Financial Risk Mitigation Essay Example

Financial Risk Mitigation Essay Discussion Paper Financial Risk Mitigation in Insurance Time for Change The Chief Risk Officer Forum Risk Mitigation Working Group Copyright  © 2006 Chief Risk Officer Forum 1 Discussion Paper Preface The Chief Risk Officer Forum is delighted to be presenting the study â€Å"Financial Risk Mitigation in Insurance – Time for Change†. The Chief Risk Officer Forum comprises risk officers of the major European insurance companies and financial conglomerates, and was formed to address the key relevant risk issues for its industry. It is a technical group focused on developing and promoting industry best practices in risk management. The membership comprises: Aegon NV Allianz AG Aviva PLC AXA Group Converium Fortis Generali ING Group Munich Re Prudential plc Swiss Re Winterthur Zurich Fin’l Services Tom Grondin Raj Singh Sue Kean Francois Robinet Peter Boller Luc Henrard Paul Caprez John Hele Charlie Shamieh Andrew Crossley Christian Mumenthaler Joachim Oechslin Andreas Grunbichler tom. [emailprotected] com raj. [emailprotected] de [emailprotected] com francois. [emailprotected] com peter. [emailprotected] com luc. [emailprotected] com [emailprotected] com john. [emailprotected] com [emailprotected] com andrew. [emailprotected] co. uk [emailprotected] com joachim. [emailprotected] ch andreas. [emailprotected] com We will write a custom essay sample on Financial Risk Mitigation specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on Financial Risk Mitigation specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on Financial Risk Mitigation specifically for you FOR ONLY $16.38 $13.9/page Hire Writer Chief Risk Officer Forum Contact Details: Via E-mail: [emailprotected] org [emailprotected] rg The report demonstrates that the use of derivatives offers insurance companies a more robust and efficient way to hedge market risk exposures, but there are definitive regulatory/accounting obstacles to the full deployment of these strategies, perversely discouraging state of the art risk management practices. With this report the Chief Risk Officer Forum is proposing a set of principles and policies for insurers and their regulators which would encourage financial risk mitigation activities in the sector. The working group which wrote the report comprised representatives of Munich Re (chair), Winterthur and Zurich Financial Services. Special thanks are expressed to the following delegates of the CROs who assisted in compiling the report: Jan Willing (Munich Re), Robert Lempertseder (Munich Re), Daniel Bronnimann (Winterthur), Doug Niemann (Zurich Financial Services), Markus Spillmann (Zurich Financial Services) and Saeid Samiei (Zurich Financial Services). We hope that this study will provide guidance for best practices in risk management, helping to improve risk management culture and facilitate the greater deployment of sound financial risk mitigation strategies in the insurance sector. Chief Risk Officer Forum Copyright  © 2006 Chief Risk Officer Forum 2 Discussion Paper Contents 1. Introduction. 7 1. 1. Purpose of this paper .. 7 1. 2. Example to support motivation: interest rate risk in life insurance . 7 2. Case for change. 8 2. . Life insurance policy: Guarantee plus option for more†¦ 8 2. 2. Dynamic duration strategy required 9 2. 3. Hedging strategies using derivative instruments evolved.. 10 2. 4. Some regulators give partial incentives for insurers to make use of hedging strategies 12 2. 5. Adequate accounting treatment for hedging strategies achievable 13 2. 6. Some considerations on market capacities for financial risk mitigation transactions. 15 2. 7. Many regulatory regimes still hinder deployment of optimal hedging strategies .. 16 3. Recommended principles.. 17 3. 1. Introduction 7 3. 2. Incentives for sound risk mitigation strategies 18 3. 3. Sound risk management framework as a precondition 19 3. 4. Permission to use financial instruments (e. g. derivatives) for risk mitigation purposes . 19 3. 5. Unrestricted capital credit for financial instruments in a risk mitigation context . 20 3. 6. Economic view should supersede legacy rules 21 3. 7. Valuation consistency of risk mitigation instruments with risk mitigation context . 21 4. Suggested policies. 23 4. 1. Policies giving effect to Principle 1 (Provide the right incentives) .. 23 4. 2. Policies giving effect to Principle 2 (Sound risk management framework) . 23 4. 3. Policies giving effect to Principle 3 (Permission to use financial instruments for risk mitigation purposes) .. 24 4. 4. Policies giving effect to Principle 4 (Equal yardsticks for qualifying financial instruments) 24 4. 5. Policies giving effect to Principle 5 (Supersede legacy rules). 26 4. 6. Policies giving effect to Principle 6 (Consistent treatment under statutory accounting) . 