Global Economic Risks

Global Economic Risks
by Noel Abkemeier

A report on the influences foreign economies have on the U.S. economy and the risks those influences create.

The vitality of the U.S. life insurance and annuity industry is heavily dependent upon economic events, and many of these are influenced by events within the broad global economy. The strength of the domestic economy, the job market and equity markets can influence the vigor of insurance marketing. Inflation and the character of investment markets can affect the profitability of insurers. While a large portion of these factors are rooted in events and actions within the United States, increasingly these are influenced by external events. While economic projecting is an elusive exercise in the best of times, it is further complicated when many of the drivers are resident in other national economies and the global economy as a whole. Sound management of an insurance company requires a good understanding of these risks so appropriate risk mitigation actions can be taken either at a corporate level or within specific segments.

Background
There currently is a tenuous balance between the U.S. Government's need to sell bonds to finance a huge annual budget deficit and certain foreign countries' (primarily China) need to invest dollars. The problem of a continuing large budget deficit is being "solved" by the handling of a continuing large trade deficit. The investment of foreign surplus dollars in Treasury debt is leaving room for corporate capital formation in the United States and is relieving interest-based inflationary pressures that would exist if the Government debt had to be funded domestically. The ability to invest overseas dollars in Treasury debt helps maintain the value of the dollar, which in turn helps maintain the value of the Treasury debt previously purchased by overseas investors. This mutually advantageous symbiotic relationship cannot be sustained indefinitely, and the impact of its ending must be considered. It is important for the insurance industry to understand the range of possible consequences.

It is also important to understand the possible consequences of another oil shock that could be created by geopolitical instability. This could not only induce additional inflation, but also directly dampen economic output. In either case, it directly affects the U.S. economy. Finally, a health pandemic could introduce a severe disruption in economies and financial markets.

Impact
If the budget deficits and trade deficits can be brought under control in tandem, the existing Treasury debt can slowly reduce in significance within growing domestic and global economies. Interest rates could remain stable, currency values could be kept reasonably stable and extraordinary inflation could be avoided. However, the two deficits may be difficult to successfully address simultaneously, and a solution in one area may create a problem in the other, e.g., a weakened dollar to help mitigate the trade deficit may erode foreign interest in purchasing Treasury bonds that may depreciate in the future due to further currency weakening. The risk is that this will not be a smooth process and that other economic shocks could occur. Specific risks are:

• Elevated interest rates in the event that overseas funding of Government debt decreases sharply. This could occur not only because the U.S. debt becomes less attractive, but also because internal capital demands become more significant. While this may create an investment opportunity for insurers, it also brings a market–value disintermediation risk if policy owners choose to replace their policies with new policies with more attractive interest rates. This could heavily impact the deferred annuity market and, to a lesser extent, the life insurance market if the higher interest rates permit premium reductions.
• Interest–induced inflation from rising interest rates. While this may create the opportunity to sell additional insurance coverage, it erodes margins on prior business.
• Exchange–rate induced inflation in the event of a falling dollar. General inflation within the economy due to the growing dependence on imports would pour over into all goods and services as wages would try to track the increased cost of living. This inflation could then both present the opportunity of greater sales and the risk of eroding margins, as discussed above.
• Shock–induced inflation and economic slowdown in the event of a specific global event, such as an oil shock or a pandemic. Earlier oil shocks have led to double–digit inflation and ultimately led to double–digit interest rates and a recession. With the current flat–to–inverted Treasury curve, there is the speculation that this could be predictive of an impending recession. This magnifies the risk that an economic shock could have a very significant impact. The implications of inflation and interest rate increases are as described above; however, they could be more severe than that induced by reduced overseas funding of Government debt or by currency devaluation.
• Depressed equity markets as a result of any of the other primary risks of increased interest, inflation or recession. This could not only devalue investment portfolios, but also reduce profitability and marketability of equity products. The impact upon individual insurers would vary based upon their reliance on equities for investing surplus and their presence in the equity–product market. The product risk can be two–fold for issuers of variable annuities and variable life. The equity market fall will reduce the basis for earning spreads that are based on the product account values. Additionally, there may be the risk of needing to reduce Deferred Policy Acquisition Cost (DAC) and thus incur accelerated charges under GAAP accounting. Finally, issuers of put–based derivative benefits, e.g., guaranteed minimum death benefits and guaranteed living benefits, will incur additional losses to the extent that they are not fully hedged.

Urgency
The global economic risk can have immense impact on the industry and individual insurance companies. There is a high probability that one or more aspects of the risk will occur because of the difficulty of addressing both the budget and trade deficits. The influence of overseas events is also difficult to predict. The risks should be viewed more in terms of when they might occur rather than if they will occur. The insurance industry would benefit from an analysis by qualified risk management specialists and economists. As a result, the industry could take appropriate actions, such as better business diversification and placement of appropriate hedges.

Noel Abkemeier is a consulting actuary for Milliman, Inc.He can be contacted at noel.abkemeier@milliman.com.