Life 2003

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Life 2003

• Risk Management Issues and Solutions in the Life
  Industry
• Birmingham
• 9 11 November 2003
• Paul Stanworth Huw Williams
• Royal Bank of Scotland

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Agenda

• Strategic Issues in the Insurance Industry
• Applications of Derivatives for Life Insurance
• Practicalities of Implementing Derivative
  Solutions Collateral Admissibility

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Section 1

• Strategic Issues in the Insurance Industry

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A changing environmentBackground Regulatory,
Agency Accounting
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Regulatory Accounting BackgroundRisk Management

• Regulatory and accounting backgrounds will be
  changing significantly over the next 2 years
• The changing environment will drive insurers
  (both UK and European) into more risk management
  and transfer techniques

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InsurersRequiring Specialist Solutions
Insurance Issues
Regulatory Change Credit Rating
Pressure Difficult Market Conditions Internatio
nal Accounting Changes Sandler Review Solvency
II Basel II
Bonds, Equity, Property Cash Management Future
s FX Management Derivatives execution Regulat
ory Compliance Rating Agency Compliance
Reinsurance Concentration Risk Management Long
Term Guarantee Management WP asset strategy and
eventual product replacement Inflation
protection strategies Pension Fund Risk
Solutions Capital Management Advisory Retail
Product Development Yield enhancement and Cost
minimisation
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The Role of Derivatives

• Derivatives can feature as part of the solution
  for many of these issues
• New product creation
• Hedging in a fair value environment
• Increasing emphasis on banking style risk
  management
• Yield enhancement
• The following slides illustrate the extent to
  which derivatives are used by all market
  participants by plotting the growth of the
  interest rate swap market since 1989.
• Interest rate swaps are used for illustration
  since they are the most common product used for
  interest rate risk management (just over 80 of
  the interest rate derivative market by
  outstanding notional amount).
• These slides highlight the importance of
  derivatives as an asset class and a risk
  management tool.

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Interest Rate SwapsMarket Growth
Sources International Swaps Derivatives
Association and BIS
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Interest Rate SwapsComparison with UK domestic
debt
Sources International Swaps Derivatives
Association, BIS, DMO
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Interest Rate SwapsTenors

• Quotes available out to 50 years
• Reasonable liquidity out to 40 years

Source Reuters
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Section 2

• Applications of Derivatives for Life Insurance

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Uses of DerivativesStrategic Tactical

• Strategic Applications
• Interest rate swaps duration convexity
  management, cashflow matching
• Inflation swaps hedging inflation sensitivity,
  asset creation (LPI), cashflow matching
• Interest rate options hybrids hedging
  guarantees
• Equity derivatives product creation
• Credit derivatives product creation
• Tactical Applications
• Cross-currency swaps other swaps asset swaps
  to widen the investment universe
• Interest rate derivatives tactical curve and
  rate views
• Equity puts or collar-type strategies managing
  equity downside risk
• Credit derivatives yield enhancement, portfolio
  credit risk management

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Interest Rate SwapsDefinition
DEFINITION An exchange between two parties of
interest rate exposures from floating to fixed
rate or vice versa. The interest payments are
calculated on a notional underlying principal
amount.
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Duration ExtensionInterest Rate Swap Overlay

• The graphs below illustrate how the modified
  duration of the bond portfolio can be improved to
  match closely the modified duration of the
  liabilities by overlaying a standard (generic)
  receive fixed interest rate swap.
• The value of the interest rate swap to the scheme
  will start off at zero and will increase when
  interest rates fall and decrease when rates rise,
  which creates the effect of higher duration.
• The swap gives an efficient way of going long a
  long-dated fixed rate bond and shorting an FRN to
  fund the position

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Duration ManagementFurther Strategies

• ISSUE Dont want cashflows in the short-term to
  be affected.
• SOLUTION Make the swap forward-starting i.e.
  swap starts in one-years time.
• ISSUE The liabilities have a higher convexity
  than the bonds swap (as can be seen from the
  curvature of the lines in the bottom right hand
  graph on the previous page)
• SOLUTION Duration and convexity can be matched
  with two interest rate swaps (one longer dated
  and one shorter dated) or an interest rate swap
  plus a constant maturity swap.
• ISSUE Bonds swap portfolio is sensitive to
  spikes at particular points on the yield curve or
  to yield curve rotations.
• SOLUTION Increase number of swaps with a spread
  of maturities
• ISSUE Want to increase bond portfolio
  sensitivity as rates fall but not as rates rise.
• SOLUTION Buy a receivers swaption i.e.
  option on a receive fixed swap

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Annuity Fund Cashflow Matching

• Example RPI-linked annuities
• Match with inflation-linked assets but only an
  imprecise cashflow match possible with
  index-linked gilts and supply of inflation-linked
  corporate bonds insufficient.
• Left with reinvestment risk/liquidity risk

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Annuity Fund Cashflow MatchingPotential range of
mismatch

• Modelling method
• Correlated one-factor short rate models for
  nominal and real yields (CIR for nominal
  shifted CIR for real)
• Process for nominal rates calibrated to swaps and
  caps. Real yield process calibrated so that
  resultant RPI levels are consistent with RPI
  LPI swap pricing

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Annuity Fund Cashflow MatchingAdditional Cash

• PV of ILG portfolio required to meet liability
  payments 1.14bn assuming that cash can be
  invested or reinvested at rates implied by
  todays LIBOR curve
• However
• Deposits may earn below LIBOR
• Future LIBOR rates will differ from those implied
  by todays curve
• The chart below illustrates the additional
  amounts of cash required at the start to ensure
  sufficient assets at different confidence levels
  allowing for the variation in future LIBOR (but
  not sub-LIBOR funding).

