25 November 2009
Published in: Capital - models, ALM, Market risks, Regulation - supervision
Insurers should use derivatives to manage risk under Solvency II
The directive will require a total balance-sheet approach to the business and encourage non-life insurers to take a more active approach to managing market risks, argues Peter McGloughlin
Derivatives have had a rough ride of late with the term frequently used to describe a wide range of asset classes from swaps and options to structured credit and catastrophe bonds. The media likes to quote Warren Buffet's famous line calling derivatives "weapons of mass destruction." Yet today, in what remain abnormally volatile markets, derivatives form one of the essential tools in any risk manager's toolbox.
When used correctly derivative strategies can be employed to hedge or transform an insurance company's exposure to financial market moves and greatly improve the risk profile of the business. In addition, with an emphasis on investment returns, derivatives are increasingly becoming an invaluable tool to help optimize risk returns in the investment portfolio. We explore some of the implications for the non-life insurance sector.
The recent market volatility, with severe falls in interest rates and a widening of bond credit spreads, has highlighted the non-life sector's sensitivity to medium-term market risk. Historically, the primary focus for non-life insurers, such as property & casualty businesses, has been on underwriting risk rather than investment risk. But many insurers are now working to improve their economic capital modelling to take full account of the assets and liabilities across the business.
As such, while nearly all non-life insurers are used to focusing on the shorter-term money market and foreign exchange risks, many have less experience in dealing with the medium-term interest rate, inflation and credit risks that will become more prevalent in today's uncertain markets and will need to be modelled under Solvency II.
Solvency II will require a total balance-sheet approach to the business and encourage a more active approach in managing these market risks. This may lead to more use of derivatives as a risk management tool and there are several areas where usage may increase.
Discounting insurance liabilities - the need to discount best estimate liabilities under Solvency II will create more sensitivity to interest-rate moves particularly for longer-tail business lines. Article 76 of the Solvency II framework directive outlines the principle of market-consistent valuation of assets and liabilities with the best estimate equal to the "probability-weighted average of future cash-flows, taking into account the time value of money (expected present value of future cash-flows), using the relevant risk-free interest rate term structure."
Derivatives can be used to help match the liabilities much more closely than traditional stand-alone fixed-income portfolios and remove the sensitivity to interest-rate moves arising from the need to discount liabilities. This can also help separate interest-rate risk management from the need to generate positive alpha investment returns through some use of zero-duration asset classes such as equities or absolute return managers.
Credit risk concentration - Insurers with multiple investment managers need to ensure that credit risk is managed across the aggregated portfolio. Often with the use of pooled and commingled funds the same fixed-income bonds may be held in different portfolios and it may not be possible to alter investment mandates to exclude an individual name. However, the insurance company can use credit default swaps (CDS) as an overlay hedge to the portfolio and remove any excess exposure to investment-grade credit risks.
Adjusting duration - In today's volatile markets there may be times when investment committees feel that the aggregated duration risk across all the managers' portfolios is too long. In times of potential interest-rate rises insurance companies can use an interest-rate swap overlay to reduce the duration risk for the business without having to change the investment mandates of their managers. This kind of flexibility allows companies to react quickly to changing market conditions.
Inflation risk - While current levels of inflation are benign and in some economies negative, non-life insurers face significant risks from a high-inflation environment. Firstly, fixed-income portfolio valuations will come under pressure and may fall in value. Secondly, many insurers are exposed to claims inflation. This is particularly the case for excess-of-loss lines and longer-tail risks. Inflation swaps linked to US CPI or UK RPI can be used to hedge and help reduce the one-in-200-year event risk as part of the capital modelling.
FX risk - Currency markets remain extremely volatile and while insurers aim to match currency assets and liabilities, many in the Lloyds market in particular found themselves exposed as a result of the depreciation in sterling at the end of 2008. Additional capital was required to cover the increase in the liabilities because of the currency move. Insurers are also exposed to the currency mismatch between the business costs of the country of domicile and the currency of the premiums generated. FX hedging solutions are available to manage these exposures.