6 5. Conclusion 28 Appendix A. Primer on financial risk concepts 29 A. 1. Duration and convexity 29 A. 2. Swaps and options on swaps. 30 Appendix B. Many regulatory regimes still hinder deployment of optimal hedging strategies 32 Appendix C. Essential components of a sound risk management framework.. 38 C. 1. Policy 2A (I): Appropriate supervisory/management oversight. 38 Copyright  © 2006 Chief Risk Officer Forum 3 Discussion Paper C. 2. Policy 2A (II): Comprehensive and documented policies and procedures 39 C. 3. Policy 2A (III): Sound risk/valuation systems. 0 C. 4. Policy 2A (IV): Independent effective risk management function.. 40 Copyright  © 2006 Chief Risk Officer Forum 4 Discussion Paper Executive summary In many regulatory regimes risk mitigation activities of insurers are not adequately incentivised, or not even allowed; sometimes even perverse incentives are given to insurers. Along the example of life insurance we will describe how research in Asset/Liability Management (A/LM) evolved in the last years and what hurdles (regulatory and other) insurers encounter in the implementation of risk mitigation strate gies. A particular focus is set on the measurement of interest rate risk and how insurers came to the conclusion that the mere linear approximation (duration) of A/L value changes for interest rate changes (i. e. ignoring convexity) was flawed and often led to inappropriate policies for managing those risks. More generally, more and more insurers realise the true financial nature of their core business. Given this development it is but a small step to the consideration of the necessary tools for interest rate risk management, e. . swaps and swaptions. Starting from these observations a series of principles is developed in this paper designed to allow the insurance industry to properly develop financial risk mitigation strategies as follows: Principle 1: Provide the right incentives Solvency II should provide incentives for sound risk mitigation strategies. Principle 2: Sound risk management framework is a precondition A precondition for the use of financial instruments for risk mitigation is a sound risk management framework for the company. Principle 3: Focus on the process, not the instrument The admissibility of financial instruments for risk mitigation should be based upon the soundness of the risk hedging process. Restrictions on the use of financial instruments for risk mitigation cannot follow a â€Å"one size fits all† approach (e. g. a list of admissible and inadmissible financial instruments). Principle 4: Equal yardsticks for qualifying financial instruments Qualifying financial instruments used for risk mitigation purposes should receive full and unrestricted capital credit under Pillar I of Solvency II. The credit given for financial instruments used for risk mitigation under Pillar I, should be based on the documented and evaluated economic effect on both the valuation of assets and liabilities and the determination of the MCR and SCR. Principle 5: Supersede legacy rules Determination of capital requirements for solvency purposes under Pillar I of Solvency II or under Solvency I should be based entirely on economic principles if the insurance company can demonstrate that it has a sound risk management framework (Principle 2) and that it is using financial instruments for risk mitigation satisfying the requirements of Principles 3 and 4. Principle 6: Consistent treatment in statutory accounting Under the statutory accounting regime, the asset valuation rules in respect of financial instruments used for risk mitigation purposes must be consistent with the valuation rules in respect of the liabilities they are designed to hedge. Copyright  © 2006 Chief Risk Officer Forum 5 Discussion Paper In section 6 policies are developed, which are designed to give effect to these principles and result in sound risk mitigation practices in the insurance industry. Copyright  © 2006 Chief Risk Officer Forum 6 Discussion Paper 1. Introduction 1. 1. Purpose of this paper Regulatory and accounting rules in many European countries posed and often still pose a real hindrance to sound risk management practices in insurance companies. This hindrance usually comes in the following two forms: Inconsistent valuation of assets and liabilities and Restricted admissibility of risk mitigating instruments. The scope of this paper is to encourage regulators to overcome these obstacles by introducing consistent valuation techniques for assets and liabilities and by fostering the admissibility and usage of any financial instrument for isk mitigation purposes in insurance companies. In its full generality, this could apply to all financial instruments (inflation linked securities, commodities, derivatives etc. ) and to all sorts of insurance companies (life and non-life, primary and reinsurance). Nonetheless, our paper is inspired by the management of interest rate risk in life insurance and the usage of swaps and swaptions in this area. The usage of swap derivatives in life insurance, will serve as a case study, which accompanies the paper to motivate our principles and policies and to make the paper less theoretical. Hence, we often refer to derivatives or even swaps and swaptions instead of the more general term financial instruments. Since interest rate risk is one of the biggest sources of risk in insurance, we also think that this example per se has most relevance to risk officers. 