Economic considerations in the time of COVID-19

By Mary Stock, FCIA, and Trudy Engel, FCIA, members of the CIA Committee on Life Insurance Financial Reporting

The world has experienced pandemics over the course of history (e.g., Spanish Flu, Asian Flu, Hong Kong Flu, etc.) but COVID-19 has been the worst virus in recent history not only due to its potency but also the ease at which it can be transmitted. To lessen the impact on health care systems of a rapid spread of the virus, governments around the world have reacted in unprecedented ways. We have fundamentally changed the way we live and work. These changes have resulted in a global economic crisis.   

Movement in economic markets in the first quarter of 2020 was profound; with Government of Canada benchmark 2-year and long-term bond yields declining 127 bps and 44 bps respectively, corporate bond spreads increasing significantly and the TSX Composite dropping by 21.6%.

Previous articles focused on considerations related to mortality, morbidity, and policyholder behaviour.  This COVID-19 article will outline a few key considerations that relate to the economic assumption setting process in these unprecedented times and will highlight a few CIA documents that may be worth reviewing. 

Considerations related to economic assumptions

The impact of COVID-19 on the economy has been unprecedented and the level of uncertainty in the market is likely to continue as countries try to restart their economies amid the uncertainty of a second wave and the potential for vaccines and effective treatments.

Given the uncertainty of what the economic recovery will look like and how long it will take, below are a few considerations in setting the economic assumptions. 

Fixed income assets – credit spreads

• Similar to the economic crisis experienced in 2008, credit spreads have widened as economic uncertainty has increased. In CALM scenarios, current credit spreads revert to historic spreads over five years, which limits the impact of these wider spreads on the level of the liability. The long-term promulgated maximum net credit spread of 80 bps continues to apply as per paragraph 2330.08 of the Standards of Practice. As we enter a new normal, current credit spreads could be expected to narrow, although this will depend on the timing and extent of the economic recovery. The actuary would consider the potential for increased risk of asset depreciation and decreased liquidity (and availability) of assets that may be associated with higher credit spreads.
• The actuary may wish to consider implications on the level of the margin applied to the credit spreads.

Fixed income – asset depreciation

• Central banks have reacted to the crisis by lowering interest rates, while the government is providing economic relief through fiscal stimulus resulting in unprecedented levels of debt.Potentially, some provincial bonds could be downgraded. It is not certain yet what the economic recovery will look like or how long it will take. Will the world ever go back to the way it was before?
• What does the increased uncertainty mean for fixed income asset depreciation? The actuary would consider short-term and long-term implications on the portfolio of fixed income invested assets, including potential downgrades. In the short term, it is likely that we will continue to experience volatility, while the long-term effects are harder to discern. The actuary may wish to consider both short-term and long-term implications on the best estimate assumption and the level of the margin applied to the asset depreciation assumption.

Fixed income assets – exercise of borrower and issuer options

• The actuary would be mindful of potential impacts the current and future economic turmoil from COVID-19 may have on how borrowers and issuers exercise their options on fixed income assets and reflect any such impacts in the forecasted cash flows.

Negative interest rates

• In response to the economic uncertainty related to the impact of COVID-19 globally, central banks have lowered interest rates; some in developed markets to the extent that interest rates are negative. Yields on Government of Canada benchmark bonds have continued to decline subsequent to March 31; with yields for 2-year and long-term bonds 30 bps and 111 bps respectively.[1] Uncertainty related to the economic recovery may potentially reduce yields further. As mentioned in Section 4 of the Guidance for the 2018 Valuation of Insurance Contract Liabilities of Life Insurers educational note, the construction of the CALM scenarios remains appropriate even if initial risk-free interest rates are negative.
• Section 4.1 of the 2015 revised educational note Investment Assumptions Used in the Valuation of Life and Health Insurance Contract Liabilities discussed the development of interest rate scenarios. The following is an excerpt from this section: “In developing deterministic scenarios, any negative or zero forward rates would be set to 1 basis point.” As part of the new guidance to be provided in the educational note, Guidance for the 2020 Valuation of Insurance Contract Liabilities of Life Insurers, the 1 basis point floor is no longer considered appropriate.

Preferred shares

• The market value of preferred shares has decreased significantly. The actuary may wish to consider any modelling implications associated with the types of preferred shares held. For example, modelling the dividends on rate reset preferred shares could result in potentially large impacts on the liabilities if the dividends are linked to risk-free rates.

