Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
MARKET RISK DISCLOSURE
Market risk is a general term describing the potential economic loss associated with adverse changes in the fair value of financial instruments. Management of market risk is a critical component of our investment decisions and objectives. We manage our exposure to market risk by using the following tools:
● Monitoring the fair value of all financial assets on a constant basis,
● Changing the character of future investment purchases as needed and
● Maintaining a balance between existing asset and liability portfolios.
FIXED INCOME AND INTEREST RATE RISK
The most significant short-term influence on our fixed income portfolio is a change in interest rates. Because there is intrinsic difficulty predicting the direction and magnitude of interest rate moves, we attempt to minimize the impact of interest rate risk on the balance sheet by matching the duration of assets to that of our liabilities. Furthermore, the diversification of sectors and given issuers is core to our risk management process, increasing the granularity of individual credit risk. Liquidity and call risk are elements of fixed income that we regularly evaluate to ensure we are receiving adequate compensation. Our fixed income portfolio has a meaningful impact on financial results and is a key component in our enterprise risk simulations.
Interest rate risk at the time of debt refinancing can also affect our consolidated statement of earnings due to its impact on interest expense. We monitor the interest rate environment and evaluate refinancing opportunities as debt maturity dates approach. Changes in interest rates do affect the fair value of our debt. However, our debt is reported at amortized cost on the consolidated balance sheet and is not adjusted for changes in fair value.
EQUITY PRICE RISK
Equity price risk is the potential that we will incur economic loss due to the decline of common stock prices. Beta analysis is used to measure the sensitivity of our equity portfolio to changes in the value of the S&P 500 Index (an index representative of the broad equity market). Our current equity portfolio has a beta of 0.9 in comparison to the S&P 500 with a beta of 1.0. This lower beta statistic reflects our long-term emphasis on maintaining a value-oriented, dividend-driven investment philosophy for our equity portfolio.
SENSITIVITY ANALYSIS
The tables that follow detail information on the market risk exposure for our financial investments as of December 31, 2022. Listed on each table is the December 31, 2022 fair value for our assets and the expected pretax reduction in fair value given the stated hypothetical events. This sensitivity analysis assumes the composition of our assets remains constant over the period being measured and also assumes interest rate changes are reflected uniformly across the yield curve. For example, our ability to hold non-trading securities to maturity mitigates price fluctuation risks. For purposes of this disclosure, market risk sensitive instruments are all classified as held for non-trading purposes, as we do not hold any trading securities. The examples given are not predictions of future market events, but rather illustrations of the effect such events may have on the fair value of our investment portfolio.
As of December 31, 2022, our fixed income portfolio had a fair value of $2.7 billion. The sensitivity analysis uses scenarios of interest rates increasing 100 and 200 basis points from their December 31, 2022, levels with all other variables held constant. Such scenarios would result in modeled decreases in the fair value of the fixed income portfolio of $111.1 million and $215.2 million, respectively. Comparatively, our fixed income portfolio had a fair value of $2.4 billion as of December 31, 2021 and scenarios of interest rates increasing 100 and 200 basis points would have resulted in modeled decreases of $126.9 million and $246.8 million, respectively.
As of December 31, 2022, our equity portfolio had a fair value of $498.4 million. The base sensitivity analysis uses market scenarios of the S&P 500 Index declining both 10 percent and 20 percent. These scenarios would result in approximate decreases in the equity fair value of $46.3 million and $92.7 million, respectively. Comparatively, our equity portfolio had a fair value of $613.8 million as of December 31, 2021 and scenarios of the S&P 500 Index declining by 10 percent and 20 percent would have resulted in approximate decreases of $56.4 million and $112.9 million, respectively.
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While the declines in market value outlined below are modeled as instantaneous changes, we would expect movements in capital markets to occur over time, with investment income offering an offset to any decrease in prices.
Under the assumptions of rising interest rates and a decreasing S&P 500 Index, the fair value of our assets will decrease from their present levels by the indicated amounts.
Effect of a 100 basis-point increase in interest rates and a 10 percent decline in the S&P 500:
12/31/22 Fair
Interest
Equity
(in thousands)
Value
Rate Risk
Risk
Held for non-trading purposes:
Fixed income securities
$
2,666,950
$
(111,136)
$
—
Equity securities
498,382
—
(46,333)
Total
$
3,165,332
$
(111,136)
$
(46,333)
Effect of a 200 basis-point increase in interest rates and a 20 percent decline in the S&P 500:
12/31/22 Fair
Interest
Equity
(in thousands)
Value
Rate Risk
Risk
Held for non-trading purposes:
Fixed income securities
$
2,666,950
$
(215,239)
$
—
Equity securities
498,382
—
(92,667)
Total
$
3,165,332
$
(215,239)
$
(92,667)
Comparatively, under the assumptions of falling interest rates and an increasing S&P 500 Index, the fair value of our assets will increase from their present levels by the indicated amounts.
Effect of a 100 basis-point decrease in interest rates and a 10 percent increase in the S&P 500:
12/31/22 Fair
Interest
Equity
(in thousands)
Value
Rate Risk
Risk
Held for non-trading purposes:
Fixed income securities
$
2,666,950
$
118,526
$
—
Equity securities
498,382
—
46,333
Total
$
3,165,332
$
118,526
$
46,333
Effect of a 200 basis-point decrease in interest rates and 20 percent increase in the S&P 500:
12/31/22 Fair
Interest
Equity
(in thousands)
Value
Rate Risk
Risk
Held for non-trading purposes:
Fixed income securities
$
2,666,950
$
244,958
$
—
Equity securities
498,382
—
92,667
Total
$
3,165,332
$
244,958
$
92,667
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