the Cause of Public Interest Indian Actuarial Profession 23 rd India Fellowship Seminar USE OF DERIVATIVES IN HEDGING INTEREST RATE RISKS AND ITS RELEVANCE IN INDIAN INSURANCE INDUSTRY Guide Name ID: 261976
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Slide1
Serving
the Cause of Public Interest
Indian Actuarial Profession
23
rd
India Fellowship Seminar
USE OF DERIVATIVES IN HEDGING INTEREST RATE RISKS AND ITS RELEVANCE IN INDIAN INSURANCE INDUSTRY
Guide Name
- ADIT TRIVEDI
Presenters Names:
Aditya
Subhash BathiyaVijay Arunachalam MudaliarVamsidhar Ambatipudi
Date : 18-June-2015Slide2
Use of derivatives in hedging interest rate risks and its relevance in Indian Insurance Industry
Interest rates and Insurance IndustryOverview of Interest Rate Risk
Interest Rate Derivatives – Conceptual Understanding
Interest Rate Derivatives – Global MarketInterest Rate Derivatives – Insurance Industry
Interest Rate Derivatives – Indian ScenarioKey Challenges www.actuariesindia.org
2Slide3
Interest rates and Insurance IndustrySlide4
Insurers – Interest Rate Environment
Sell long-term products whose present value depends on interest ratesProtection from adverse
financial consequences
Allow customers to save for
the futureTraditional savings products with built-in guaranteed rates or attached riders that promise a minimum return to the
policyholdersChallenge -
Investing the customers’ payments to ensure funds are available to satisfy policyholders in the futureLife insurers generally invest largely in fixed income securities because most of their liabilities are largely
fixed in sizeLikely impacted by Falling rates(real + Inflation) and tightening spreadwww.actuariesindia.org
4Slide5
Typical Structure of Assets & Liabilities
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5
Source: Presentation at Life & Annuity Symposium (SOA) – 4
th
and 5
th May 2015Slide6
Bond Allocations - Globally
www.actuariesindia.org6Slide7
Overview of Interest Rate RiskSlide8
Interest Rate Risk – Insurance Products
Risk of Matching assets and liabilities to interest rate sensitivityValues of a life insurer’s assets and liabilities
change
with changing interest rates
Matching Fixed Income Investments to the liability profile across all terms is difficultLack of sufficient availability of longer duration of assets to match the duration of liabilitiesReinvestment RiskCredit Risk on Underlying Assets (Default/Downgrade)
Liquidity Risk associated with certain investments
Behaviour of Policy HoldersContribute more to an annuity with a high guaranteed return when interest rates are low Surrender an annuity with a low return guarantee if interest rates rise significantlyNot high for P & C Products Protection Based and Re-priced every year
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8Slide9
Ways of Limiting IRR
Participating ProductsDistribution of bonuses can be controlled in case of falling interest ratesGuarantees are still exposed
Portfolio Immunization
(on-balance-sheet technique)
Duration Matching and Cash Flow Matching can be doneLimited due to unavailability of instruments across all durationsInterest Rate Derivatives (Capital Markets) (off-balance-sheet technique)
Protect against adverse movement in interest ratesBetter management of solvency and hence capital
Instruments for different maturities can be structuredCan help in Tactical Asset Allocation www.actuariesindia.org9Slide10
Risk Management – Insurer’s Business
Accept risks on one hand, and manage them on the other
Risk
pooling and diversification only mitigate but do not eliminate underwriting
riskNeed to transfer part of the extra risk externally to mitigate capital requirementReinsurance is a better option for
insurance risks (longevity, natural
catastrophes, deviation of reserves)Securitization where investors act as a reinsurer conceptuallyRecourse to derivatives is most common technique for financial risks
www.actuariesindia.org10Slide11
IRD for Insurers
Liabilities extend up to sixty years in future whereas the financial markets typically do not offer bonds that extend more than thirty years into the future
Market
for interest rate derivatives has become much more
liquid and can be used effectively Combination
of investments in bonds of a relatively short maturity and advanced (long term) interest rate
derivatives can be used to reduce the risk associated with the liabilitieswww.actuariesindia.org11Slide12
Reasons for less usage of IRD by Insurers
Unfamiliarity with advanced derivativesConservatismDerivative horror stories
in the past
Regulatory resistanceLack of adequate focus
on financial risk managementSlide13
Interest Rate Derivatives – Conceptual UnderstandingSlide14
Derivative
Any instrument or contract that derives its value from another underlying asset, instrument, or contractOver the CounterForwards
SwapsMany types of Options
Exchange TradedFutures
Some Optionswww.actuariesindia.org
14Slide15
Introduction to IRD
Instruments whose payoffs are dependent in some way on the level of interest ratesUnderlying asset is the right to pay or receive a notional amount of money at a given interest rate
