Asset Markets and Macroeconomics

Asset Markets and Macroeconomics
by Narayan Shankar

Actuaries' assumptions have an enormous effect on the pricing and valuation of many insurance products. This article reports on the factors that affect those assumptions.

Environmental trends in asset markets and macroeconomics are relevant to the actuary in life insurance practice from at least three perspectives: Impact of these trends on actuaries at a technical level, i.e., how do they change the way actuaries do their jobs? Impact on the actuarial profession at a competitive level, i.e., do they create new opportunities, threats and areas of application of actuarial knowledge? Impact on the life insurance industry, i.e., its products and competitiveness.

The interest of actuaries in asset markets stems from their role in modeling asset market behavior, over the short term and the long term. Actuaries also develop and execute ALM strategies, so the tools to perform ALM and the cost/reliability of these techniques are of interest. The interest in macroeconomics is from a broader perspective, since the state of the economy impacts everyone in numerous ways.

Actuaries are called upon to apply professional judgment in modeling asset markets. Their assumptions have an enormous effect on the pricing and valuation of many insurance products. For this reason, most actuaries have considerable interest in the following questions:

• Currently, is the stock market valued fairly? If not, how far off is it? This is very important for long-term projections–if the market is currently over–valued, there will be a correction within the next several years. If it is under–valued (few professionals currently think this is the case), this is a good time for a long–term investor to buy. Demand for insurance products and the pricing and risk management of these products are affected by the answer to these questions.
• What is the correct Equity Risk Premium (ERP)? How is it affected by demand and supply of savings and capital? How do trends in demographics and globalization affect the ERP over the long term? What will the ERP be in the coming decade or two? Note that it is easier to think about this question if we de–couple it from the first question i.e., assume that markets are fairly valued and then ask what the ERP is going to be. The answers to these questions affect the demand, supply and pricing of equity–oriented insurance products as well as the pricing of all insurance products in general due to their bearing on the cost of capital of insurance companies.
• What can we expect the long–term interest rate to be over the next decade or two? How will it be affected by the fiscal and trade deficits, federal debt, value of the dollar, growth of the debt market in other countries, trends in risk aversion (driven by demographics and other factors) and sources of demand/supply for long–term debt? How are long–term rates related to the ERP? These questions are closely tied to the interest rate guarantees in insurance products, which constitute a bedrock of much of the insurance business.

In our scanning effort, we identified trends that bear on the broad issues of professional competitiveness, industry competitiveness and work environment. We also noted the past and potential future developments in the asset markets and broad economy that impact the modeling–related questions posed above.

Synthesizing these trends to reach conclusions and make predictions requires much more research and analysis than is possible with the resources available to the EIAC. The charge of the Committee is to shine a spotlight on issues that have a high–impact potential and leave it to other groups at the SOA with more specialized expertise on a topic to pursue it further. We have attempted a partial synthesis in this article, and some predictions and conclusions are mentioned throughout the remainder of this paper. However, more detailed research needs to occur, probably under the direction of the Investment and/or Risk Management sections.

Environmental Scanning Challenges
The asset markets are complex and it is difficult to gain insight into this area. As for macroeconomics trends, they are not too difficult to identify after the fact, but many economic data series are subject to considerable volatility and are notoriously difficult to project into the future. Economists use complex multi–variate time series models and crunch through massive amounts of data in order to make predictions. At best, they are only modestly successful in getting it right.

In some ways, it is easier to predict the contours of the long–term economic future (though not the specifics), rather than the short–term future. It is accepted that in the long run, equilibrium will be attained in markets, and the long–term future is determined by broad forces such as demographics, productivity, strength of institutions and the infrastructure you start with. However, surprises are always possible even in the most "predictable" areas, such as demographics. Not many demographers foresaw what occurred over the last 50 years, including the worldwide fertility changes that occurred due to contraception, China's demographic policy and the impact of women's education and economic independence in developed countries.

Scope of Topics Scanned
Based on the objectives of the scanning noted above, it is useful to track the following:

Asset Markets

• Innovation such as new trading instruments, risk management tools and techniques.
• Market structure changes and impact on investment or risk management practice including the following considerations:
1. Rules of engagement: order execution procedures, trading cost, trading restrictions, disclosures and licensing.
2. Market microstructure: market segments, participant characteristics and counterparty issues.
3. Market macrostructure: market efficiency, integration across markets, liquidity, price continuity and stability.
4. Trends in risk aversion or "risk culture" within the economy.
5. Factors affecting security values, including stock market valuation and interest rates.

Macroeconomics

• State of the U.S. economy–demand/supply conditions in labor, goods and money markets.
• Business cycle tracking.
• Trends in key macroeconomic measures.
• Monetary and fiscal policy.
• Impact of all of the above on the insurance industry and demand for insurance/annuities.

