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The Actuary The magazine of the Institute & Faculty of Actuaries

Minimum rate guarantees across Europe

Structural solvency weaknesses across the European life industry have been exposed by falls in equity markets and bond yields, as a result of large volumes of participating contracts with minimum rates of return. Accordingly, several insurers have been forced to raise extra capital, for example via deeply discounted rights issues.
An article spanning Europe by necessity must generalise; most of the relevant points in this article have, however, been discussed in recent months with insurers in the Netherlands, Belgium, Denmark, Norway, Italy, Spain, France, Switzerland, and Germany (among others) by myself and my colleagues.

Heads you win, tails we’re quits
The generic contract offers guaranteed minimum returns for terms of 20 years or more on both past and future premiums.
Example guaranteed returns on legacy business are 4% in the Netherlands and Germany, 4.75% in Belgium, 5% in Italy, and up to 6% in Spain. Even on current new business, guarantees can be high relative to risk-free rates, for example 3.25% in Germany, 3% in the Netherlands, and up to 3.75% in Belgium.
In addition there is upside participation in profits and early surrender options with only modest penalties.
Matching these benefits is difficult:
– Assets of sufficient duration are not readily available.
– Surrender guarantees give the policyholder an option against the insurer, inhibiting the ability to match with cash market assets.
– Consequently, insurers are exposed to reinvestment risk on future premiums and asset maturity proceeds.
– Policyholders expect exposure to upside returns on equity markets.
– Participation in upside profits on a formulaic basis, as in Italy and The netherlands, increases the effective floor and the complexity of the guarantee.
– Even where profit participation is discretionary, market pressure forces up the effective guarantees. German life companies have, until recently, paid 7%+ returns each year.
Policyholders have the best of all worlds: a valuable floor in difficult circumstances, upside participation if markets perform well, and the ability to cash out on fixed terms if more attractive returns are available elsewhere a case of ‘heads you win, tails we’re quits’.
Someone must pay for these benefits. In the first instance the cost is borne by shareholders and, ultimately, bondholders of the insurer. If the guarantees cannot be met, the cost will fall back onto policyholders, or on any industry insolvency fund, as seen in Japan in the last five years.

Danish precedent
The first large-scale hedging activity took place in Denmark in 2001. Danish insurers and pension funds offered guaranteed returns of 4.5% on pension contracts until 1994. Allowing a 0.5% margin for costs, the yield guaranteed was 5%. Falling bond yields, exacerbated by a change in tax rules, reduced risk-free rates below 5% from 1992 onwards.
In addition, Danish funds held approximately E35bn of fixed-rate callable mortgage bonds as one of the main assets to back around E70bn of liabilities. As yields fell, the mortgages were prepaid, forcing funds to reinvest at low rates. By 2001, falling equity markets and bond yields put solvency under severe pressure.
The industry initially hoped that the government would come to the rescue, since their tax changes had heightened the problem. Instead, the government’s response was to promise policyholders that guarantees would be met, offering little comfort to the existing management and shareholders.
The regulator increased the pressure, introducing a market-related yield for valuing liabilities and, in the second quarter of 2001, solvency stress tests of a further fall in bond yields and equity values.
Consequently, Danish funds engaged in large volumes of hedging from mid 2001. This was typically in the form of CMS floors, an interest-rate option providing a floor on future reinvestment returns. The cost of the hedge was less than the cost of raising additional capital to withstand the regulatory stress test. Once the first large hedging programme became public, most funds felt compelled to follow, prompted by the need to satisfy regulatory tests at year-end 2001.
Hedging was mostly in euros, as the Danish krone market lacked the necessary capacity. Even in the euromarket, hedging had a marked impact in late 2001, forcing down long-dated yields and causing a spike in implied volatility, a factor in determining interest rate option prices (see figure 1 across).
Lessons from Denmark are:
– Avoid doubling up Asset portfolio exposures can add to risks, rather than offsetting liability exposures.
– When the going gets tough, the regulator gets going The regulator responded to the pressure on funds by tightening the solvency rules, rather than relaxing them, ultimately forcing companies to hedge.
– Winners act first Hedging activity had a noticeable market impact, increasing the cost of future hedges. The funds that waited until they were forced to hedge paid a high price.

