CRR requirement for additional deposits.
In the end, I would like to summarize this section of the presentation by saying that these are interesting and unusual times for our country.
And while we can speculate all we want about the future, there would always be differences in Actual vs Expected, owing to the millions of factors and their interactions that are at play.
On that note, I’d like to handover the mic to Mr. Rakesh to take you through the second part of this presentation: “How to manage Interest Rate Guarantees?”

8. Why interest rate guarantee arises?
Non-life Business
Life Business
Pension
Relatively very less interest rate guarantee
Mostly Short term protection business with yearly renewal premium
To make the saving products attractive and competitive
To improve the persistency and increase the NB volume
To comply the regulatory requirements
- Guaranteed surrender benefit/Minimum DB/Guaranteed minimum MB
- Positive return under saving product at 4% p.a. interest rates Scenario
Major contribution of Saving products under Life business
Immediate annuity products with guaranteed rates
Deferred Pension plans have similar guarantee requirements as in saving products of life business
In case of sudden fall of interest rate the smoothing in interest rate declaration on fund based group products may lead to guarantee

9. How interest rate guarantee arises?
How interest rate guarantee arises under life business
Pricing and other reasons
Assets
Implicit interest rate guarantee as assumed in pricing basis
Explicit Interest rate guarantee (which may be 0% p.a.)
Non-reviewable premium
Guaranteed annuity rates under Immediate annuity products
Without profits single premium products priced at higher interest rates
Limited investment avenues available and allowed to insurers
Higher reinvestment risk as large changes have been observed in G-sec returns
Under-developed Corporate Bond and Derivative Markets
Volatile return on invested funds

10. Impact on Different Type of Products
Others ( ULIPs, Term, Health.)
Minor impact on all
Impact on ULIPs: if guarantee is given ,withdrawal rate may increase, marketability may reduced
30 to 40 years term assurance have higher sensitivity of interest rates
Long term care product may be impacted
Annuities
Significant impact
Revision of rates and marketability issues
ALM mismatch
Reinvestment risk
Reduction in projected profits
Participating
Bonus rate may not sustain
Withdrawal rate may increase
Non-Participating
Maturity and/or surrender may burden
Increase in Capital requirement
Others (ULIPs, Term, Health etc.)

11. Management of Interest Rate Guarantees: Reasons and Strategy
Reasons for Management
Strategy for Management
To reduce the volatility in profits
Capital Management
To maintain the solvency position
To meet PRE of par policyholders
Reduce dependency on non-par sales
Remove the products with heavy guarantee in current scenario
Sell more protection and shorter term products
Introduce income benefit products rather than endowments
Re-price the products to reduce guarantees
Keep appropriate mathematical reserve
Hedge the risk through derivatives
Continuous monitoring and reporting to the top management

12. Management of Interest Rate Guarantee: Possible Actions, Implications and Challenges
Revise the premium for without profits product
Reduce or eliminate the guarantee from new business
Regulatory restrictions, marketability and competition
Revise the Immediate annuity rates on continuous basis
Regulatory restrictions of maximum 10% changes, marketability and competition
Bonus cut (RB and/or TB), additional interest rate cut
Reduction in guarantee and hence value of liability.
PRE and TCF, breaching of regulatory conditions, Persistency and NB volume.
Matching Asset and Liability
Due to change in interest rate the duration of liability gets change and hence duration of asset needs to be adjusted
Matching assets may not be available and transactions cost
Use of derivatives or immunization technique
May reduce the impact of change in interest rate
Cost and complexity, increase in credit risk and regulatory restrictions.

13. Management of Interest Rate Guarantee: Regulations and Professional Guidance
GNs
APS
IRDAI Circular on ALM and Stress Testing, 2012
GN6: Management of Participating life assurance business with reference to distribution of surplus
APS1: Appointed Actuary and Life Insurance Business
APS2: Additional Guidance for Appointed Actuaries and Other Actuaries involved in Life Insurance
IRDAI Investment Regulations, 2013
GN22: Reserving of Guarantees in Life Assurance Business
APS3: Financial Condition Report
IRDAI Guidelines on Interest Rate Derivatives, 2014
GN29: Valuation of Interest Rate Guarantees on Exempted Provident Funds
APS5: Appointed Actuary and Principles of Life Insurance Policy Illustrations
Other regulations such as ALSM, Product Regulations, 2013, Investment in Credit Default Swaps(CDS), 2012 etc.
APS7: Appointed Actuary and Principles for determining Margins for Adverse Deviation (MAD) in Life Insurance Liabilities

14. Solvency II: Management of Interest rate guarantees
1. The capital requirements under solvency II are designed to promote the insurers to match the duration of assets and liabilities
2. The impact of fall in interest rate is higher on value of liabilities as the duration of liabilities is much longer than assets and so matching is important aspect
3. Stress testing exercise consider the several low interest rate scenarios
4. Use of derivatives:
Derivatives can be used for hedging interest rate risk

15. A Case Study: Japanese Life Insurance Industry
The impact of sudden decrease in interest rate and stay at low level for longer period of time
Rapid decline in the interest rate in1980s, led to heavy sales of insurance product with high guarantees
Insures invest their assets stock market and shock in equity market leads to large loss
8 out of 27 Japanese life insurance companies had defaulted from 1997 to 2008 due to “Negative Yield Spread”
Insurers lost the policyholders confidence and leads to large surrenders
Steps taken by Japanese LI companies after sharp decline of Interest rate:
Stop selling high-yield saving products
Reduce guarantee interest rate and commission of saving products
Increase the policy reserves
Purchase the longer term bonds to improve yields and reduce duration gap
Use of interest rate swaps to hedge the interest rate guarantee under annuity portfolio

16. Summary
Interest rate guarantee management is mainly for Capital management , profitability and solvency
Management through proper product mix, matching of asset and liability and use of derivatives
Follow the Regulatory provisions and Profession guidance
Take lesson from the countries have already faced the burden of interest rate guarantees

17. 26th Indian Fellowship Seminar
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