1. 2. Example to support motivation: interest rate risk in life insurance The typical financial risk, which one encounters in a life insurance company is a duration gap between assets and liabilities, i. e. assets will typically have a significantly shorter duration than liabilities. This duration gap exposes the insurer (and hence its share holders, other investors and policy holders) to falling interest rates, but the net A/L position gains in value if interest rates rise. Although unintended, this A/L mismatch was (and often still is) favoured by many regulatory and accounting regimes in Europe as liabilities are valued at a statutory interest rate, which does not flex with market interest rates. Fixed income assets on the other hand have to be valued at the lower of market value and acquisition cost. This method of asset valuation does give preference to shorter duration assets, which exhibit less price volatility if interest rates change. In addition, many regulatory environments prohibited or discouraged the use of certain financial instruments (e. g. derivatives) that are often vital for affecting a proper hedge. Hence the regulatory and accounting rules in many European countries hindered the introduction of sound interest rate risk management in life insurance. Other reasons for this A/L mismatch reside in the historically scarce availability of longer duration assets in some jurisdictions and in the presumed policy holder expectation to participate in rising bonus rates if interest rates rise. Copyright  © 2006 Chief Risk Officer Forum 7 Discussion Paper 2. Case for change In 2001 and 2002 the financial markets underwent a serious revaluation, characterised by falling equity markets and interest rates and rising volatilities and credit spreads. These market disruptions led to significant losses in the European life insurance industry. In addition to that, as was mentioned in the previous section, most regulatory and accounting frameworks aggravated the problem by incentivising A/L mismatches. The need to improve A/LM capabilities became obvious after this turmoil. As a consequence, considerable improvements have been made in the area of A/LM throughout the European life insurance industry in the past 3 years, with a central focus on managing guaranteed benefits. Driven by ever declining interest rates, many insurers had a closer look at the liabilities and learnt about the long duration of the guaranteed benefits. Also at around this time, the capital markets were undergoing rapid evolution offering liquid and targeted instruments for hedging certain risks (e. g. development of the derivative markets). Matching of guaranteed policyholder benefits with corresponding assets evolved as a credo in many insurance companies. As a result, considerable lengthening of fixed income portfolio durations took place in times of low interest rates. (For the reader not familiar with the subject matter, Appendix A provides a primer on financial risk concepts including duration and convexity and describes the structure of important risk mitigation instruments such as swaps and swaptions). 2. 1. Life insurance policy: Guarantee plus option for more†¦ While these efforts have clearly brought considerable insight to management, it has also left management with open questions. The reason for this is that significant options embedded in life insurance policies, such as policyholder expectations above guaranteed benefits, the surrender option, and a series of other options, were not always given their due attention. The central question is around the impact of these options on the â€Å"right† duration strategy. Let us consider a typical with-profits life insurance policy to understand the impact of the embedded options. The policyholder is guaranteed a minimum rate of return on its paid premiums, and in addition is entitled to at least 90% of the surplus investment returns, i. e. returns exceeding the guaranteed rate. Since this guaranteed rate of return is always out of the money at inception of the policy, the policyholder is expecting surplus returns. Indeed, the surplus distribution is an essential selling point for this product and therefore much of the competition between life insurers centres around surplus (expectations and realisations). The