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The Use of Derivatives by Life Insurance Companies Globally
The Actuarial Society of Hong Kong
Mark C. Hoogendijk
21 May 2013
2
Agenda
Introduction Risk Categorization
Market & Credit Risk, &
Embedded Optionality
NAIC & IMF Reports
USA Global Players Global Market
Size
Market Research
Overall Rationale for Derivatives
Credit Risk Accounting
Deep Dive Met Life
Historical Analysis
Summary Key Takeaways
3
Portfolio Management
(Assets & Liabilities)
Market Risk
Credit Risk
Operational Risk
Insurance Risk
Liquidity Risk
Risk Summary
As
se
ss
ing
Monitoring
Mitig
atin
g
Enterprise Risk Management
4
NAIC Report 2012
Life Insurance Industry
Swaps Split
• Total outstanding notional: US$ 1.4 Trillion, a 28% from 2010
• 152 were Life Insurance companies
• 95.8% of Notional with Life Insurers
274 Derivative Participants
• Investment & Portfolio Hedging
• Replicating Assets
• Generating Income
Rationale for Derivatives
5
Global Insurers
Total Derivative Notional on Balance Sheet All numbers in US$ Bln
AXA
MetLife
Pru Fin
ManuLife
AIG L&G
Aviva
Hartford
Old Mutual
Zurich Standard
Life
AIA
6
Derivative Interconnectedness
Source: IMF Working Paper
7
Research Project
Rating SystemGeneral Derivative Policy Statement 4 3
Derivative Committee 4 3
Separate Derivative Booking Entity 1 0
Full Overview Derivatives 4 4
Mtm On All Derivatives 4 4
Classification "Hedging" Derivatives 4 3
Classification "Non Hedging" Derivatives 4 3
Overview of Notional & Mtm on Derivatives hedging guarantees 1 0
Cash-Flow Maturity Analysis Derivatives 4 4
Notional Maturity Analysis Derivatives 1 0
Scenario Analysis MtM Derivatives 4 3
Level (1/2/3) Split on FV Derivatives 4 3
Credit Risk & Collateral with Derivatives 4 3
Overview of CDS's written (According to rating & Industry) 4 2
Gains & Losses on Non Hedging Derivatives flowing through income 5 2
Overview mtm of Embedded Derivatives within Liability host contracts 1 0
Discussion Models Derivative Pricing 4 2
Market Data Providers for input Option Pricing 1 0
8
Derivative Usage – Common reasons
• Equity Puts, Collars
• Swaptions, Floors, Caps Market Risk
• Credit Default Swaps
• Index Swaptions Credit Risk
• Variance Swaps
• Interest Rate Swaps Embedded Optionality
• Swaps, Floors & Caps
• Swaptions ALM
• FX Forwards
• FX Swaps
Hedging Shareholders Equity
• Equity Puts
• CPPI Capital Optimization
• Basket Options
• Fund Options
Retail Savings Products
9
Derivative Usage – Examples
• “AEGON utilizes derivative instruments as a part of its asset liability risk management practices” Aegon
•“At 31 December 2011 the Group’s shareholder funds held £3 billion notional of equity hedges, with up to 12 months to maturity with an average strike of 89% of the prevailing market levels on 31 December 2011.”
Aviva
• “Derivatives are primarily used for efficient investment management, risk hedging purposes or to structure specific retail savings products.”
AXA
• “We began early on to make substantial provision for prolonged phases of low interest rates by purchasing derivative financial instruments (“swaptions”) to hedge against the reinvestment risk.”
Munich Re
• “For UK with-profits funds the derivative program is undertaken as part of the efficient management of the portfolio as a whole.”
Prudential Plc
10
Derivative Policy – Sun Life
11
Annual Reporting - Credit Derivatives
• “Certain derivatives are used to add risk by selling protection in the form of single name credit default swaps and tranches of synthetic collateralized debt and commodity obligations.”
Aegon
• “The AXA Group, , use strategies that involve credit derivatives (mostly Credit Default Swaps), which are mainly used as an alternative to debt security portfolios, when coupled with government debt securities”
AXA
• “The Company also enters into credit default swaps that assume credit risk as part of replication transactions. Replication transactions are used as an economical means to synthetically replicate the characteristics and performance of assets that would otherwise be permissible investments under the Company’s investment policies.”
Hartford
12
Annual Reporting - Credit Derivatives
• “Our general fund fixed income investments ……., we have recently launched a program for selling CDS that employs a highly selective, diversified and conservative approach.”
ManuLife
• “We use credit derivatives to enhance the return on our investment portfolio by creating credit exposure similar to an investment in public fixed maturity cash instruments,……………”
Prudential (USA)
13
Derivative Maturity Profile - AXA
14
Derivative Maturity Profile – Legal & General
15
Derivative Accounting – Overall Industry
16
MetLife - Derivatives
• “We use derivatives as an integral part of our management of the investment portfolio to hedge certain risks, including changes in interest rates, foreign currencies, credit spreads and equity market levels.”
Policy
• “MetLife uses derivatives to mitigate its equity exposure both in certain liability guarantees such as variable annuities with guaranteed minimum benefit and equity securities. These derivatives include exchange-traded equity futures, equity index options contracts and equity variance swaps”
Equity Hedging
• ”The Company has employed various asset/liability management strategies, including the use of various derivative positions, primarily interest rate floors and interest rate swaps, to mitigate the risks associated with such a scenario.”