Current regulatory approach
Regulatory solvency is typically measured on a book value basis for assets and liabilities. Liabilities are discounted on a passive basis using a yield established at outset, normally the guaranteed rate, rather than at current market yields. No reserves are held for out-of-the-money guarantees.
This is reasonable when the insurer matches the liability at outset. However, as explained above, this is seldom done. The approach does not highlight the exposure of the insurer to reinvestment risk, and the impact of guarantees is recognised only gradually, if and when the guarantee bites each year.
This causes a delay in recognising that the insurer has a problem and, hence, a delay in taking appropriate action. Once a problem is highlighted, it is typically too late for an insurer to manage its way out of the position, other than by seeking extra return by taking on additional asset risk.

Regulatory change
The International Accounting Standards Board is moving towards fair value methods for valuing insurance liabilities. Simultaneously, the EU is reviewing its regulatory regime under the Solvency II project, and a more market-consistent and risk-based approach is likely to result.
Fair values of liabilities are based on the portfolio of financial instruments that best replicate the options granted to policyholders. A fair value approach to regulation would require insurers to hold additional capital to cover mismatches between their assets and this replicating portfolio. Therefore, under a fair value regulatory regime, apparently expensive option-based hedging strategies actually become cheap contingent capital, as seen in Denmark.

The North EastSouth West divide
There is a divide between the current approach of companies across Europe, in particular into north east (UK, the Netherlands, and Scandinavia) and south west (eg Germany, Switzerland, Belgium, Italy).
This reflects a divide in regulatory attitudes, as seen in differing reactions to the proposed introduction of fair values. Regulators in many south-west countries have expressed doubts about the applicability of fair value approaches to insurance liabilities.
North-eastern regulators have been supportive and have acted to anticipate these developments. In the UK the FSA is moving towards a risk-based approach, and the Danish regulator was discussed above. The Dutch PvK is introducing a new financial assessment framework, including a market-based minimum test and a long-term prospective continuity test for asset-liability matching.
North-eastern insurers have typically been at the forefront of risk management and hedging techniques, and have been active buyers of long-dated interest-rate options to protect their long-term portfolio yield.
In contrast, the typical south-western response to falling bond yields has been to seek alternative assets offering enhanced short-term returns. One method is to sell interest-rate options via structured asset products. Investment banks act as intermediaries in large hedging programmes, but ultimately look to lay off the risks. Much of the risk absorbed from Danish insurers in 2001 was ultimately passed on to the asset portfolio of German insurers.
Europewide regulatory change may simultaneously increase the demand for hedging solutions and reduce the potential supply, with obvious implications for the cost of hedging.

Bridging the divide
Risks should be modelled prospectively using long-term models, with a market-consistent approach used to value the options granted to policyholders and measure the economic capital required.
Having measured the risk, the insurer needs to manage it. This typically involves dynamic asset allocation, moving towards closer matching as surplus economic capital diminishes, akin to an option replication strategy.
Structured credit portfolios can achieve the necessary enhanced yield to cover guarantees. A diversified portfolio of credit, with an investment bank providing credit protection by absorbing the first losses, offers attractive returns relative to risk.
Closer matching can be achieved using an interest rate swap overlay. This extends duration and locks in reinvestment returns on the bond portfolio.
An option replication strategy is exposed to increased volatility. A volatility bond is a financial asset paying a higher coupon when interest rates are volatile.

For legacy business, insurers need to properly measure and then manage the risks inherent in their contracts. This requires a market-consistent approach to analysing exposures, combined with a dynamic or option-based investment strategy.
For new business, insurers should confront the realistic cost of continuing to offer guarantees. As we are seeing in the case of with-profits business in the UK, this may call into question the viability of the product, as neither policyholders nor shareholders may wish to bear this cost. Solutions may involve a more transparent approach to guarantees, backed from outset by suitable derivative contracts. But that is another story.