guaranteed interest rate and entitlement to surplus makes the insurance policy an asymmetric product: the policyholder is participating in (and expecting) the upside when markets (or interest rates! ) rise and is protected when markets fall. This asymmetry can be expressed in the language of financial options. The policyholder is entitled to the investment returns of the insurer’s portfolio, and additionally holds a floor (set at the guaranteed interest rate) on these investment returns. Copyright  © 2006 Chief Risk Officer Forum 8 Discussion Paper Hence, the insurer sold an option on its investments to the policyholder, but is free to choose an investment strategy. Clearly, the value of the policyholder’s floor depends on the investment strategy chosen by the insurer. For example, the insurer could choose to: Minimize the value of the policyholder’s floor option: Assume a portfolio of life insurance liabilities in run-off. In this case, management might focus on protecting the share holders’ capital, i. e. reduce the risks arising from the guarantee part of the liabilities. The investment portfolio would then match the guaranteed cash flows as closely as possible. This strategy is clearly also increasing the protection of policy holders’ interests. Maximize the possibility of declaring attractive bonus rates: Assume a portfolio of life insurance liabilities in a well-capitalized company managed on a going-concern basis. The asset/liability position of this insurer will exhibit some financial risks in order to increase the possibility of declaring attractive bonus rates. The typical financial risk which one encounters in this situation is a duration gap between assets and liabilities, i. e. assets will typically have a significantly shorter duration than liabilities. This duration gap exposes the insurer and its shareholders to falling interest rates, but allows the insurer to declare higher bonus rates as interest rates rise. Of course other sources of financial risk (and hence potential upside for policy holders) are present in life insurance portfolios, e. g. real estate or equity investments. The example illustrates that the insurer has to cope with two conflicting targets: securing guarantee risk versus fulfilling policy holder expectations (and hence enhancing the franchise value of the firm), although it is by no means obvious, what surplus (and hence what sort of A/L risk) policy holders do and reasonably can expect. 2. 2. Dynamic duration strategy required The life insurance industry has been increasingly adopting the more advanced technique called market consistent valuation. It has helped the insurance industry to quantify these embedded options in a manner consistent with what it would cost to hedge or insure these risks. The bases for market consistent valuation are risk-neutral valuation concepts commonly used in the capital markets for pricing of financial derivatives. Market consistent valuations have shown that the options embedded in life insurance policies may indeed have a significant impact on the duration strategy. A central implication of the market consistent valuation work is that it is not always advisable to lengthen the duration of the investment portfolio to match the duration of the guaranteed benefits, but instead the duration gap has to be seen in conjunction with the capital base of the firm and the risk appetite of the management (see the last bullet point in the preceding section). The reason for this is the sensitivity (in opposing directions) of the value of the guaranteed benefits and the embedded options with respect to small interest rate changes. The resulting duration of the combined liability (i. e. uaranteed benefits plus embedded options) is thus shorter than the duration of the guaranteed benefits only. In case of a drastic fall in interest rates, however, it is indispensable to lengthen the duration of the investment portfolio to bring it close to the duration of the guaranteed Copyright  © 2006 Chief Risk Officer Forum 9 Discussion Paper benefits. The objective is to protect the guaranteed benefits, while the embedded options (on surplus) have little value. Vice versa, in the case of substantially rising rates, the value of the embedded options is rising steadily, requiring a shortening of the duration (Figure 1). Figure 1 Illustrative duration strategy of a portfolio of life insurance policies (EUR) 12. 0 10. 0 Guarantee Duration strategy considering guarantees plus options Duration 8. 0 6. 0 4. 0 2. 0 0. 0 1. 0% 2. 0% Asset portfolio Today s interest rate level 3. 0% Interest rates 4. 0% 5. 0% Protecting guarantees Providing upside This lengthening of the duration as interest rates decline (and vice versa) is called convexity. The market consistent valuation allows a company to determine the most appropriate duration for every interest rate environment, and with this the convexity of the respective portfolio. The convexity risk has not been actively managed in the past by many life insurers, thus leaving life insurers with substantial interest rate risk. 2. 