ALM
• “Certain of the Company’s reinsurance agreements and most derivative positions are collateralized and derivatives positions are subject to master netting agreements, both of which, significantly reduces the exposure to counterparty risk”
ISDA / CSA
17
MetLife - Derivatives
US$ 290 Bln
Plain Vanilla IR Swaps
Basis Swaps
Inflation Swaps
Implied Volatility Swaps
Structured IR Swaps
18
MetLife - Derivatives
• “Equity and Interest Rate futures, interest rate swaps, currency futures/forwards, equity indexed options and interest rate option contracts and equity variance swaps.”
Living Guarantee Benefits
• “Long Interest Rate floors” Minimum Interest Rate
Guarantees
• ”Zero Coupon Interest Rate Swaps & Swaptions”
Reinvestment Risk in Long Duration Liability
Contracts
• “Currency Swaps & Forwards” Foreign Currency Risk
• “Interest rate futures, interest rate swaps, interest rate caps, interest rate floors and inflation swaps”
General ALM Hedging Strategies
19
MetLife - Derivatives
20
MetLife - Derivatives
21
MetLife - Historical Growth Derivatives
• Increased percentage of Derivatives to General Account Assets from 2002 to 2007
• Since 2008 in Range from 45% to 55%
• Percentage Derivatives = Notional Derivatives / General Account Assets
Observations
22
MetLife - Derivative Categorization
• 60% - 70% Interest Rate Derivatives
• 10% - 15% Equity Derivatives, however in 2009 & 2010 to 25%
• Numbers in graph are in Millions and are Notional amounts
Observations
23
MetLife - Derivative Categorization
• Increased Percentage in Equity Hedges in 2009 & 2010
• Growing Percentage in Interest Rate Swaps
• Substantial increase in Interest Rate Floors in 2012!
Observations
24
MetLife - Remaining Life Derivatives
• Relatively small portion in > 10 Years
• Large variations in < 1 Year bucket
• MetLife did not provide statistics in 2012 Annual Report
Observations
25
Singapore Derivative Positions
Total Derivative Notional on Balance Sheet All numbers in SG$ Mln
NTUC
GE AIA
PRU
Aviva
100%
≠
HSBC
26
Summary
Derivatives are part of a Life Insurer’s daily operations
Policies, Governance, Risk Measures, Accounting, Valuation, Education & Communication are all key to successful implementation of Derivatives
Collateral Management is a key area of attention within the derivative process
Derivatives (OTC) are flexible contracts!
27
Hybrids
28
• FX Option with Notional according to a specified
Equity Index return.
• Plain vanilla FX Option: The option buyer pays an
upfront premium in exchange for having the right to
buy/sell currency at a specified exchange rate for a
specified Notional.
• Hybrid FX Option: The option buyer pays an upfront
premium in exchange for having the right to buy/sell
currency at a specified exchange rate for a specified
formula based Notional, where the Notional will vary
according to the performance of a specified Equity
Index.
Hybrid FX Options
FX Option
Option
Buyer
Option
Seller Fixed Premium
Hybrid FX Option
Option
Buyer
Option
Seller Fixed Premium
Max [Strike – Spot, 0] x Notional*
*Cash settled, Notional = X
Max [Strike – Spot, 0] x Notional*
*Cash settled, Notional = Index t / Index 0 * X
29
• Constant Maturity Credit Default Swap (CMCDS)
• The protection buyer pays a premium (spread) in
exchange for protection where the spread is:
– floating
– set equal to the prevailing reference CDS spread
at each reset date times a factor known as the
participation rate (PR)
• The CMCDS instrument allows investors:
– To take views on the future shape of the CDS
curve or
– Through a CDS and a CMCDS combination to
isolate spread risk (i.e. the risk of changes in
the premium not related to an actual credit
event) and to hedge default risk
CMCDS
CDS
Protection
Buyer
Protection
Seller Fixed Prem X% pa
CMCDS
Protection
Buyer
Protection
Seller 70% x 5Yr CDS pa
Protection upon Default
Protection upon Default
*Reset Annually
30
• “Following a number of discussions and extensive ALM analyses, the Board decided during the third quarter of 2007 to implement a hedging strategy comprising a combination of*:”
– hybrid options (equity-linked receiver swaptions) and
– ‘standard’ swaptions plus equity put options.
• The strike price of these receiver swaptions on the expiry date depends on the return on a pre-determined equity index basket.
• The strike price increases as equity prices drop and decreases when equity prices rise.
• This product mainly protects the pension fund in situations where both equities and interest rates have dropped dramatically.
Hybrid Swaptions
*Source: Cardano Press Release
Receiver Swaption
Receiver Swap at 5% (strike)*
Swaption
Buyer
Swaption
Seller Upfront Premium
* If Swaption buyer exercises his right
Hybrid Receiver Swaption
Rec. Swap strike if Eq Ret *
Upfront Premium Swaption
Buyer
Swaption
Seller
* If Swaption buyer exercises his right
The Use of Derivatives by Life Insurance Companies Globally
The Actuarial Society of Hong Kong
Thank You – Q&A