Rethinking risk management for insurers

The financial crisis and global economic slowdown has not fundamentally altered the situation for institutional investors, but it has accelerated trends that were already in place. Demographic change turned pension surpluses into deficits, and the bursting of the technology bubble at the start of the decade laid bare the risk of market underperformance that was driven home by the losses from 2008 onwards. In addition, a weaker economy leaves companies with less cash to shore up their corporate pension schemes, forcing scheme trustees to raise their game.

"The affordability of pensions for many corporate sponsors is increasing the focus on the whole risk profile across both the asset and liability sides, and marrying up more coherently the funding strategy with the investment and liability risk management strategies is going to be essential," says Guy Coughlan, co-head of pensions advisory at JPMorgan in London.

The specifics of each national pension system and how far funds are required to mark assets and liabilities to market tend to shape the funds' derivative activities.

German companies have only begun to segregate and fund their pension schemes over the past decade. In contrast, in the most sophisticated European pension markets, namely the Netherlands and the UK, regulation and especially liability accounting techniques have already driven the use of derivatives for liability hedging purposes for some time. Pretty Sagoo, a director in the European pensions and insurance advisory team at Deutsche Bank in London, says derivatives frequently provide funds with a more effective hedge of their unrewarded risks than cash instruments such as bonds, especially in terms of duration, inflation and interest rate hedging.

"For inflation especially, you are limited in how far you can achieve a hedge in the cash bond market. The UK government has issued about 19 inflation-linked bonds, but these give you a very defined structure of inflation. The derivatives market allows you to very exactly match the inflation risk in your liability stream," says Ms Sagoo.

Emmanuel Naim, head of equities structuring in the cross-asset solutions team at Société Générale Corporate & Investment Banking (SGCIB), says institutional investors are increasingly convinced that the exit strategy for eurozone governments coping with high sovereign debts will involve a weak euro and a tolerant attitude towards inflation, which will reduce the real -value outstanding debt. Consequently, inflation-linked investment products, including proxies such as commodities and real estate, are all in demand.

Getting comfortable

The experience of implementing liability-driven investment (LDI) and using the inflation swaps market has gradually generated a growing number of schemes with the governance structures to handle more sophisticated derivative market activities. Robert Gardner, co-founder of pensions and investment consultants Redington Partners and a former pensions advisory banker at Merrill Lynch, says once funds have the infrastructure in place, there is nothing to stop them looking at synthetic exposures through total return swaps on equities or commodities, or through credit default swaps, all of which can generate return with less commitment of capital upfront than cash instruments.

"Once you enter this mindset, the degrees of freedom available to you to manage interest rate risk, equity risk or credit risk are a lot greater. Pension funds have entered the world in which they have the CSA [credit support annex], they have agreed the collateral posting, they have the custodian, and they are now able to manage and transact all forms of derivatives. So the question becomes what is the smartest way to manage each risk at a given time?" says Mr Gardner.

The increasing use of mark-to-market accounting has also changed the financial dynamics for corporate sponsors. Even if the pension fund trustees can adequately forecast economic fundamentals such as inflation and interest rates, market values for these variables are driven by many other technical and human behavioural factors such as liquidity, fund positioning and stop-loss settings. Consequently, says Mr Gardner, in most cases the fund is best advised to take as many risks off the books as possible, or face holding a larger capital cushion to cope with increasingly heavy market gyrations.

On the asset side, some funds take the view that the risk premium rewards them suitably for taking risks in equity or bond markets without hedging. They may look to profit from the higher levels of volatility in the short term, given their long-term investment horizon and the fact that equity valuations today are cheap based on historic multiples, says Mr Naim.

He adds: "We are seeing demand for products that generate income provided there is no or only a limited decrease in equity markets. This view is well remunerated in today's volatile markets, and allows a return even if there is no clear upward trend in equities."

But the uptake of LDI strategies also encourages trustees to look at the rate of return needed to meet the funds' pension obligations. This allows the fund to consider surrendering upside beyond that, as a means to pay for capping the downside risks. According to Ms Sagoo, many clients prefer this approach of paying away part of their return on an ongoing basis, rather than paying a large upfront fee for downside protection.

There are also signs that pension funds are thinking beyond their traditional asset management structures that separate each asset class into discrete allocation buckets, and beginning to look at hedging solutions across the whole portfolio. Sean Kurian, senior investment consultant at Towers Watson, one of the world's largest investment and actuarial advisors, says funds are increasingly using options strategies both for their equity assets and for interest rate and inflation liabilities. In the current ultra-low interest rate environment, Mr Kurian emphasises, a few extra basis points can make a significant difference to the long-term financial path of the fund.

"Pension funds are now much more open to take equity option strategies such as collars to manage risk in a more focused manner and gear it down... Or they can use swaption strategies to sell interest rates upside through the swaps market to fund downside protection. There are many different ways to structure their risk/reward profile, and for the most sophisticated clients there is nothing really off limits to get the best deal," he says.

Mr Coughlan suggests fund trustees can go even further, working with their sponsors to look at hedging strategies that take account of the entire company balance sheet. "As a corporate sponsor, you take a look across the board at where you are taking risks, not just on your pension plan but also in corporate treasury, financing and corporate risk management processes. Are you doing unnecessary hedging or doubling up on exposures when you put the pension fund and corporate balance sheets side by side?" he says.