Different tools to manage interest rate risk
Volume of trading in interest rate derivatives in both the over-the-counter and exchange-traded markets has been increasing rapidlyPopular
for investors with customized cash-flow needs or specific views on the interest rate movementswww.actuariesindia.org
15Slide16
Types of Interest Rate Derivatives
www.actuariesindia.org16
Interest Rate Derivatives - Vanilla
Forwards
Futures
Options
Swaps
Forward Rate Agreement
-
Agreement to purchase or sell a specified quantity of interest bearing security for an agreed price with delivery and settlement at a specified future
dateCustomized, No MtM
, No guarantee of PerformanceInterest Rate FuturesAgreement to buy or sell a fixed interest instrument at a specified future date for a price agreed todayShort Term – Eurodollar, Treasury BillsLong Term – Treasury Bond & Notes
Interest Rate Swaps
A
greement
between two parties to exchange floating interest payments for fixed interest payments on a specified notional amount for a specified
period
Basis Swap – Both Legs floating rates
Caps, Floors and Collars
-
Agreement that
gives right but not an obligation to buy or sell a specified fixed interest instrument at a fixed price within specified
time
Cap – Upper Limit on Rates
Floor – Lower Limit on Rates
Collar – Buy Cap and Sell FloorSlide17
Other Types of IRD
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Non Traditional
Derivatives
Corridor Option
Entitles
the holder to receive a coupon at maturity for each day that a specified rate remains within an agreed-upon
range.Used by holders with exposure to floating rates
CDS and Other Credit Derivatives
Holder gets protection against the default of a Reference Entity
In the CDS market, buying protection means
reducing credit risk, and selling protection means assuming credit riskSwaptionsGives the right,
not obligation, to enter into a swap in future
Inverse Floater
Bond that pays a coupon that varies with changes in the rate
Constant Maturity swap/note/bond
Medium or Long term rate is used instead of LIBOR for floating leg
Other Floaters
Range – Coupon that depends on number of days the underlying rate is in a range
Ratchet – Floating interest rate – Increase or decrease relative to previous coupon
Inflation Linked – Fixed Coupon linked to inflation index
Callable and Puttable BondsSlide18
Key Risks Addressed by IRD
www.actuariesindia.org18
Meeting Guaranteed rates to policy holders in case of falling rates and Duration of Assets < Duration of Liabilities
Fixed Receiver Swaption can be used to mitigate (Pay Float and Receive fixed during falling rates)
Guard
against massive potential losses resulting from a major natural
disaster (Catastrophe Swap – Pay Fixed Receive based on Catastrophe Index)
Actuarial Risk
Mismatching of Assets and Liabilities – Gap Risk
Duration matching is difficult because of high volatility
Interest Rate Futures/Swaps can convert Fixed to Floating and vice versa and reduce volatility of Balance sheet
Volatility Swap, Correlation Swap , Constant Maturity swap also serve the purposeMarket Risk
Forced Selling of assets to meet surrenders
Entering into FRA or IR Options with large banks as
counterparties enable to adjust their liquidity holdings to an upcoming
liquidity
Widening Bid offer spreads can be reduced
Withdrawal option: A put of the illiquid underlying at the market
price
Return Swap, Return Swaption, Liquidity Option can address liquidity risk
Liquidity Risk
Credit Derivatives like CDS enable investment in having exposure to different types of Fixed Income Securities
Credit Default Swap, Total Returns Swap and Credit Linked notes address the exposure to interest rates and hence the default risk
Credit Risk
Risks AddressedSlide19
Interest Rate Derivatives – Global MarketSlide20
A Glance of Global OTC Derivatives Market
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20Slide21
A Glance of Global IRD Market
www.actuariesindia.org21Slide22
Interest Rate Derivatives – Insurance IndustrySlide23
Insurance Industry and Derivatives
Exposure is less than 1% of total cash and invested assets as per NAIC 2013 Report
Notional amount of derivatives exposure
is increasing year over
yearUse derivatives to implement various investment and portfolio strategies, such as hedging, Lower the funding costs, replicating assets and generating
incomewww.actuariesindia.org
23Slide24
Commonly used Derivatives
Derivatives play a significant role in insurer risk management practices and implement the overall asset-liability management strategiesLong-dated interest rate swaps to increase the interest rate duration of assets
Credit
default swaps to synthetically replicate investments that are otherwise more expensive or
unavailableCDS to hedge existing credit exposures where uneconomical to sell the existing related asset
Equity options to
reduce market risks associated with certain policies, and financial guaranty contractsDerivatives to earn additional investment income - sell covered call options (Speculative Positions)
Replicate illiquid securities by selling credit protection on a corporate name through a credit default swap while buying a liquid government securitywww.actuariesindia.org