Equity risk - Many insurers found out at a cost that in times of market distress investments in hedge funds were locked in just when they wanted to cash out. In some cases using an equity or commodity derivative as an overlay to hedge downside risk in the fund can be an effective way of macro-hedging the investment risk for the locked-in period.
Investment strategy - Derivatives can also be used as an asset class for the investment portfolio. One example of this is using interest-rate swaps to take advantage of a steep yield curve. For example, an insurer may feel that the long end of the US dollar curve will steepen significantly when the TARP programme ends and yields will rise. They may, however, not want to invest capital for a 10-year period and take long-dated credit risk. Instead, a cash-collateralized 10-year interest-rate pay-fixed swap or a 10-year constant maturity swap (CMS) can be used to take a view on 10-year swap rates rising for a one-year investment period. The capital is then invested in shorter dated instruments. If the 10-year swap rate increases, the swap will increase in value and will help protect potential losses on fixed-income portfolios. The swap and the short-dated instruments are highly liquid and the swap can be closed out at the end of the one-year investment or held open for a longer period.
Discounting insurance liabilities
The move to Solvency II will force non-life insurers to take a total balance sheet approach to calculating their solvency capital requirement (SCR). The largest liability on the balance sheet is normally the technical provisions (for property and casualty), which is reported on an undiscounted basis in the current UK regulatory regime. Solvency II will require these technical provisions to be recorded on a discounted basis. This can be seen in the diagram below which shows an example of a UK insurer moving from ICAS, the current UK regulatory regime, to Solvency II.
In addition, it is likely that phase two of the international financial reporting standards (IFRS) will mean that liabilities are reported on a discounted basis as well. This should benefit insurers who currently have to mark-to-market their investment portfolios while the liabilities are reported undiscounted.
The new approach is driven by the need to calculate liabilities on a market-consistent basis. For non-life insurers this will mean that technical provisions as laid out in chapter six of the Solvency II framework directive will be determined as:
Technical provisions = NPV of [best estimate] + NPV [risk margin]
Where
- best estimate: the undiscounted probability-weighted average of future cash flows
- NPV: the net present value calculated by using the relevant discount-rate term structure. Insurers will need to use a market-consistent yield curve to generate the discounting which will add a new dynamic as yield curves can change in steepness and shape
- risk margin: cost of holding the SCR for non-hedgeable risks during the run-off period of the in-force portfolio
The impact for insurers is likely to be a reduction in technical provisions compared with current calculations. Clearly the impact of discounting alone will drive this effect, and longer- tail business lines will show an even greater sensitivity to discounting. Feedback from the fourth quantitative impact study (QIS4) in the UK seems to support this conclusion.
The choice of discount factor can have a significant effect on the calculations. While this is an interesting point of discussion, we will assume that discounting is done using the swap curve for the purposes of this article. Note that in life insurance the outcome of the current debate on the liquidity premium in corporate bond markets may allow insurers to discount at swaps + liquidity premium thus producing a greater impact from discounting given the longer-term nature of their liabilities.
What will be the impact of interest rate volatility?
Under the current solvency rules, whether interest rates are high or low, the undiscounted best-estimate liabilities reported are unaffected. So in times of extreme market volatility, such as the past 18 months where interest rates have fallen dramatically, insurers have actually benefited from the fact that the liabilities are undiscounted and provisions have not increased. Under Solvency II it is likely that provisions will increase as interest rates fall which, when combined with lower investment returns, may create more capital volatility.
To put this in perspective, imagine an insurer is holding a discounted provision of $100m based on an average term of five years. At year-end 2008 the five-year interest-rate swap rate (commonly used for discounting) was 2.16%. At year-end 2007 the same five-year rate was 4.21%, a fall of over 2% in one year. This means that on a simplistic basis the insurer would need to move the provision up to nearly $113m -- an increase of 13% on capital.