Scanning Sources
There is a wealth of information relating to these topics. Indeed it is difficult to avoid being overwhelmed by data and analysis. It is important to stay focused on a few reliable and high–quality sources that cover the range of issues we are interested in from a variety of perspectives. For the most part, we limited our scanning to U.S. government data/analysis and major financial publications. Our primary sources were Federal Reserve Web sites and publications, The Economist (magazine), The New York Times and the Wall Street Journal.

Scanning Results
The results of our scanning fall into three categories and are presented below in three sections. In Section I, we identify recent trends in the asset markets, with a focus on long–term trends, some of which have persisted for decades. Many of these trends will continue into the future, since the technological, demographic and institutional drivers remain a powerful force.

In Section II, we examine future long–term demographic trends in detail, due to the important effect they have on the world economy and asset markets. By evaluating the interplay of these demographic trends with economic and asset market trends, we can form an opinion about long–term economic and asset market prospects, and the overall effect on the insurance business. We made some attempt at this synthesis, but a more detailed analysis is a research project that is left to other experts to pursue and inform SOA members in the future.

In Section III, we examine briefly the U.S. fiscal and trade deficit situation and its implications. This is covered in more detail in the EIAC paper on "Global Economic Environment." Our interest in this matter stems from the major impact that U.S. government financial policy has on the global economy and asset markets.

We conclude the article with observations on the possible impact of these trends on the insurance industry. The Committee did not directly discuss the impact of the trends on the actuarial profession and its competitiveness. This is a project we will pursue in 2006.

Section I: Historical Long–Term Asset Market Trends
The following trends are primarily the consequence of technological innovation in information processing and communication, expansion of free markets, advances in finance theory, government policy promoting tax–advantaged individual savings accounts, investor ingenuity, deregulation and removal of price controls in commission costs. The world is becoming one large marketplace for the trading of future financial claims, with a growing number of people of modest means participating in this market.

• Market participation: Direct ownership of stocks or mutual funds has grown considerably, resulting in a substantial percentage of the population having some stake in the securities market (however, the bulk of the nation's wealth is still held by a small fraction of the population).
• Access to information: There has been extraordinary growth in easy and cheap access to market and company data.
• Trading cost: The direct cost of trading has declined considerably to very low commission levels.
• Trading hours: The hours have expanded, so we now have 24 hour trading and global trading.
• Daily volume: The volume has grown significantly. About $70 billion worth of shares is traded daily. Overall price volatility has been increasing.
• Derivatives: There is continued growth in derivatives markets and synthetic portfolio construction techniques, especially at the institutional level.
• Trading styles and strategies: These have expanded, with bifurcation of portfolios into diversification and isolation categories (style funds versus hedge funds).
• Securitization: There is continued growth in securitization, with the structuring of an ever–widening range of contracts, leading to depth of trading, liquidity and efficient allocation of risks to appropriate categories of market participants.
• Customization: There is increasing complexity and customization, especially in OTC markets, particularly with respect to new instruments such as credit derivatives, swaps, etc.
• Globalization: Cross–border capital flows in currency and debt markets has grown to staggering levels, accompanied by a rapid expansion of international investing through accessible vehicles such as ADRs, ETFs and emerging market funds.
• Technology: We have reached a state of total dependence on technology for recordkeeping and transaction execution at all levels of the asset markets–we increasingly depend on plastic cards or computer passwords/codewords to access our assets.
• Standardization: There is convergence of accounting standards, data standards and regulatory standards at the international level.

Section II: Future Demographic and Asset Market Trends–The World in 2050
Demographics is an effect that actuaries are well–suited to analyze. In its discussion, the EIAC used the report of the proceedings of the Federal Reserve Bank of Boston's conference (FRBB conference) on "Economic Impact of Demographic Change." This conference took a comprehensive look at the effects of demographic changes on the world economy and financial markets. The conference organizers published an outline of possible future demographic scenarios and the economic outcomes driven by those scenarios.

The EIAC began by envisioning the world as it might look in 2050, somewhat guided by facts and opinions expressed at the FRBB conference. Looking far into the future is highly speculative, and the EIAC by no means expects the following scenario to actually materialize. It is one scenario within a wide range of possibilities that captures and extrapolates trends noted by economists and demographers. However, it is a useful visualization exercise on where current trends might lead, if they continued well into the future. By interpolating between now and 2050, we can develop some sense of the trajectory by which we might attain the projected state. While this is a crude approach, it does provide a high–level understanding of what might come to pass.