24Slide25
Insurers use Derivatives for
Efficient portfolio management (Grow Asset Portfolio Faster and have diverse risk profiles)Reduce Investment RiskTactical Asset AllocationTax ManagementHedging Specific Liabilities
Products with Embedded Options
With profit guarantees
Improving returnsCreating Synthetic Assets Floating rate Bond = Fixed Rate Bond + Interest rate SwapPay Fixed IRS = Long Floating rate Bond + Short Fixed rate BondExploiting investment opportunities
Solvency managementSubstitute risk management (Inexpensive) for capital (Expensive)
Equity Put option to reduce falling equity valueSolvency Protection against adverse Interest rate movementwww.actuariesindia.org25Slide26
Using Interest Rate Derivatives – Examples
Existing Fixed Rate LiabilitiesRiskExposure to variability in future valueHedging StrategyConvert Interest paid to floating by entering into IRS
Asset
Lock in a minimum value by buying a put option or buying a Payer Swaption
Liability Lock in a Maximum Value by buying a call option or a Receiver Swaptionwww.actuariesindia.org26Slide27
Commitment towards Fixed rate LiabilitiesRisk
Exposure to variability in interest rate payments due to changes in Interest RateHedging StrategyPay Fixed Receive Floating IRS (Lock in the future rate)
Buy a Cap or enter into a collar (Upper limit on future interest to be paid)
Participate in declines of interest rate by buying a payer swaption
or a put option on a BondFloating Rate LiabilitiesRisk
Exposure to variability in interest rate payments
Hedging StrategyConvert the Interest paid to fixed by entering into Interest rate swapBuy a Cap or enter into a collar (Upper limit on future interest to be paid)www.actuariesindia.org27
Using Interest Rate Derivatives – ExamplesSlide28
Interest Rate Derivatives – Indian Scenario Slide29
Interest rate risk in India
Increasing Long term Debt issuance by Government Higher IRR Cost efficient hedging mechanism is
needed
Volatility of interest rates increased manifold in the last few years
Greater convergence of Indian economy with global markets increases more drivers for interest rate riskwww.actuariesindia.org
29Slide30
Interest rate OTC Derivatives Trade volume
IRS Trade Summary
(Rs. in bn)
Period
MIBOR
MIFOR
INBMK
TotalTradesNotional Amnt
TradesNotional Amnt
TradesNotional Amnt
TradesNotional Amnt
2007-087949547,281181396,476385144
9801953,901
81.10%
87.72%
18.51%
12.01%
0.39%
0.27%
2008-09
40912
26,448
4,799
2,237
132
66
45843
28,751
89.24%
91.99%
10.47%
7.78%
0.29%
0.23%
2009-10
20,352
14,521
1,050
539
77
51
21479
15,111
94.75%
96.10%
4.89%
3.56%
0.36%
0.34%
2010-11
33,057
23,597
1,291
749
150
88
34498
24,434
95.82%
96.58%
3.74%
3.07%
0.43%
0.36%
2011-12
33,642
24,510
2,101
1,100
14
9
35757
25,619
94.09%
95.67%
5.88%
4.29%
0.04%
0.03%
2012-13
22,713
20,216
1,252
754
11
6
23976
20,977
94.73%
96.37%
5.22%
3.60%
0.05%
0.03%
www.actuariesindia.org
30Slide31
Interest Rate Futures
Fundamental Risk management tool for financial markets worldwideGlobal market turnover is around $1000 trillion (10 times that of equity index futures)Future contract based on 8.4% GOI Securities with maturity on July-2024Future contract based on 7.72% GOI Securities with maturity on May-2025Insurance companies can use for Hedging, Changing duration of their portfolio and lock-in of yield
www.actuariesindia.org
31Slide32
Pros and Cons – Interest Rate Futures
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32
Advantages
Disadvantages
10 Year G-Sec is the underlying – Most Liquid
Good to hedge Long duration non participating liabilities
Less Basis Risk – Cash Markets closely Mirrored
No counterparty default risk
Possibility of Rollover risk – Less Liquidity beyond 1 month
Basis Risk – Change of Benchmark
Cannot offer a good hedge for all maturities
Volumes
yet to gain sufficient tractionSlide33
Pros and Cons – Interest Rate Swaps
www.actuariesindia.org
33
Advantages
Disadvantages
C
ustomized
as per ones
requirement
Fairly Liquid market
Better duration matching and reducing reinvestment risk thus enhancing portfolio returns
B
asis
risk if the spread between G-sec and OIS is
wider
Require
close monitoring of credit risk and interest rate
risk
Liquidity only up-to 5 year period exists
Counterparty risk
Volumes
declining over last few yearsSlide34
Interest Rate Derivatives for Indian Insurance Industry
IRF was introduced by RBI first time in 2003 and again in 2011 but failed
Re-launched
on 21st
Jan 2014 on both NSE and BSE (Cash settled and no physical delivery is required)IRDA
Guidelines 2004 Permitted
use of derivatives with a maximum tenure of 1 year to hedge the interest rate risk on investments and forecasted transactions – Not suitable for InsurersNew Guidelines 2014 Allowed to hedge reinvestment of maturity proceeds, investment of coupon payment receivable and expected future premiums on existing business already written beyond 1
yearWhile dealing in FRAs and IRS, insurers have to ensure that their counter parties are either commercial banks or primary dealers onlyDisclose the details of their hedging strategy, accounting policy and nature of outstanding interest rate derivatives in their financial statements
