Derivatives are important risk management tools that have made it possible for financial and non-financial institutions to buy and sell exposures, thereby diversifying their risk portfolio and reducing earnings volatility. Given the benefits of using derivatives, the market in derivative products has undergone explosive growth over the last 15 years. Today, derivatives are being extended beyond the mainstream interest rate, currency, commodity, equity and credit markets to manage new underlying risks, such as catastrophe, pollution, electricity, weather and inflation risk. Insurers can use derivatives to effectively manage their risks. A life insurer with a large portfolio of Guaranteed Minimum Death Benefit annuities can hedge against a steep decline in equity markets. Life insurers offering interest rate guarantees on their life savings products can use derivatives to hedge against low interest rates. Property and casualty insurers can transfer some of their catastrophic risk to the capital markets via swap transactions. Finally, insurers can use derivatives to manage their assets and liabilities and to enhance their capital adequacy: for example, they can use derivatives to redress any asset-liability mismatches by adjusting the duration of their assets in line with that of their liabilities. Furthermore, they can purchase options to sell their equity to a counterparty at a pre-negotiated price should they face a liquidity crisis. In the following sections we discuss the various risks that insurers hold and then explain, with examples, how they can manage them using derivatives.
Insurers have actuarial, market, liquidity, credit and operational/legal risks. When it comes to derivatives, the main actuarial risks are the pricing of embedded options, such as interest rate and principal guarantees. Market risk arises when the economy affects product performance through an impact on equity markets, interest rates, inflation, exchange rates, etc. Liquidity risk arises when a financial institution finds it has insufficient liquid assets to meet its immediate obligations. Credit risk stems from a counterparty potentially failing to meet its debt obligations. This paper explains how these four risks can be mitigated using examples of appropriate derivatives. Operational and legal risks are not dealt with in this paper.
Managing Actuarial Risk
Guaranteed annuity options have become a serious problem for the U.K. life insurance industry due to a sharp decline in interest rates. A large number of pension policies, written in the 1970s and 1980s guarantee annuity rates that are above current market rates. Falling interest rates in the 1990s reduced the insurance industry's ability to earn an investment return sufficient to meet the guaranteed annuity rates, forcing insurers to tap into their surplus or earnings. Regulators imposed additional reserve requirements, so the insurers attempted to reduce terminal bonuses on these policies. In one specific case, an insurer was taken to court for doing this and lost the case. This resulted in the company coming under serious financial stress.
A swaption is an example of derivative instrument an insurer could use to mitigate the risk arising from these typical interest rate guarantees. The insurance company can buy a swaption from a counterparty in which it agrees to pay a LIBOR-based floating rate in return for a fixed interest rate. These swaptions would be exercised if interest rates fell below those guaranteed by the insurance company. Once the swaption has been exercised, the insurance company receives fixed interest payments and it pays the floating rate to the counterparty. With the swaption, the insurance company in our example is transferring its interest rate risk to the counterparty. 1 Of course, the swaption must be purchased before the market rates decline below the guaranteed rates and its cost must be priced into the insurance products.
Besides derivatives that help manage the financial risk embedded in insurance products, derivatives can also be used to transfer insurance risk to investors or other counterparties. One way of transferring catastrophe risk using derivatives is through a swap transaction: here a series of fixed, predefined payments are exchanged for a series of floating payments, the amount of which depends on the occurrence of an insured event such as a catastrophe. The transaction can be structured as a swap or an option, but the cash flows are the same. The cedent can enter directly into the swap with counterparties or through a financial intermediary.
Managing Market Risk
Interest rate risk constitutes a major risk to an insurer, especially one selling life products. Life insurers sell insurance to clients and invest the premiums in bonds, stocks, mortgages, etc. Changes in interest rates may affect the value of assets and liabilities in a different way and lead to a difference in value between assets and liabilities, which in some cases can lead to insolvency. The effect of an interest rate change on the value of a security depends on the security's duration. 2 To avoid the value of assets and liabilities changing disproportionately, insurers often match their duration. Duration-matching is a complex task, as duration is difficult to measure for assets and liabilities with uneven cash flows, especially during periods of interest rate volatility. Several insurers that did not match the duration of their assets and liabilities became insolvent in the 1970s when interest rates were highly volatile.
