Derivatives in insurance: managing risk and optimizing capital

How do insurance companies typically engage with derivatives and how can listed derivatives support those strategies?Sushil Krishan: A large portion of insurance companies’ assets are on balance sheet and some of them are very illiquid. That means that they have to either hedge those assets or match them with their liabilities.Compared to equity investments, the challenge is not as stark for fixed income investments. The insurance company can choose from a large variety of derivatives, listed and OTC, for duration management or can match a lot of its investments to its liabilities.For equity investments there are two distinct challenges. Firstly, the volatility of the assets is historically much higher than that of a fixed income portfolio. That means to comply with solvency requirements, insurance companies need to hedge a lot.However, the hedges that are most beneficial in this regard — lookback puts, forward strike puts (i.e. path dependent options) and similar products, are all OTC. In the fixed income, or even credit market, all of the most commonly used hedges have been moved into clearing houses, such as Eurex. There has been a transformation in those markets which has alleviated stresses on booking and potentially risk modelling within insurance companies. Meanwhile, the equity derivatives world, especially exotic derivative products which are interesting for insurance companies, is still exclusively OTC.This ties into the second challenge facing insurance companies, which is that it's hard for them to book and model options which would suit their needs best.One solution that could improve access and liquidity is moving these products into a listed and cleared world, which makes it easier for booking purposes.Can you explain how OTC markets create an operational burden for insurance companies?The main burden that OTC participation creates is complexity of access. Whenever a firm trades in an OTC market, it needs ISDA documentation or the equivalent for its respective jurisdiction. Obtaining that is a super lengthy process that can be very arduous. However, if you are trading through a clearinghouse, the documentation process is completely standardized. You only need to go through it once with the CCP, after which you can start trading without facing multiple counterparties. The listed environment creates other advantages. To engage in an OTC trade, someone has to read through a term sheet and pay close attention to all the legal aspects. In an exchange-traded environment, standardization reduces those obligations.An exchange also offers a system where trades can be booked and potentially modelled. Even if your firm hasn’t the capabilities to model a trade itself, an exchange, which is an independent marketplace, provides a model that can be priced from on a daily basis. The availability of an independent price may reduce risk management concerns, compared to an OTC derivative.Are those complications leading to lost opportunities for insurance companies? We are currently in an environment where forward volatility is trading at multi-year lows, yet buying a put which strikes in one year is not accessible for the majority of all insurance companies. They know that in one year’s time, they will most likely have an equity position and need to hedge it for solvency requirements. However, most cannot lock in that very cheap volatility. The biggest insurance companies might be able to. But the second-tier firms, which are still vast organizations, cannot. Are there other products that would benefit from a listed environment? Besides the asset side, also the liability area could benefit, such as the unit-linked market, which is typically associated with life insurance products that have an equity or multi-asset performance. This is a super OTC area and not accessible through any cleared type of product. If there was a way for exchanges to allow for the customization inherent in those options, it could bring great benefits. Another area where we have had a lot of discussions with clients is around private markets. This is an area where many insurance companies will have felt some pain in recent market conditions and haven’t been able to properly hedge their exposure. Bringing more of this market into a tradable and hedgeable state might make private markets more and more accessible and liquid.Weiter zum vollständigen Artikel bei Deutsche Boerse AG Unsponsored American Deposit Weiter zum vollständigen Artikel bei Deutsche Boerse AG Unsponsored American Deposit