www.actuariesindia.org34Slide35
Interest Rate Derivatives for Indian Insurance Industry
Banks are the major players on Short side of IRS (Duration of assets is longer and for liabilities is shorter)
Life insurance companies can go long on IRF to hedge the interest rate risk thus creating good
liquidity
IRS can now be used to match liability profile more closely and at nominal costMore insurance companies participation in IRS will augur well for better price discovery and reduce arbitrage opportunity
www.actuariesindia.org
35Slide36
Recent Advances - Interest Rate Derivatives market
Consider an electronic Swap Execution Facility (electronic trading platform) for the IRS market
Consider introducing a CCP for providing guaranteed settlement of trades executed through the electronic
platform
Standardize IRS contracts to facilitate centralized clearing and settlement of these contractsInsurance companies and mutual funds permitted to participate as users in CDS Market
www.actuariesindia.org
36Slide37
Key ChallengesSlide38
Few essential aspects for insurers
Reliable measures for potential exposure are neededClosing out the positions should not be difficultMarketabilityIndependent verification of pricing
Credit worthiness of the counterparty
Admissibility of underlying assets for solvencyCap on Potential of Losses in comparison to investment
Amount of Leverage to be takenCovered vs. Naked Derivativeswww.actuariesindia.org
38Slide39
Challenges/Issues to Indian Insurers
Managing derivatives for hedging purpose is complicated processEnsuring detailed Risk management policy in placeBoard approved derivative policy with adequate understanding of the risks associatedRobust IT management systems, experienced staff
Suitable risk limits and effective monitoring of risk limits
Measuring and demonstrating hedge effectivenessCompliance to hedge accounting
Regulatory reporting on derivatives position along with counterparty exposures www.actuariesindia.org
39Slide40
Challenges regarding IRD
Robust procedures for pricing and hedging these productsMore difficult to value than equity and foreign exchange derivativesBehaviour of an individual interest rate is more complicated than that of a stock price or an exchange rate
Necessary to develop a model describing the behaviour of the entire zero-coupon yield curve
Volatilities of different points on the yield curve are differentInterest rates are used for discounting the derivative as well as defining its payoff
www.actuariesindia.org40Slide41
www.actuariesindia.org
41Question TimeSlide42
AppendixSlide43
Bond Options
Option to buy or sell a particular bond by a particular date for a particular priceEmbedded in bonds - More attractive to
the issuer or potential purchasers
Callable BondIssuing
firm can buy back the bond at a predetermined price at certain times in the futureStrike Price Predetermined price that must be paid by the issuer to the holder
Lock-in Period for the first few years of their
life – Decreasing price with timeBonds with call features generally offer higher yields than bonds with no call featuresPuttable BondAllow the holder to demand early redemption at a predetermined price at certain times in the futureIncreases the value of the bond to the holderLower yields than bonds with no put features
Prepayment privileges on loans and mortgages are similarly call options on bondswww.actuariesindia.org
43Slide44
Caps, Floors and Collars
Interest rate capProvide insurance against the rate of interest on the floating-rate note rising above a certain level (Cap Rate)Tenure, Life of the cap and Cap rate need to be definedPortfolio of
call
options on interest rates (Caplets) or a portfolio of
put options on zero-coupon bondsFloorsPayoff when the interest rate on the underlying floating-rate note falls below a certain ratePortfolio of put options on interest rates or a portfolio of call options on zero-coupon bonds
CollarInstrument designed to guarantee that the interest rate on the underlying LIBOR floating-rate note always lies between two levels
Combination of a long position in a cap and a short position in a floorConstructed so that the price of the cap is initially equal to the price of the floor (Zero Priced Collar)Value of cap = Value of floor + Value of swap (Same Strike Rate)www.actuariesindia.org
44Slide45
Swaptions
Options on interest rate swapsGive the holder the right to enter into a certain interest rate swap at a certain time in the futureProvide companies with a guarantee that the fixed rate of interest they will pay on a loan at some future time will not exceed some levelRegarded as an option to exchange a fixed-rate bond for the principal amount of the swap
Company is able to benefit from favourable interest rate movements while acquiring protection from unfavourable interest rate movements
Alternative to Deferred/Forward Swaps
Involve no up-front cost but have the disadvantage of obligating the company to enter into a swap agreementwww.actuariesindia.org
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