Financial Risk Management of Insurance Enterprises Use of Financial Derivatives by US Insurers

Overview Over the past few weeks, we have introduced the basic financial derivatives used to manage financial risk Cummins, Phillips, and Smith review the use of these basic derivatives in the insurance industry

Review of Insurer Function Risk bearing and risk pooling –Insurers accept risk of loss in return for premiums –Insurers diversify risk by writing policies on independent risks Intermediation –Insurers issue “debt” contracts in the form of policies and invest proceeds in assets –Earn a spread of asset return less debt yield

Financial Risk Management Needs Matching interest rate sensitivities of assets and liabilities is known as asset-liability management (ALM) Existing assets may not allow insurers to exactly match the liability cash flow –If cash flows of assets and liabilities match, then their interest rate sensitivities must also match

Financial Risk Management Needs (p.2) ALM becomes more difficult if options in policies exist which may alter cash flow –e.g., the right to lapse or the right to borrow against cash value Derivatives can be used in two ways: –To offset any options in the insurer’s policies –To adjust the interest rate sensitivity of assets/liabilities more cheaply than direct investment

Hypotheses Explaining Use of Derivatives Size is positively related to usage –Human capital economies of scale Organizational form (stocks vs. mutuals) –Stock companies have comparative advantage to take up risky business due to ease of monitoring by owners Line of business –Life insurers have more exposure to interest rate risk

Hypotheses Explaining Use of Derivatives (p.2) Amount of asset/liability mismatch –Difficult to determine given lack of financial data –Maturity of bonds is used as a proxy Use of derivatives may be related to asset risk –As percentage of equities or foreign assets increase, so does use of derivatives –Asset holdings can affect amount of options bought for protection or sold for income enhancement Use of reinsurance hedges underwriting risk and may be substitute for derivatives

Data of the Study 1994 annual statements filed with NAIC 1,760 life insurers and 2,707 PC insurers Categories of derivatives included: –Options, caps, and floors owned –Options, caps, and floors written –Collars, swaps, and forward agreements –Futures contracts What is special about each of the groups? –Credit risk and one- vs. two-sided performance

Types of Contracts Used “Most popular” types of contracts are ranked by notional amounts Tables 3-4 and Tables 5-6 report type of contract two ways –At end of year (snapshot of protection provided at one point in time) –Opened in 1994 (can be skewed by length of contract)

Types of Contracts Used (p.2) Swaps, caps, and forwards are the most popular derivatives among insurers –Less use of options and futures Still, notional amount of call options written is noteworthy –May be income enhancement strategies such as a covered call

Table of Results - Average Values

Results 12% of life insurers and 7% of PC insurers use derivatives –About the same number of users for each Stock insurers use derivatives more –Life insurers: 16% of stock companies, 7% of mutuals –PC insurers: 10% of stock companies, 4% of mutuals As the size of companies increase, so does the proportion of derivatives users

Results (p.2) Derivatives can provide liquidity protection –Insurers with a higher percentage of assets in privately-placed bonds use derivatives –Insurers with more short term investments do not use derivatives Users of derivatives have longer bond maturities than non-users –Insurers may try to pick up yield but use derivatives to hedge interest sensitivity Insurers who use reinsurance less use derivatives more

Underlying Assets of the Derivatives - Life Insurers Options in life insurer policies make liabilities very interest rate sensitive –Companies with higher reserves in GICs, whole life, and group annuities are users of derivatives –Companies with higher reserves in group life are not Life insurers overwhelmingly use derivatives to manage interest rate risk –Caps/floors –Interest rate swaps –Options and/or futures positions on bonds

Underlying Assets of the Derivatives - PC Insurers PC insurers have higher percentage of assets in equities –Use of equity options both provide protection and enhance income PC insurers do use FX forwards –Foreign subsidiaries’ hedge

Counterparty Exposure Top dealers (counterparties) are mostly investment banks –e.g., Prudential Bache, Goldman Sachs, Salomon Brothers, Bankers Trust –Prudential Bache was counterparty to 36.8% of contracts opened during 1994 Top exchanges are Chicago Board of Trade, Chicago Board of Options Exchange, and New York Stock Exchange

Use of Derivatives by Insurers - Update Many insurers still do not use derivatives Use of derivatives for interest rate risk management has increased Use of derivatives could be expanded for optimal risk management Some insurers now use credit default swaps Some insurers have been hurt by inappropriate use of derivatives