The style of presentation in the following consists of declarative statements (e.g., The population of the world in 2050 will be 50 percent larger than today.) This style is used for simplicity, to avoid the awkwardness of noting every statement as speculative or continually conveying the sense that these statements are subject to considerable uncertainty. The entire presentation of what the world might look like in 2050 should be treated as highly uncertain and only one of a wide range of possibilities.

Population Structure in 2050
The population of the world in 2050 will be 50 percent larger than today. People will be older–the median age, which is now in the mid–20s, will increase to the mid 30s. The population will be largely urban, with 90 percent of the people living in countries that are currently classified as third world countries.

Approximately 80 percent of the population now lives in poverty, with most of the affluent living in a few wealthy countries. By 2050, the affluent will continue to comprise about 20 percent of the world population, but large numbers of the affluent will live outside of these few wealthy countries. For example, by 2050, China is projected to have about 750 million working age, educated people, with only about 500 million in the United States and Europe. Like China, India will also have a large population of the affluent, mixed in with a broader population of the poor. Except for a few third world countries whose level of affluence will improve, most of the rest will remain very poor, but with much larger populations than today, concentrated in urban centers.

The wildcards in these demographic projections are fertility, environmental surprises and epidemics. Longevity enhancing technology will have little impact on the world's population, since the greatest benefits of technology will likely not reach the third world. But continued improvements in public health could help. In the baseline scenario, fertility in these countries will remain high and mortality will continue to improve, rapidly increasing the share of the world's population living in these countries.

Currently, the vast majority of the population in poor countries is very young (under age 20). The main hope for improving living conditions in poor countries is investment in education so that this mostly young population will have a better future. Education, particularly of girls, also has a powerful impact on fertility, which will also mitigate the ill effects of population growth. However, it is a massive challenge for poor countries with limited resources to educate such large numbers of young people today and the battle is being lost in many of the poorest countries.

Poorer countries that invest in education and can maintain a stable political environment will be better off compared to others. The biggest question mark pertains to Africa, which is beset with staggering challenges today in education, healthcare, population growth, epidemics, political instability, ethnic strife, status of women and is experiencing declines in real education levels, mortality and economic conditions in certain areas of the continent.

Population Structures in Europe and America
The population will be more diverse, but immigrants are more likely to be poor. Older folks are more likely to be working, as retirement at age 60 will become a thing of the past, due to social security cuts, Medicare cuts, declining pension plan income and increasing longevity. Poverty is already present among the elderly, and it will increase, with greater levels of poverty among the elderly who are working.

There will be a higher wage premium for education, and the overall level of education in the U.S. population is not expected to improve, widening the income gap among the affluent and non–affluent.

Due to a relative shortage of young people with new cutting–edge skills, the "seniority" effect in wages will decrease further compared to today, continuing a trend already in effect arising from changing business practices.

Production is likely to be more internationalized, with countries competing on their relative resource advantages. This partly compensates for the demographic imbalance issue related to an aging population in rich countries with the purchasing power and a young working–age population in poor countries with the human resource pool. It also substitutes for migration, which is likely to be at only a modest level due to cultural and political barriers to migration. Migrants in wealthy countries are likely to be a mix of highly qualified professionals and essential low–wage workers performing personal services and working in sectors avoided by the native–born population.

The center of gravity for new innovations and fundamental scientific advances will shift somewhat toward China, which will play an increasing role in creative discoveries.

Asset Markets in 2050
The major economies will be integrated. Markets in China and India can rival European and U.S. markets in their significance. Due to the prevalence of common accounting standards and confidence in the strength of the major economies, international investing, which is already beginning to take hold, will be prevalent among major economies.

There does not appear to be a strong likelihood that asset prices will crash due to baby boomers cashing in upon retirement. Market valuations will continue to depend on factors such as productivity improvements, new markets and technological innovation which drive business profitability.

A few good studies of demographic effects of market valuation exist, and they have generally found no support for the prediction that markets will crash due to baby boom effects. The "cashing in" effect is long term (played out over a couple of decades) so a catastrophic demand/supply situation is unlikely. With the internationalization of the asset markets and the growing affluence of new economies with young populations, there is likely to be demand support when baby boomers sell. Also, the majority of stocks are already held by a small segment of the ultra–wealthy in the population and it is unlikely that this population segment will be selling stocks to finance their retirement. If anything, with the widening gap in income levels, the wealthy may provide their own demand for new stock purchases.

Current trends in asset markets impacting demand and supply include: broader stock ownership and comfort among the broad population to equity investments, easy access to investment/company information, low trading costs and internationalization of financial markets.