Non-fixed income (NFI) assets

• Equity markets continue to be volatile, with initial significant losses in global equity indexes. Other NFI assets such as oil and gas, infrastructure funds, etc. are also experiencing volatility in market values. It is expected that current market values would be reflected in the valuation with the liability impact of these changes not typically being disclosed as basis changes.
• The actuary may wish to consider the impact on both the best estimate and the level of margins on the income and growth assumptions.
• As the economic uncertainty due to COVID-19 continues what impact will this have on the fair value of various NFI asset classes and what are the corresponding implications on the liabilities?
• Businesses are now working virtually to the extent they are able. Will more businesses continue to work from home in the long term leading to less demand for commercial real estate and potential write downs of real estate values? Will the deferral of residential mortgage payments and increased unemployment ultimately lead to higher asset depreciation?
• What impact will the current economic situation have on the liquidity of different NFI asset classes? The actuary may wish to consider any potential impact on the reinvestment assumption.
• The actuary would consider the various NFI asset classes supporting liabilities, and be aware that certain classes are more impacted than others, and that this could change as the economic situation evolves.

Segregated fund products

• The decrease in global equity markets would have decreased the fund values which would lower the anticipated “net spread” on these products. This will lead to some products being closer to or more “in-the-money,” which could drive up expected guarantee costs. The impact will depend on whether the business was hedged and how it was hedged. If a common delta/rho hedging strategy was used, this likely still produced losses due to the extreme market volatility largely in the last few weeks of March. This could be viewed as a real-life stress test case of these hedging programs and the actuary could use this to consider the appropriateness of the hedge effectiveness assumptions used within their valuation. It may also highlight potential opportunities to improve hedging performance.

Universal life products

• The decrease in markets will lead to lower fund values which will lower the present value of the “net spread” on these products resulting in an increase in the liability. If a hedge ratio approach to determining the level of assets backing these liabilities was used, the impact may not be as material.
• Policyholders may choose to transfer funds to “safer” investments options, especially those with minimum guarantees. The actuary would monitor exposures to these minimum interest rate guarantees.

Participating and adjustable products

• The actuary would consider the impact of the current economic environment on participating and adjustable products. These considerations may include but are not limited to policyholder reasonable expectations, minimum interest guarantees, and implicit guarantees on participating products.

Reinsurance recoverability

• The actuary would consider the potential of reinsurance company downgrades from the significant adverse economic impacts due to COVID-19, if prolonged, and how these could impact reinsurance recoverability.
• At this time the risk to reinsurance recoveries due to increased mortality and morbidity from COVID-19 is not anticipated to be significant.

Although there are more questions than answers at this point, these are a few considerations that actuaries would be encouraged to analyze and review as they assess the continued appropriateness of the economic assumptions used in the valuation.   

The considerations outlined above apply to the development of economic assumptions in Canada.  There may be additional considerations when setting economic assumptions for business in other jurisdictions.   

CIA publications pertaining to economic assumptions

Actuaries are encouraged to review the following CIA publications:

• Paragraph 2330.08 that relates to the credit spreads within subsection 2330 of the Standards of Practice.
• Paragraph 2330.13 that relates to considerations in setting interest rate scenarios for investments not denominated in Canadian dollars within subsection 2330 of the Standards of Practice.
• Paragraphs 2340.04 to 2340.08 that discuss the factors affecting the asset depreciation assumption for fixed income assets within subsection 2340 of the Standards of Practice.
• Paragraphs 2340.12 to 2340.14 that discuss the factors affecting the credit spread assumption for fixed income assets within subsection 2340 of the Standards of Practice.
• Paragraphs 2340.15 to 2340.20 that discuss the factors affecting the NFI asset investment return and associated margins within subsection 2340 of the Standards of Practice.
• Paragraphs 2340.09 to 2340.11 that discuss the considerations in reflecting issuer and borrower options on fixed income assets in the forecasted cash flows within subsection 2340 of the Standards of Practice.
• Section 4 of the revised educational note Investment Assumptions Used in the Valuation of Life and Health Insurance Contract Liabilities that relates to the considerations in setting investment assumptions for fixed income and NFI assets.
• The educational note Investment Return Assumptions for Non-Fixed Income Assets for Life Insurers that discusses considerations for setting the return assumptions for NFI assets.

Other documents pertaining to economic assumptions and CALM are listed in Appendix A: CIA Guidance of the educational note Guidance for the 2019 Valuation of Insurance Contract Liabilities of Life Insurers.

This article originally appeared on the CIA COVID-19 Hub.