In this simple example we would naturally expect to see some gains on the investment portfolio to help offset this additional cost of capital. Insurers with short-tail risks normally try to negate interest-rate sensitivity by matching assets to the liabilities: in other words setting the discounted value of the assets equal to the discounted value of the liabilities and the average duration of the assets equal to the average duration of the liabilities.
However, often in stressed markets, sudden downward moves in interest rates also coincide with (or are caused by) a blow-out in credit spreads. While broadly speaking a fall in interest rates would lead to gains in the mark-to-market of a portfolio of fixed-rate bonds, increasing credit spreads will devalue the portfolio and could easily offset the gain from interest-rate moves. This was certainly the case throughout 2007 and early 2008. In this case, in a Solvency II world, an unexpected fall in interest rates could lead to a double hit to insurers from the assets and liabilities on the balance sheet.
Interest-rate swaps as an overlay to manage duration mismatch
As such, insurers should consider strategies to minimize their volatility from swings in the technical-provision liabilities that are purely due to interest-rate moves. Take another example of an insurer which at the onset of the credit crunch decided to reduce duration risk across the investment portfolio, and instructed its managers to keep assets at a very short duration of less than one year, primarily on credit market concerns. However this particular insurer had medium- and longer-term liabilities creating a duration mismatch with the assets from a discounting perspective.
The first graph below shows the impact of parallel shifts in interest rates on the value of the liabilities relative to the value of the investment portfolio. As interest rates start to fall, a mismatch in value becomes clear and the value of the bond portfolio does not cover the increase in the value of the liabilities.
One way to manage this is to use an interest-rate swap overlay to ensure that the interest-rate risk between the assets and liabilities is removed. The second graph below shows that the insurance company has entered into a receiver interest-rate swap to ensure that the value of the bond portfolio, plus the swap, will move one-for-one with changes in the value of the liabilities. The notional amount and maturity of the swap are chosen to ensure the asset- liability mismatch is closed.
The insurer has now managed to reduce longer-term credit risk by shortening the investment portfolio while at the same time using an interest-rate swap (which can be cash-collateralized to remove counterparty risk) to hedge the interest-rate sensitivity of the liabilities.
Derivatives can be used to deal with market risks identified by economic modelling
The idea of an overlay -- putting a derivative in place at the insurance company level to overlay the underlying investment portfolio -- allows insurers to become more flexible and reactive to reducing risks in the business. We have gone into some detail on interest-rate swap overlays but in a similar way derivatives can also be used to manage FX, credit, inflation and equity market risks.
The advent of dynamic financial analysis (DFA) and economic modelling across liabilities and investment portfolios should mean that insurers will be able to get capital benefits by putting market-risk hedges in place for certain risks. The DFA process should highlight all the market risks in the insurance liabilities and investment portfolios and give insurer the chance to ask: "Am I being rewarded for taking this market risk?"
If the answer is "No" then it may be appropriate to hedge the risk from the balance sheet. Similarly, some insurers may choose to use their own capital to keep some market risks on the balance sheet, i.e. clearly some market risks will be required to generate the investment income.
In this way the economic-modelling process will help drive the decision-making for the chief investment officer and chief risk officer of many non-life insurers in the future. Investment committees will be able to make decisions on investment strategy and risk management by comparing the savings gained in capital requirements with the cost of putting a market hedge or investment in place and then take actions accordingly.
In summary, the advent of Solvency II and the issues surrounding technical-provisions discounting and dynamic financial modelling are likely to increase non-life insurer's awareness of the medium-term market risks in their business. Derivative usage is likely to rise as a result and given the insurance-like nature of derivative instruments, insurance companies are well placed to adopt the use of these instruments for the capital management of their business.
Peter McGloughlin is a director in the Financial Institutions Solutions team at Lloyds Banking Group specializing in the insurance sector and fixed income derivatives. Peter is a member of the Chartered Securities and Investment Institute and an affiliate member of the Institute of Actuaries.
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