The Federal Reserve announced in December that it will reduce its bond purchases from $85 billion to $75 billion per month, starting the process of scaling back its massive quantitative easing program. In mid-2013, interest rates headed up as investors anticipated that this tapering would begin soon. Yield on 10-year Treasury notes rose from 1.61 percent in May to as high as 3 percent in September. Most economists agree that the tapering program will continue to drive rates skyward.
Treasury & Risk sat down with Greg Mateja, a managing director with Alvarez & Marsal and a fellow of the Society of Actuaries, to discuss how higher interest rates are likely to affect insurance companies and their customers. What we got was good advice for every company contemplating the different ways in which tapering of the Fed’s bond buying might affect their business.
T&R: And what should a company do—an insurance company or other type of business—to determine where it faces risks related to Fed tapering and the prospect of rising interest rates?
Board members and senior management may be more responsive to specific scenarios, so it may be helpful to take a draft proposal of a framework for their company’s risk appetite to the organization’s leaders and say, ‘Hey, if this event happened and we had a loss of X dollars, how would you feel about that?’ Then they have to triangulate with people because different members of the board and senior management will have different views on risk. The goal is to bring all those different people together, reach consensus, and get a set of parameters that everyone is relatively comfortable with.
As part of the process, some companies will perform stochastic analyses and consider results at a targeted level such as a 90th or a 99th percentile as part of the development of their stress tests. These stochastic models are complex, with some subjective elements, and they may not be effective for all risks. For an annual model, this could result in a risk constraint expressed as not wanting to lose more than X dollars once every 10 years or 100 years. In the end, there should be consideration of both magnitude and likelihood of potential risk.