A seismic change happened recently to the way that life insurance companies were regulated within the UK through the introduction of the Financial Services Authority’s (FSA) PS04/16 regulations. Its effects were as profound for the insurance industry and as far-reaching for the capital markets as were the effects of the implementation of the Basle capital adequacy regime for banks in the early 1990s.
Fundamentally, the FSA wanted insurance companies to be able to meet the obligations they have undertaken to policyholders. This means that they need to hold assets and capital commensurate with liabilities they have undertaken and the risks they take. Assets and liabilities have to be valued at current market rates.
The reported capital requirements – now described as Pillar I, in line with the banking terminology – are based on the more onerous of two calculations. This dual valuation assessment is known as the ‘twin peaks’ approach. In addition, firms have to carry out an individual capital assessment (ICA), described as Pillar II, which is disclosed privately to the FSA to demonstrate they have adequate capital resources.
For substantial with-profits life funds - i.e. those whose liabilities exceed £500m (€734m) - a “realistic” approach to assets and liabilities, namely marking to market, is compulsory. Companies must conduct resilience tests to check the basic solvency of the fund and hold a Risk Capital Margin (RCM) against the potential loss. (Smaller with-profits funds currently have an opt-out from realistic reporting and non-profit funds are exempt.)
The effect of these rules, broadly speaking, is that substantial with-profit funds will have to have more capital the greater their holdings in equities, property and corporate bonds, and the greater the duration mismatch between their assets and liabilities.
Insurers are able to reduce the amount of regulatory capital they need to hold, by making sure that they are effectively hedging their liabilities and reducing their exposure (within their with-profits funds) to equities and corporate bonds – all within the context of their policyholders’ reasonable expectations (PRE), which would typically include equity exposure.
Real yields tend to be less of an issue for insurers than for pension funds (except possibly in the annuity fund), as they have relatively few retail price index linked liabilities. However, index-linked bonds and inflation swaps can be substituted for government bonds and interest rate swaps in the following discussion.
In terms of protection against nominal yields, life offices have historically matched reasonably closely with cash bonds. In recent years insurers have used credit bonds, which offer higher yields compared to government bonds, but introduce a measure of credit risk. The limited supply of bonds – government or credit, sometimes makes it difficult to hedge long durations properly. Also, cash flows occur throughout the life of the bonds with a final redemption payment, swamping earlier coupon flows and creating some complexity in achieving matching.
Since the insurer is attempting to satisfy two different objectives through the purchase of appropriate bonds, matching using bonds has other another disadvantage. Firstly, he wants to optimally hedge his liabilities against interest rates. Secondly, he wishes to add excess return over and above government yields. But the return on the assets is set by the yields at time of purchase and so any excess yield is constrained.
A better alternative for insurers is to use derivatives (swaps) to hedge against interest rate liabilities. Interest rate swaps offer at least as good liquidity as government bonds and good liquidity at longer durations. Zero coupon swaps enable a specific future interest rate liability to be exactly matched, and swap markets are relatively liquid out beyond 30 years. Essentially, the swap offers an investor the opportunity to receive a fixed interest rate against paying a floating one (e.g. cash or Libor). Therefore, the liability is turned from a fixed interest rate liability into one that is floating. Any residual counterparty credit exposure is likely to be minimal as most counterparties now transact swaps under documentation that allows for counterparty credit risk to be managed through collateral transfer arrangements.
The key advantage of using swaps over bonds is the separation out of the hedging operation from the investment return. The insurer using swaps to match liabilities has the opportunity to take the investment decision separately. His liabilities are now exposed to a floating rate (cash/Libor) and so the most appropriate assets are those that aim to outperform cash or Libor - such as absolute return funds. As many of these absolute return funds are relatively market neutral, the regulatory capital charge for such assets should generally be much lower than equities or property.
The regulations introduced by the FSA are laudable. On the whole they encourage insurers to manage assets and liabilities appropriately so that they are in a good position to make delivery against promises to policyholders. Pillar I twin peaks are more prescriptive and formulaic, but Pillar II addresses a broader range of risk, of which the investment book is a part, requiring stochastic modelling. They demand a balanced approach to seeking solutions, which have economic value and are not simply driven by regulatory capital efficiency.
They have removed artificial barriers to using sophisticated instruments like derivatives to seek better financial solutions – while still giving due weight to operational risks introduced by using more complex instruments. These solutions are more suited to insurers’ long-term investment objective to attain smoother real investment returns to match policyholder’s reasonable expectations. This is also a good thing.
When insurers approach the protection of their liabilities against real and nominal interest yield changes, they should look at opportunities presented through derivatives, which allow the action of hedging to be separated from the creation of excess return.
Paul Bourdon is director of investment solutions at Threadneedle Asset Management.