Arnaud Sarfati, global co-head of financial engineering in cross-asset solutions at SGCIB

Residual risks

For the sophisticated pension funds, longevity risk is the residual question focusing minds as life expectancy rises in the developed (and much of the developing) world. Traditionally, the only natural counterparty to take on longevity risk has been insurance or reinsurance companies that have significant life insurance portfolios - which will face lower claims as longevity rises. Mr Coughlan says equity release mortgage portfolios can also display longevity profiles that are suitably opposite to those of pension funds.

"Until a couple of years ago, longevity was not considered in the overall value-at-risk assessment, but pension funds have been bitten by it as life expectancy assumptions are pushed out, and they are asking providers like us to bring hedging products onto the market that fix the pension fund's exposure, either through derivatives or through a contract of insurance," says Andrew Reid, who joined Deutsche Bank as head of corporate pension origination earlier this year from Credit Suisse.

Insurers, pension providers and bankers are working together through the Life and Longevity Markets Association, of which JPMorgan and Deutsche Bank were founding members in February 2010, to create a deeper market for longevity swaps. This is particularly important for insurers that offer pension products, in the context of the impending Solvency 2 regulations that are due for implementation from 2012. These will impose larger capital charges on more illiquid market-based transactions, or those that do not match liabilities exactly.

"Depending on the structures that insurers use, they could be significantly affected, or hardly affected at all. For a typical, customised long-duration longevity swap where you are exchanging fixed and floating cashflows, where floating cashflows based on the actual survival of the population of annuitants or pensioners, for that kind of structure an insurer might get the same kind of treatment as reinsurance, if the economics are similar. But for an index-based hedge, you would get a model-based Solvency 2 assessment," says Mr Coughlan.

Matthew Yandle, BNP Paribas's head of global equity and commodity derivatives structured products design

Digesting Solvency 2

The new capital regulations could have much wider implications for insurance companies in general, although these are hard to act on until the guidance for pan-European implementation and quantitative impact study (QIS5) stress-testing of insurers has solidified after discussions between regulators. In particular, insurers are lobbying hardest on the treatment of fixed-income assets, which form the bulk of investment portfolios for all but the largest and most sophisticated insurers in many European jurisdictions.

Despite that uncertainty, some general themes and trends are already becoming clear, and the overall expectation is that the introduction of risk-based funding and capital requirements across Europe - already prevalent in the UK, the Netherlands and the Nordic countries - will raise demand for derivatives to hedge out risks. Ms Sagoo of Deutsche says the impact will also depend on the type of risks underwritten by insurers - products with embedded guarantees or exposing the insurer to market risk are likely to need greater risk management using derivatives.

In the first instance, it appears that interest rate liabilities will be calculated using the interest rate swaps curve across the EU. This is already the case in the Netherlands, but in other jurisdictions such as the UK, insurers had been able to calculate the discount on future liabilities using the interest rates on the corporate bond curve. The move is likely to encourage a further switch away from investing in cash bonds, to using the swaps market as better matching assets for liability profiles. That change will be more challenging for some of the newer EU jurisdictions such as Poland or Hungary, which have relatively large insurance sectors but less liquid swaps markets to work with.

A second central theme of Solvency 2 is that market risk will generally receive a more stringent capital treatment than credit risk. According to Arnaud Sarfati, global co-head of financial engineering in cross-asset solutions at SGCIB, this is likely to prompt insurers to look for products that can effectively convert mark-to-market exposures into transactions that mainly expose them to credit or counterparty credit risks. Methods might include buying call options or products with embedded capital guarantees from an investment bank.

Mr Sarfati also notes that the use of stress testing will make volatility-stabilised products more attractive to insurers. SGCIB has recently launched a product called the Risk Volatility Absorber (RIVA), an Undertakings for Collective Investment in Transferable Securities (UCITS) structured fund that allows investors to take a long equity and a long volatility position at the same time. Backtesting showed a 15% outperformance of a straight long equity position, as volatility tends to rise when markets fall. Mr Sarfati says the product was devised with one eye on insurers facing severe Solvency 2 stress tests (possibly requiring them to model market falls of up to 45%).

"Typically, the QIS5 will look not only at the equity value, but at the level of volatility itself. So if you have a product that can benefit from higher volatility, we calculate that it could cut back by about 30% to 40% the cost of capital that has to be held against a pure long equity investment with a similar rate of return," he says.

Matthew Yandle, BNP Paribas's head of global equity and commodity derivatives structured products design, says the potential capital charge is causing risk officers to think about the all-in risk/reward ratio of investing in risk assets such as equities, including the hedging costs.

"If a certain asset historically has returned, say, twice as much, but the cost of hedging is three or four times higher, then the insurer may opt to invest in a less performing asset that is much cheaper to hedge. So it is not about which asset class performs best in the long run, but which hedged asset position performs best in the long run," says Mr Yandle.

He believes Solvency 2 will encourage structured product providers to take into account the difficulty of modelling their products under the stress-tests. In particular, he sees interest in products that incorporate protection features to improve predictability, for example, those that cap the maximum potential drawdown on a one-year time horizon, as this variable is likely to be measured in QIS5 tests.