The level of risk management sophistication on the part of insurers is rising, resulting in brisk business for banks specialising in the provision of products such as derivatives. Edward Russell-Walling explains.

Insurance companies have been learning – the hard way, some of them – that they need to manage and price their risk more intelligently. One visible result is more creative use of equity derivatives in their investment portfolios, often in the shape of structured products, and the specialist banks providing these products have targeted the sector as a growing source of business.

Life insurance markets have changed significantly over past decades, and the nature of the risks faced by insurers has changed in tandem. The purpose of life insurance remains the same – to provide a financial benefit to policyholders and their families. But while the traditional benefit was a fixed, guaranteed lump sum, today’s policyholders are more tuned in to investment opportunities. They want more participation in any upside from equity investment, while retaining their mortality protection.

Guaranteed response

The industry’s response has been a proliferation of equity-linked products, invariably with some form of guarantee – unit-linked insurance in the UK and some other parts of the Commonwealth, variable and equity-indexed annuities in the US, and segregated fund contracts in Canada.

Even Germany, slow to succumb to the lure of equity markets, has now introduced equity-linked endowment insurance. In these products, some or all of the premium goes into a separate account, or equity fund, that will be the main part of the policyholder’s benefit. It also represents a very different form of risk.

As Mary Hardy points out in Investment Guarantees: Modelling and Risk Management for Equity-Linked Life Insurance (John Wiley & Sons), the assessment and management of financial risk is not at all the same as managing insurance risk. “The management of insurance risk relies heavily on diversification,” Ms Hardy notes. “With many thousands of policies in force on lives that are largely independent, it is clear from the central limit theorem [the rules for analysing sample means] that there will be very little uncertainty about the total claims.”

Potential liabilities

With investment guarantees, however, the shape of the risks changes. Taken together, each group of policies has only limited diversification and, if a market crashes, it is likely to affect all contracts at the same time. So the risk is low in frequency terms – meaning that market performance has to be very disappointing for the guarantee to apply – but high in terms of severity. If the guarantee does kick in, the potential liability is huge – just how huge was demonstrated by the closure of the UK’s Equitable Life in 2000 to new business after being swamped by guarantee liabilities.

There are two common ways of managing investment guarantees – the actuarial approach, which assumes that the capital is invested in risk-free bonds, and the dynamic hedging approach, which is more appropriate for equity-linked products and which generally relies on the Black-Scholes options pricing model.

Hands-on dynamic hedging, however, is a specialist activity for which few insurance companies have the time, skills or inclination. It is against this backdrop that the products designed for insurance companies (and others with a taste for capital guarantees) have evolved, from relatively simple index-linked structures, through zero coupon bonds plus options, to the latest generation, which include new asset classes and trading strategies.

Transparent options

One of the newest product lines, developed specifically for insurers, is the guaranteed minimum benefit contract. These are known generically as GMxB, where ‘x’ – the subject of the guarantee – may stand for ‘death’ (minimum payout on death), ‘accumulation’ (minimum guaranteed surrender payouts on specified dates), ‘withdrawal’ (minimum guaranteed periodic withdrawals) or ‘income’ (minimum guaranteed fund growth rate with a guaranteed annuity rate). One of their attractions for consumers is their transparency, compared with the traditional with-profits product, and they are expected to make a considerable impact in European insurance markets in years to come.

“In Europe, the advent of risk-based capital means that traditional with-profits life insurance are becoming less attractive for insurance companies, while unit-linked policies have enjoyed spectacular growth,” says Emmanuel Goudouneix, head of global solutions for financial institutions at Société Générale Corporate & Investment Banking (SGCIB). GMxB is essentially an embedded option, he notes, representing a risk that is fundamentally different from insurance risk. “However, dynamic replication of these embedded options can be a strong distraction for insurance companies.”

Banks such as SGCIB have the trading, operational and risk control experience that most insurance companies lack. Combining underlying investments with options and swaps, their latest products occupy a space somewhere between traditional asset management and conventional structured products – “structured asset management”, as some bankers call it. “Structured asset management aims to replicate some of the more sophisticated strategies used by hedge funds, in a format suitable for investors such as high net worth individuals, private banks and insurance companies.” says Hassan Houari, Barclays Capital’s head of equity derivatives structuring. “It offers capital guarantees and upside participation, capturing some alpha from smarter indices or even trying to extract value from hidden assets like volatility, dividends or correlation.”

Barclays Capital’s Voltaire Notes illustrate the kind of product being created typically for insurers’ own-account use. In this instance, the notes allow them to invest in volatility as an asset class. A euro-denominated three-year Euro Medium Term Note (EMTN) with 100% principal protection at maturity, Voltaire uses variance swaps to arbitrage between implied and realised volatility.

A zero coupon bond provides capital protection and the balance of the initial investment is used to buy a succession of short-term variance swaps. The final payout is linked to the success of that trading strategy.

Derivative attractions

Without that sort of market access, trading variance and volatility would remain an activity that most investors could merely read about in hedge fund magazines. For an insurance industry sandwiched between the demands of its customers and the unpredictability of equity markets, this type of asset diversification is one of the attractions of derivative-intensive products.

Another is the fact that International Financial Reporting Standards (IFRS) accounting rules require naked options to be marked to market. “Insurance companies like to avoid that if they can’t put an asset against it,” says Mr Houari. “So they are looking for packaging that allows them to buy derivatives with a more favourable accounting treatment.”

Local stress testing requirements and the prospect of Solvency 2 are also affecting the way insurance companies think about their assets and liabilities. With equities risk-weighted more heavily than bonds, it suits insurers to have equity exposure via structured products rather than directly. Solvency 2, the new capital adequacy regime for European insurers, will not be implemented until the end of the decade but, in the meantime, the attention of credit rating agencies is having a similarly bracing effect on insurers’ thinking.

“The rating agencies are driving insurance companies to focus better on day-to-day risk,” says Mr Goudouneix. “They want them to identify and to price the guarantees they have given, to be able to define the risks on the other side of the guarantee coin. There have been lots of efforts to understand risk, but less to understand price – what is the price of a put, of a guarantee? Banks in general can provide appropriate prices, and can go more deeply into what is needed and how to buy it. We can show in terms of market prices what costs are embedded in giving guarantees.”

Ms Hardy notes that price, capital requirements and asset allocation are closely inter-related. “Using the option approach for pricing maturity guarantees gives a price, but that price is only appropriate if it is suitably invested – in a dynamic-hedge portfolio, or by purchasing the options externally,” she says. “Different risk management strategies require different levels of capital [for the same level of risk], and therefore the implied price for the guarantee would vary.”

Barclays Capital’s Mr Houari believes that the gap between banks and insurance companies in risk management sophistication is now closing.

“There is convergence – the insurers are catching up,” he says. “Local and EU regulations are forcing them to price correctly and to diversify their portfolio risk by investing in new types of products. In the past they were just outright long traditional asset classes. But their thinking is changing and, in the future, they will be much bigger users of derivatives.”

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