John Godden discusses the implications of insurers’ increasing use of derivative instruments
The economic conditions of the late 1990’s in the western world are notable for the low interest rates that pervade the mature economies and the almost universal reduction in government borrowing requirements. These ongoing conditions, allied to significant increases in medium and long-term equity market volatility, have undermined a lot of the principles on which asset/liability management is built particularly the models adopted by anglo-saxon insurers.
The job of matching an insurer’s assets to its liabilities is becoming increasingly more difficult as the falling returns and liquidity squeeze on the accepted assets, predominantly sovereign long-bonds, increases the spread to the liability portfolios built in times of higher yields and seemingly endless debt issuance.
It is in these circumstances that the transference of the risk of further falls in yield to investment banks and the receipt of yield enhancement using structured notes through the purchase of OTC derivatives takes on a new appeal.
The investment banking community has made clear its ability to structure financial instruments that can hedge particular liabilities or provide enhanced payoff profiles by using combinations of short and long positions on market forwards to extract value or lock-in a position.
But where can these instruments be of assistance, what are insurers using them for and how effective can they be?
Yield enhancement: When insurance companies find themselves forced to make income payments or offer deposit rates above the risk-free level, either through contractual or competition driven commitments, they can purchase notes that use the forward shape of the curve to provide higher, fixed yields now buy place future yields at risk.
One such idea providing significant pick-up on the current curve is to play on the sterling constant maturity swap (CMS) rate where an insurer would purchase a swap that pays a fixed coupon, say 8% annualised, for each day in a five year period that the CMS rate is below a barrier level ( say 8.5%), but pays no coupon when the rate is above this level. This trade relies on the insurer receiving sufficient coupon from the balance of its bond holdings above the barrier level to offset the loss of coupon on the swap, meantime the boosted coupon relative to current yields would satisfy immediate commitments.
Another popular mechanism for boosting yield on a bond portfolio through swap and swaptions is the addition of a callable feature. This gives the bank the right to unwind the trade a one of several, predetermined dates. This can add as much as 100 basis points for the minor inconvenience to the insurer that the portfolio will be disrupted slightly by the early termination of the swap. UK insurers are currently looking to shift their index-linked long bond portfolio from UK to European holdings, as the spread is stronger. Again, the use of a swap with embedded currency hedge, can offer greater efficiency than liquidating the existing portfolio and buying bunds with an accompanying currency hedge.
The use of credit derivatives to provide controlled exposure to high yielding issuance has been greatly increased by the advent of capital protected structures that provide suitable protection against default moving the risk/reward profile into acceptable territory for use within insurance portfolios.
Liability mis-match protection. As the result of different circumstances, insurers across Europe are struggling to match their assets to the profile of their liabilities and are purchasing OTC derivatives to either close the gap or to prevent any further deterioration of their position.
In the UK, insurers have been hit hard by the guaranteed annuity options sold in the 1970’s and 1980’s falling rapidly ‘in the money’ creating massive, unhedged liabilities that have required decisive action on a large scale. Many have entered into swaption programmes by way catastrophe cover to avoid tying up any further reserves.
In France and Belgium, insurers are looking at methods of sustaining income rates on bond-backed life contracts at above market levels for fear of losing future business. portfolios hamstrung by existing holdings are buying swaptions that will boost yields in a rising market without having to liquidate existing positions.
The German insurance market is faced with lowering the minimum annual return on its savings contracts from 4% to 3% in the light of the long term fall in yields. The use of swaptions is assisting them in their desire to maintain the 4% level to avoid accelerating the move to unit-linked product.
Pension regulation in Denmark requires providers to offer a minimum return of 4% after tax which is proving difficult given the adverse tax treatment for equity holdings. Insurers are looking to derivatives to provide equity exposure via bond instruments that do not attract this taxation.
Liquidity crunch in fixed income derivatives: The dramatic increase in demand for fixed income derivatives has caused severe market disruption, particularly in the sterling market. This has driven market volatility up to the point where swaption pricing is abnormal and relatively expensive. Further, some banks have been stung by the volatility shift having undertaken sizeable hedges for insurers and maintained them on their own books due to insufficient market liquidity to place it in the market.
This is being solved to some extent by
providing slightly imperfect hedging in alternative markets with correlation risk floored in the event of greater than expected deviation.
Equity portfolio protection: Whilst the declining yield environment is causing insurers a headache on one hand, increased equity market volatility and concern of over-heating are creating disruption in the management of equity portfolios.
The use of non-cost collars has multiplied many fold over the past year as insurers realise the value in using potential out-performance to fund protection against market adjustments occurring at sensitive times.
Particularly popular is the sale of local, annual caps on the performance of a share portfolio in return for the purchase of a global floor to lock-in value at current levels. The volatility neutral nature of such trades makes them good value for insurers and banks alike if constructed correctly.
The irony of the increased level of interest in OTC derivatives by insurers at this time is the concerns occurring in times of high volatility which in itself is a dominant factor in driving the cost of such protection higher. The current cycle of high volatility/ high interest could act as a catalyst for greater use of such protection structures during less volatile periods.
One common trade that has created a market of its own is the use of the reverse convertible on single stocks, or baskets, to provide high coupon levels in return for placing capital at risk from market falls. This involves the purchase of volatility by the banks from the insurers and, as such, high volatility levels are a distinct advantage. Many retail products have been issued on the back of such structures.
With the exception of the UK, European insurers are gradually increasing their exposure to equities at the expense of bond holdings. With asset/liability management also becoming a dominating factor, the use of derivative structures that provide equity participation within an instrument that offers capital protection, or bond-linked downside, is becoming widespread. These can also assist pension providers bridge the gap between defined contribution arrangements and defined benefits by providing synthetic liability links.
The wider use of derivative instruments by insurers is an obvious product of current European economic conditions but their success will depend greatly upon the markets’ ability to absorb the demand with as little disruption as possible to avoid pricing being forced up by liquidity anomalies.
John Godden is head of structured insurance products at Paribas in London.