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Inflation Swap OverlayCashflow Matching for
Annuity Funds

• An inflation swap can be used to exchange
  cashflows generated by a bond portfolio for
  RPI-linked or LPI-linked cashflows to match the
  precise nature and timing of annuity payments.
• This gives a more precise inflation match than
  with index-linked gilts and allows freedom to
  invest in a wide range of underlying assets.

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Hedging GuaranteesSwaptions and CMS floors

• Standard hedge for GAOs in the UK
• Insurer buys a strip of receivers swaptions
• Cash Payoff max(0, (5 - r20y) x a(20, r20y) )
• Common hedge for minimum interest rate guarantees
  in Europe either receivers swaptions or CMS
  floors
• As with the standard interest rate floor contract
  a CMS floor consists of a strip of options known
  as floorlets. The CMS floor contract will
  specify
• Nominal amount
• Strike
• Maturity of floor
• Frequency of floorlets (i.e annual, semi-annual
  or quarterly)
• The reference swap rate to use (e.g. The 10yr
  Euribor swap rate as quoted on Reuters).
• When this swap rate is referenced (e.g. set in
  advance two days before the date of the previous
  floorlet payment date or set in arrears two days
  before the date of the current floorlet payment)

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CMS Floors Example

• For a floor with a nominal of 150m, strike of
  4.75, 10-year maturity, annual floorlets, based
  on the 10 year swap rate, set in arrears there
  will be
• 10 floorlets with payments made annually.
• The payoff for each floorlet will be
• Payoff 150m x max(0, 4.75 - 10 year CMS rate)
• Where the 10 year CMS rate is the 10 year EUR
  interest rate swap rate taken from Reuters two
  days before payment.
• So if the observed rate is 3.5, the payoff will
  be 150m x (4.75 - 3.5) 1.875m

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Receivers Swaptions CMS floors CMS floor
replication by receivers swaptions
Convex swaption payoff
Lines cross at 20y rate 3.13. 20yr annuity
value 14.70 _at_ 3.13, which is the ratio of the
CMS notional to the swaption notional
Linear floorlet payoff
CMS payoff exceeds swaption payoff at rates
closer to strike
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Section 3

• Practicalities of Implementing Derivative
  Strategies
• Collateral Admissibility

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Counterparty Credit Risk Collateral

• OTC derivatives create counterparty credit
  exposure
• Exposure can be managed through a collateral
  process
• Counterparty who is out-of-the-money provides
  security in the form of collateral to the party
  who is in-the-money similar to variation margin
  for exchange-traded contracts.
• Market standard International Swaps Derivatives
  Association (ISDA) documentation is used to
  support the collateral process in the form of a
  Credit Support Annex (CSA) to an ISDA Master
  Agreement
• Collateral agreements becoming standard across
  all market participants.
• According to the ISDA Margin Survey 2003
• US 719bn of collateral in circulation
• 38,500 agreements in place

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Common Collateral Terminology
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Collateral Call Example

• Example CSA terms between Party A and Party B
• Zero threshold
• Monthly valuation date (30th of each month)
• Minimum transfer amount of 1,000,000
• Rounding 100,000
• Derivative portfolio valuation as at close of
  business on 29th 23,465,341 in-the-money to
  Party A. Collateral already held by Party A
  15.3m
• Delivery amount after rounding 8.2m to Party A

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Derivative Contracts - Admissibility

• Current guidance admissible value only if the
  derivative instrument satisfies
• Efficient portfolio management or reduction of
  risk
• Held in connection with admissible assets
• Fully covered
• Listed on a regulated market or transacted with
  an approved counterparty
• Can be readily closed out
• Based on underlying assets which are admissible,
  an index of such assets or an official index of
  retail prices
• Have a prescribed pricing basis
• New guidance is on its way

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What does the Future Hold?

• Simplified regulation
• Clear accounting treatment
• Derivatives a mainstream risk management tool
• Questions

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Contacts

• The contents of this document are indicative and
  are subject to change without notice. This
  document is intended for your sole use on the
  basis that before entering into this, and/or any
  related transaction, you will ensure that you
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  of this, and/or any related transaction and
  determine it is appropriate for you given your
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  should consult with such advisors as you deem
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  (RBS) will not act as your advisor or owe any
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  and/or any related transaction and no reliance
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