The Use of Derivatives by Life Insurance Companies Globally

The Actuarial Society of Hong Kong

Mark C. Hoogendijk

21 May 2013

2

Agenda

Introduction Risk Categorization

Market & Credit Risk, &

Embedded Optionality

NAIC & IMF Reports

USA Global Players Global Market

Size

Market Research

Overall Rationale for Derivatives

Credit Risk Accounting

Deep Dive Met Life

Historical Analysis

Summary Key Takeaways

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Portfolio Management

(Assets & Liabilities)

Market Risk

Credit Risk

Operational Risk

Insurance Risk

Liquidity Risk

Risk Summary

As

se

ss

ing

Monitoring

Mitig

atin

g

Enterprise Risk Management

4

NAIC Report 2012

Life Insurance Industry

Swaps Split

• Total outstanding notional: US$ 1.4 Trillion, a 28% from 2010

• 152 were Life Insurance companies

• 95.8% of Notional with Life Insurers

274 Derivative Participants

• Investment & Portfolio Hedging

• Replicating Assets

• Generating Income

Rationale for Derivatives

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Global Insurers

Total Derivative Notional on Balance Sheet All numbers in US$ Bln

AXA

MetLife

Pru Fin

ManuLife

AIG L&G

Aviva

Hartford

Old Mutual

Zurich Standard

Life

AIA

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Derivative Interconnectedness

Source: IMF Working Paper

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Research Project

Rating SystemGeneral Derivative Policy Statement 4 3

Derivative Committee 4 3

Separate Derivative Booking Entity 1 0

Full Overview Derivatives 4 4

Mtm On All Derivatives 4 4

Classification "Hedging" Derivatives 4 3

Classification "Non Hedging" Derivatives 4 3

Overview of Notional & Mtm on Derivatives hedging guarantees 1 0

Cash-Flow Maturity Analysis Derivatives 4 4

Notional Maturity Analysis Derivatives 1 0

Scenario Analysis MtM Derivatives 4 3

Level (1/2/3) Split on FV Derivatives 4 3

Credit Risk & Collateral with Derivatives 4 3

Overview of CDS's written (According to rating & Industry) 4 2

Gains & Losses on Non Hedging Derivatives flowing through income 5 2

Overview mtm of Embedded Derivatives within Liability host contracts 1 0

Discussion Models Derivative Pricing 4 2

Market Data Providers for input Option Pricing 1 0

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Derivative Usage – Common reasons

• Equity Puts, Collars

• Swaptions, Floors, Caps Market Risk

• Credit Default Swaps

• Index Swaptions Credit Risk

• Variance Swaps

• Interest Rate Swaps Embedded Optionality

• Swaps, Floors & Caps

• Swaptions ALM

• FX Forwards

• FX Swaps

Hedging Shareholders Equity

• Equity Puts

• CPPI Capital Optimization

• Basket Options

• Fund Options

Retail Savings Products

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Derivative Usage – Examples

• “AEGON utilizes derivative instruments as a part of its asset liability risk management practices” Aegon

•“At 31 December 2011 the Group’s shareholder funds held £3 billion notional of equity hedges, with up to 12 months to maturity with an average strike of 89% of the prevailing market levels on 31 December 2011.”

Aviva

• “Derivatives are primarily used for efficient investment management, risk hedging purposes or to structure specific retail savings products.”

AXA

• “We began early on to make substantial provision for prolonged phases of low interest rates by purchasing derivative financial instruments (“swaptions”) to hedge against the reinvestment risk.”

Munich Re

• “For UK with-profits funds the derivative program is undertaken as part of the efficient management of the portfolio as a whole.”

Prudential Plc

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Derivative Policy – Sun Life

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Annual Reporting - Credit Derivatives

• “Certain derivatives are used to add risk by selling protection in the form of single name credit default swaps and tranches of synthetic collateralized debt and commodity obligations.”

Aegon

• “The AXA Group, , use strategies that involve credit derivatives (mostly Credit Default Swaps), which are mainly used as an alternative to debt security portfolios, when coupled with government debt securities”

AXA

• “The Company also enters into credit default swaps that assume credit risk as part of replication transactions. Replication transactions are used as an economical means to synthetically replicate the characteristics and performance of assets that would otherwise be permissible investments under the Company’s investment policies.”

Hartford

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Annual Reporting - Credit Derivatives

• “Our general fund fixed income investments ……., we have recently launched a program for selling CDS that employs a highly selective, diversified and conservative approach.”

ManuLife

• “We use credit derivatives to enhance the return on our investment portfolio by creating credit exposure similar to an investment in public fixed maturity cash instruments,……………”

Prudential (USA)

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Derivative Maturity Profile - AXA

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Derivative Maturity Profile – Legal & General

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Derivative Accounting – Overall Industry

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MetLife - Derivatives

• “We use derivatives as an integral part of our management of the investment portfolio to hedge certain risks, including changes in interest rates, foreign currencies, credit spreads and equity market levels.”

Policy

• “MetLife uses derivatives to mitigate its equity exposure both in certain liability guarantees such as variable annuities with guaranteed minimum benefit and equity securities. These derivatives include exchange-traded equity futures, equity index options contracts and equity variance swaps”

Equity Hedging

• ”The Company has employed various asset/liability management strategies, including the use of various derivative positions, primarily interest rate floors and interest rate swaps, to mitigate the risks associated with such a scenario.”