3. Hedging strategies using derivative instruments evolved There are generally two approaches to manage the convexity of life insurance portfolios, dynamic hedging and hedging using financial instruments (Figure 2). Combinations of the two approaches are also feasible. Figure 2 Dynamic duration management 12. 0 10. 0 Guarantee Hedging using interest rate options 12. 0 10. 0 Guarantee Underlying FI pf plus hedge Duration 6. 0 4. 0 2. 0 0. 0 Dynamic strategy Optimal strategy Duration 8. 0 8. 0 6. 0 4. 0 2. 0 0. 0 Underlying fixed income portfolio 1. 0% 2. 0% 3. 0% Interest rates 4. 0% 5. 0% 1. 0% 2. 0% 3. 0% Interest rates 4. 0% 5. 0% 2. 3. 1. Dynamic hedging A dynamic hedging strategy is to adjust the duration of the fixed income portfolio when interest rates reach certain trigger levels. The duration can be adjusted either by sales of Copyright  © 2006 Chief Risk Officer Forum 10 Discussion Paper bonds and subsequent reinvestment in bonds with a different duration, or through the use of interest rate derivatives like swaps. Dynamic hedging strategies require a great deal of management attention, since the fixed income portfolio is constantly rebalanced. Dynamic strategies sometimes require tough trade-offs by management. Imagine interest rates are low and have declined further, and are now next to a trigger point. Management’s view is that interest rates will rise. Do you lengthen the duration in this situation? The A/LM strategy requires lengthening, but intuition tells you to stay shorter versus the benchmark – an unpleasant situation. Dynamic strategies often lead to high transaction costs due to the constant rebalancing. Furthermore, rebalancing usually leads to profit or loss recognition and ultimately, to PL volatility. The management of this volatility is demanding and may result in even higher transaction costs. For these reasons, dynamic interest rate hedging strategies are not widely used by life insurance companies. Generally it can be said, that this dynamic hedging strategy is equivalent to the delta hedging technique, which a bank uses to hedge the linear risks of a short option position. The choice between dynamic hedging strategies and the use of the corresponding financial derivatives will also depend on the price of the latter, i. e. he implied volatility of their underlying. If the implied volatility is considerably higher than the estimated future volatility of the underlying, then a dynamic hedging strategy could look more attractive. There is clearly a risk of misestimating the future volatility and in fact banks also hedge this so-called vega risk in their option books. 2. 3. 2. He dging using financial instruments A better way is to position the duration of the fixed income portfolio shorter than the duration of the guaranteed benefits (to account for the embedded options), and on top of it to enter into a series of interest rate options to hedge against convexity. The purpose of the options is to significantly lengthen the duration of the combined portfolio (fixed income plus options) as interest rates fall. In order to determine this strip of options, the reinvestment risk (taking into account future premiums of the existing book) is considered. By positioning the duration of the fixed income portfolio shorter than the guaranteed benefits, a reinvestment need will arise in the future. The reinvestment risk is the risk of not achieving the technical interest rate at the time of reinvestment. The reinvestment risk can be hedged with a strip of corresponding receiver swaptions. The strip of receiver swaptions hedging the reinvestment risk introduces the precise convexity required to protect the guaranteed benefits in case of a material interest rate decline (Figure 3). Depending on the life insurance portfolio to be hedged, the terms of the required receiver swaptions vary. Usually, the required options are of a long-term nature, just as the corresponding liabilities are. Depending on the currency, such options may be available in liquid markets (e. g. in the EUR swaption market), or may not be (e. g. in the CHF market). In the latter case, a company may choose to hedge the reinvestment risk in a different currency providing the required liquidity in long-term interest rate options, but leaving a certain basis risk. Based on the strong correlations of certain currencies (such as CHF and EUR), it is evident that the basis risk is only a fraction of the reinvestment risk hedged. (See also the case study below). Copyright  © 2006 Chief Risk Officer Forum 11 Discussion Paper Figure 3 100% Reinvestment Volume 80% Assets/ Liabilities 60% 40% 20% 0% 0 Reinvestment 30% 20% 10% 0% 0 5 #6 #4 #1 #5 #2 #3 Reserves Asset Portfolio 5 10 15 20 25 30 35 40 45 10 15 20 25 Year 30 35 40 45 As opposed to the dynamic hedging strategy, this strategy does not require an ongoing rebalancing of the portfolio although it is advisable to monitor the effectiveness of the hedge periodically. 