Asset-Liability Management (ALM) can be described as a process of managing a financial institution's assets and liabilities in such a way that its balance sheet is immunized against movements in risk factors such as interest rates. Derivatives, such as interest rate futures, options and swaps, are used to fine-tune the sensitivity of assets and liabilities and to minimize the effect of interest rates on an institution's balance sheets. Since the early 1970s, the insurance industry has developed a full range of techniques to offer protection against interest rate risk.
While most of the investments of U.S. insurance companies are in fixed-income products, such as bonds and mortgages, they increased their equity exposure after 1995 due to the stock market boom, thereby exposing themselves to more equity market risk. The market decline witnessed since March 2000 has adversely affected the capital of global property and casualty insurers 3 as well as that of life insurers. Insurers can buy put options or sell futures on market indices such as the Standard & Poor's 500 to mitigate the impact of market decline on the value of their assets and to lower their exposure to life products with equity guarantees.
Managing Liquidity Risk
Liquidity risk arises when depositors or insurance policyholders demand immediate cash from an insurer without sufficient liquid assets to honor its obligations. Usually, insurers keep investments in liquid assets, such as government bonds, to meet any unpredictable demand for cash on the part of investors or policyholders. Still, concerns about an insurer's solvency can lead to investors withdrawing their funds and surrendering their policies. This could force an insurer to sell its less liquid investments at a loss, thereby pushing it closer to insolvency.
Instead of liquidating assets, insurers can raise capital on the equity markets or borrow money. However, when faced by the need to seek immediate funding, an insurer may suddenly find the cost of external financing to be high, while its stock price takes a nosedive. Under these circumstances, it may be unable to raise external capital at a reasonable price. To protect itself against such situations, an insurer can buy put options to sell its equity to a counterparty at a pre-negotiated price, or borrow from them at a pre-negotiated rate if a pre-agreed event, such as a catastrophe, occurs.
Managing Credit Risk
Credit risk management is increasingly important for financial and non-financial institutions. Credit derivatives are useful tools for managing credit exposure and credit risk. In the process of building its proprietary investment portfolio, writing trade credit insurance, surety bonds protection or credit enhancement in structured finance transactions, an insurer may find that it is overexposed to default by a particular corporation. To hedge its exposure, the insurer can buy credit derivatives that pay the insurer if the corporation defaults. In addition to managing the credit risk of counterparty default, some insurance companies write credit derivatives so as to diversify their books and increase income.
Use Of Derivatives By Insurance Companies
Surveys on the use of derivatives and our analysis of data indicates that primarily large insurers, particularly in the life industry, use derivatives. This is explained by the significant economies of scale that are possible when using derivatives. Smaller firms do not have the resources to invest in the latest risk management technologies, and management may be uncomfortable using such new tools. Systems that monitor fraud and risky trades and correctly account for entries are costly. However, such infrastructure is necessary for the proper management and operation of a derivatives unit in any financial institution. The increasing cost of managing the operational risk associated with derivatives could be the biggest hindrance to the proliferation of derivatives among small insurers. Lack of familiarity with the regulatory and accounting treatment of derivatives is apparently another reason for insurers' cautious derivative usage.
As with all instruments which involve the transfer of risk, the use of derivatives requires prudent management. Several cases of major losses in the financial markets--such as Barings Bank , Orange County and Long-Term Capital Management --have been laid at the door of derivatives. In these cases, it is now apparent that management failed to have a full appreciation of how these instruments work. In addition, large losses tend to be associated with highly leveraged transactions and it is often the leverage rather than the derivatives that causes the financial stress.
This week's Learning Curve was written by Mayank Raturi , senior economist in economic research and consulting at Swiss Re in New York.