ALM

• “Certain of the Company’s reinsurance agreements and most derivative positions are collateralized and derivatives positions are subject to master netting agreements, both of which, significantly reduces the exposure to counterparty risk”

ISDA / CSA

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MetLife - Derivatives

US$ 290 Bln

Plain Vanilla IR Swaps

Basis Swaps

Inflation Swaps

Implied Volatility Swaps

Structured IR Swaps

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MetLife - Derivatives

• “Equity and Interest Rate futures, interest rate swaps, currency futures/forwards, equity indexed options and interest rate option contracts and equity variance swaps.”

Living Guarantee Benefits

• “Long Interest Rate floors” Minimum Interest Rate

Guarantees

• ”Zero Coupon Interest Rate Swaps & Swaptions”

Reinvestment Risk in Long Duration Liability

Contracts

• “Currency Swaps & Forwards” Foreign Currency Risk

• “Interest rate futures, interest rate swaps, interest rate caps, interest rate floors and inflation swaps”

General ALM Hedging Strategies

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MetLife - Derivatives

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MetLife - Derivatives

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MetLife - Historical Growth Derivatives

• Increased percentage of Derivatives to General Account Assets from 2002 to 2007

• Since 2008 in Range from 45% to 55%

• Percentage Derivatives = Notional Derivatives / General Account Assets

Observations

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MetLife - Derivative Categorization

• 60% - 70% Interest Rate Derivatives

• 10% - 15% Equity Derivatives, however in 2009 & 2010 to 25%

• Numbers in graph are in Millions and are Notional amounts

Observations

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MetLife - Derivative Categorization

• Increased Percentage in Equity Hedges in 2009 & 2010

• Growing Percentage in Interest Rate Swaps

• Substantial increase in Interest Rate Floors in 2012!

Observations

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MetLife - Remaining Life Derivatives

• Relatively small portion in > 10 Years

• Large variations in < 1 Year bucket

• MetLife did not provide statistics in 2012 Annual Report

Observations

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Singapore Derivative Positions

Total Derivative Notional on Balance Sheet All numbers in SG$ Mln

NTUC

GE AIA

PRU

Aviva

100%

≠

HSBC

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Summary

Derivatives are part of a Life Insurer’s daily operations

Policies, Governance, Risk Measures, Accounting, Valuation, Education & Communication are all key to successful implementation of Derivatives

Collateral Management is a key area of attention within the derivative process

Derivatives (OTC) are flexible contracts!

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Hybrids

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• FX Option with Notional according to a specified

Equity Index return.

• Plain vanilla FX Option: The option buyer pays an

upfront premium in exchange for having the right to

buy/sell currency at a specified exchange rate for a

specified Notional.

• Hybrid FX Option: The option buyer pays an upfront

premium in exchange for having the right to buy/sell

currency at a specified exchange rate for a specified

formula based Notional, where the Notional will vary

according to the performance of a specified Equity

Index.

Hybrid FX Options

FX Option

Option

Buyer

Option

Seller Fixed Premium

Hybrid FX Option

Option

Buyer

Option

Seller Fixed Premium

Max [Strike – Spot, 0] x Notional*

*Cash settled, Notional = X

Max [Strike – Spot, 0] x Notional*

*Cash settled, Notional = Index t / Index 0 * X

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• Constant Maturity Credit Default Swap (CMCDS)

• The protection buyer pays a premium (spread) in

exchange for protection where the spread is:

– floating

– set equal to the prevailing reference CDS spread

at each reset date times a factor known as the

participation rate (PR)

• The CMCDS instrument allows investors:

– To take views on the future shape of the CDS

curve or

– Through a CDS and a CMCDS combination to

isolate spread risk (i.e. the risk of changes in

the premium not related to an actual credit

event) and to hedge default risk

CMCDS

CDS

Protection

Buyer

Protection

Seller Fixed Prem X% pa

CMCDS

Protection

Buyer

Protection

Seller 70% x 5Yr CDS pa

Protection upon Default

Protection upon Default

*Reset Annually

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• “Following a number of discussions and extensive ALM analyses, the Board decided during the third quarter of 2007 to implement a hedging strategy comprising a combination of*:”

– hybrid options (equity-linked receiver swaptions) and

– ‘standard’ swaptions plus equity put options.

• The strike price of these receiver swaptions on the expiry date depends on the return on a pre-determined equity index basket.

• The strike price increases as equity prices drop and decreases when equity prices rise.

• This product mainly protects the pension fund in situations where both equities and interest rates have dropped dramatically.

Hybrid Swaptions

*Source: Cardano Press Release

Receiver Swaption

Receiver Swap at 5% (strike)*

Swaption

Buyer

Swaption

Seller Upfront Premium

* If Swaption buyer exercises his right

Hybrid Receiver Swaption

Rec. Swap strike if Eq Ret *

Upfront Premium Swaption

Buyer

Swaption

Seller

* If Swaption buyer exercises his right

The Use of Derivatives by Life Insurance Companies Globally

The Actuarial Society of Hong Kong

Thank You – Q&A