2. 4. Some regulators give partial incentives for insurers to make use of hedging strategies Some European insurance regulators recently introduced new solvency regimes making interest rate risks more transparent and hence provide an incentive for life insurers to hedge these risks. The UK regulator, the FSA, introduced the â€Å"Realistic Valuation Requirement†, a form of market consistent valuation, for With-Profits Funds, as well as an â€Å"Individual Capital Assessment† requirement. These standards have encouraged many insurers to hedge their exposures to guaranteed annuity options (GAO) in recent years. The Danish insurance regulator introduced a reporting regime based on market valuation of assets and liabilities in 2003, as well as a stress test based on the market value of assets and liabilities in 2001 (yellow test/red test). The consequence was a large-scale hedging of interest rate risk (duration matching, hedging of convexity from guarantees and mortgage bonds). The industry entered into Constant Maturity Swap floors, swaptions, and swaps on underlying in excess of EUR 70bn. The Swiss insurance regulator introduced the Swiss Solvency Test in 2006. A field test was performed in 2004 with selected companies, and a second field test was performed in 2005. However, no significant trend towards hedging has yet been observed in Switzerland as yet. 2. 4. 1. Case study: The hedging activities in Denmark In the second quarter of 2001 the Danish regulator introduced a market stress test on assets and liabilities to ensure that life and pension companies had sufficient reserves to withstand substantial declines in interest rate and equity markets. The test consists of two parts: Copyright  © 2006 Chief Risk Officer Forum 12 Discussion Paper Red test: Equities down 30%, interest rates up/down 100bps Yellow test: Equities down 12%, interest rates up/down 70bps In October 2001, it was announced that all Danish life and pension companies had to account for assets and liabilities on a market basis starting from 1 January 2003. It is worthwhile noting that the Danish regulator sets the accounting regime for the life and pensions industry and it could therefore introduce a â€Å"fair value† accounting regime and a â€Å"fair value† solvency regime at the same time. Under this â€Å"mark-to-market† solvency/accounting regime, insurers’ solvency would be hurt as interest rates fall due to the existence of minimum guarantees. It is instructive to look at how the costs of derivatives changed during the hedging activities in Denmark. The Danes used the â‚ ¬-market for hedging because the DKKmarket is way too small and illiquid to absorb the hedging volumes. The currency risk between â‚ ¬ and DKK can be regarded as limited. Two numbers characterize the costs of a swaption very well: the forward rate and the normalized volatility. The following graph shows the development for 5 in 10 year forward rates and 5Yx10Y normalized swaption volatilities for the â‚ ¬. Figure 4 7. 00 0. 80% 6. 50 0. 75% 6. 00 0. 70% 5. 50 0. 65% 5. 00 0. 60% 4. 50 0. 55% 4. 00 3. 50 Danish hedging Danish hedging activities activities 30/11/2000 08/09/2001 18/4/2002 26/12/2002 09/04/2003 13/5/2004 20/1/2005 0. 50% 0. 45% 3. 00 23/3/2000 0. 40% 5 in 10 forward rate (lhs) x10 normalised swaption volatility (rhs) As can be seen in the chart, the Danish hedging activities had a huge impact on the European interest rate markets and hedges quickly became more expensive. 2. 5. Adequate accounting treatment for hedging strategies achievable The principles laid out in this paper do not require or presuppose a move to fair value accounting. Under specific circumstances, hedge accounting can be achieved for these receiver swaptions under both US-GAAP and IFRS and under some national accounting principles, avoiding substantial PL volatility. It should be noted, however, that achieving hedge accounting for this type of strategy is a privilege rather than a right. It requires substantial documentation work and limits managements flexibility in trading the hedging instruments for a very long period of time. Copyright  © 2006 Chief Risk Officer Forum 13 Discussion Paper The following review of local/international accounting standards is not intended to be exhaustive, but rather illustrates the range of treatments of risk mitigation strategies and the accounting hurdles that need to be considered. 2. 5. . US-GAAP and IFRS Under both US-GAAP and IFRS, derivatives are generally carried at fair value in the balance sheet, and fair value changes are recognized in