Section III: US Fiscal/Trade Deficit
An issue of special importance for the world economy is the persistent U.S. trade deficit and the recent return to large (and growing) federal fiscal deficits. The origin and consequences of these deficits are explored in more detail in the EIAC paper on "Global Economic Environment." We touch briefly on this topic here in the context of stock market returns and interest rates.

In the near and intermediate term, outsourcing and economic–interdependency can slow the economy down in the United States, due to depressed consumer demand as wages stagnate in America and the country becomes more vulnerable to economic factors in other countries. We currently have stagnation problems that lead to unexciting stock markets, with no clear prospects for an upturn any time soon. This makes it attractive for an investor to invest with an international perspective. This can have a further negative effect on market valuations.

The full effect of stagnant wages in America has not been felt in the economy. This is because the U.S. savings rate has been extremely low, which has helped keep the economy humming due to consumer spending. Low interest rates have contributed to the low savings rate (which has reduced the motivation to save as well as created the ability to take money out of home values by refinancing). Higher savings rates are needed to address a variety of economic issues as well as providing for the future needs of the population in retirement. If savings rates kick back up, that will be good for the insurance industry.

Conclusions
Impact on the Insurance Industry
The EIAC then considered the following question: Insurance companies are solid players in the retail supply of investment products. What is the long–term prospect for demand for insurance company products–investment–oriented as well as protection– oriented? How do the trends in demographics and asset markets noted above bear on this question?

The insurance industry's foundation and primary reason for being has always been long–term guarantees and protection for its customers. That will never go away and new opportunities in that domain will continue to arise in the environments that exist in the future, whatever they turn out to be. The industry has shifted more risk to the consumer of the products in recent years. We may move back from that trend to return to our roots of providing guarantees and accepting risk that customers want to transfer to the industry. As one EIAC member commented ironically, "pretty soon we will be reinventing whole life..."

Opportunities may also arise to issue policies at older ages, as longevity creates a new market at those ages. The motivations for buying life insurance at those ages is not clear (other than estate planning reasons), but new protection needs we cannot envision currently may arise. A need for life insurance may be "discovered" by the market when many healthy seventy–year–olds face a prospect of living for another 40 years and make commitments with that expectation and face the hazard of "premature" death.

In a previous era, people saved using bank accounts and life insurance policies. That has undergone a transformation, and the life industry has taken advantage of the changes, as have mutual funds and other providers of savings products. However, the life industry is where the rest of the investment industry used to be 30 years ago, when bond/stock investments were held by an elite few. The mutual fund industry has since broadened its market to the top 20– to 50–percent of the population, but the insurance industry's savings products are targeted at the top 2– to 5–percent. There are probably opportunities for the insurance industry to serve a broader cross–section of the population if we invent products with broader appeal. This is necessary if the industry is not to be marginalized, especially if the tax advantage that drives the top 2– to 5–percent of the wealthy to buy annuities goes away.

There is probably considerable potential in the future for immediate annuities, if "underwritten" annuities are designed and marketed to a population facing longevity risk. Similar potential exists for LTC.

The immigrant population consists of conservative investors, which fits the profile of insurance company products. This can be an attractive market, especially since it is expected to be the fastest growing population segment in America.

The environmental changes noted also point to the need for solid risk management in the insurance industry, which provides an opportunity for actuaries.

One thing that sets the life insurance industry apart from any other is its coverage of mortality risk. This is its core strength, which it needs to capitalize on in the new demographic future that we face.

The U.S. insurance industry should take advantage of the insurance needs of the growing numbers of middle class/affluent people in economies such as China. Capitalizing on such opportunities is good for growth in "high–end" service industries such as insurance and finance that require unique professional skills that are currently scarce in less–developed countries. They are also good for the economy as a whole, helping bring down the trade deficit.

Future Work
The topics covered here are of continuing interest and integral to the long–term understanding of the environment in which insurance companies operate and actuaries practice. We have outlined a number of fundamental trends and issues, but have not fully synthesized them to distill the key implications for the actuarial profession and the insurance industry.

Some of this work is beyond the scope of the EIAC. The out–of–scope items include the questions raised regarding the current valuation level of stocks, the predicted level of ERP in the future and the long–term prospects for interest rates. Much research has been done on these questions by renowned experts in Finance. We recommend that a survey of this extensive body of work be undertaken by the SOA, possibly with the guidance and oversight of the Investment Section. The findings and the various lines of thought in the enquiry into these questions should then be published to the SOA membership.

The EIAC plans to pursue questions that pertain to the competitiveness of the actuarial profession and the insurance industry in light of the trends and the environment presented here. Pertinent issues in this connection will be identified and worked on in 2006. Members interested in contributing to this effort are invited to contact Narayan Shankar at nshac@allstate.com.

Narayan Shankar is senior actuary for Allstate Financial.