The effects of COVID-19 coupled with the ongoing impact of structural economic change – and policy responses to both – have resulted in unparalleled uncertainty around future interest rate and credit environments. This uncertainty calls for a heightened focus on duration risk management, says Tomer Yahalom, Senior Director of Research at Moody's Analytics.
Life insurance companies' exposure to credit risk was traditionally limited to high quality, vanilla credit instruments, meaning the need to understand the credit effects in duration risk analysis was not a priority. But given the significant increase in credit risk exposure in recent years, insurers must now pay greater attention to the interactions between credit and duration risk.
Since the 2008 financial crisis, the low interest rate environment has driven life insurance companies and other credit market participants to search for yield and invest in lower rated and increasingly complex credit assets. This has been supported by a proliferation of credit issuance1. US life insurers have increased their bond holdings at the lower end of the investment grade spectrum (Baa rating) from 28% of their bond portfolio in 2010 to 35% in 2019 (Wong, M., 2020). By some measures structured assets now comprise a quarter of life insurance credit assets, not to mention alternative assets, private placements, and, more recently, direct lending in the CRE and retail markets. This unprecedented exposure to credit risk – to non-vanilla credit assets in particular – makes credit considerations more important to insurers than ever before.
The acute and lingering effects of COVID-19 on credit markets are aggravated by the changing business landscape adapting to technological innovation, and efforts to mitigate and manage climate change; for example, automotive firms accelerating their shift to electric vehicles or the demise of retail and downtown office space. This evolving marketplace is generating uncertainty about both short- and long-term credit conditions, especially for some specific sectors, and these dynamics will further bring credit risk to the forefront for insurers.
Meanwhile, interest rate risk is on the rise. Market signals in the US indicate the economy is picking up speed, as the virus is more under control, potentially leading to a sharp increase in rates. Conversely, the low interest rate environment may be here to stay if the pandemic effects persist (new variants, slow recovery for some sectors). Yet another possibility is a stagflation scenario where the large March 2021 COVID bill increases prices and nominal rates but with low real growth. By the end of 2020 swaption-implied volatility smirk had already suggested markets were pricing in the possibility of higher rates, and the first few months of 2021 have seen treasury rates rise and swaption implied volatility almost double. This increased volatility in interest rates requires a heightened focus on managing duration risk. While increasing interest rates are generally beneficial to insurers, they could still feel the pain of mismatched duration and falling asset prices in the short term.
Duration is the price sensitivity to changes in yield, which for credit-risky bonds should capture sensitivity to all drivers of yield: interest rates, migration in credit ratings and spreads. Credit risk introduces uncertainty around the amount and timing of cashflows due to defaults. This uncertainty in cashflows increases bond duration risk ('convexity').
Furthermore, migration introduces additional uncertainty about future yields. Both these effects can be material and, with insurers' increased exposure to credit risk, insurers must now pay greater attention to the effects.
The figure below compares future duration risk at a one-year horizon for stylized bonds of different initial credit ratings and the same initial duration (ten years), using a Market-Credit risk-integrated simulation that accounts for dynamics in credit, interest rates and spreads. For example, the 1.2 standard deviation estimated for a stylized Baa3 bond indicates that rather than having a duration of approximately nine at the one-year horizon, there is roughly 30% likelihood of the value falling outside the 7.8 - 10.2 range. Notice that duration risk can be over 8 times higher across investment grade credit ratings. We can see that the credit risk 'convexity' effect translates to a material increase in sensitivity to interest rates for lower rated credit. This 'convexity' persists even when interest rates are held fixed due to credit migration and changes in spread.
Figure 1: Horizon Duration Risk by Initial Credit Rating
Similarly, duration risk for a credit portfolio is sensitive to portfolio concentration/diversification. Diversification reduces uncertainty around the amount and timing of cashflows and lowers duration risk. A duration-matched bond portfolio supporting a fixed annuity book can exhibit a 20% higher duration gap volatility at a one-year horizon as a result of industry concentration. Said simply, diversifying credit mitigates credit risk as well as duration risk.
Given the unprecedented credit risk already in insurers' portfolios it is vital to understand the impact this risk will have on their businesses, especially as we face the prospect of a new interest rate paradigm.
Amnon Levy is managing director of Research at Moody's Analytics
Brett Manning is director of research at Moody's Analytics
Tomer Yahalom is senior director of research at Moody's Analytics