Institute of Actuaries of India

Indian Actuarial ProfessionServing the Cause of Public Interest

Rishabh PrakashRamnath Shenoy

GuideAnuradha Lal

Indian Fellowship Seminar

USE OF INTEREST RATE SWAPS IN INSURANCE WHY THE MARKET IS NOT GROWING?

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AGENDA Interest Rate Swaps – Overview

Interest Rate Swaps – Types

Interest Rate Swaps – Regulation

Interest Rate Swaps – Use in Insurance

Interest Rate Swaps – Market Overview

Why the market is not growing

Take Aways

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INTEREST RATE SWAP | OVERVIEWWhat is an IRS?

Interest Rate Swap

A contract between two parties to exchange a series of two different sets of interest payment

Based on a notional principal amount which never gets exchanged

Frequency and term of payments are same for both sides of payment

Payments made in the same currency

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INTEREST RATE SWAP | TYPESVariations in the product

“Plain Vanilla” Interest Rate SwapA series of fixed interest payment is exchanged with a series of floating interest payment

Zero Coupon SwapEach individual payment under plain vanilla IRS is traded separately

Amortising SwapNotional principal reduces in a predetermined way

Accreting SwapNotional principal increases in a predetermined way

Deferred SwapSwap commences at some future date

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INTEREST RATE SWAP | REGULATION Highlights of the latest derivative guidelines

Allowed Instruments

Forward Rate Agreements, Interest Rate Swaps, Exchange traded Interest Rate Futures

Allowed Purpose

Derivatives must be used only for hedging purposes, specifically for1. Reinvestment of maturity proceeds of existing income investments2. Investment of interest income receivable3. Expected policy premium income receivable of the underwritten insurance contracts in Life and Pension & Annuity business

Allowed Counterparties Commercial Banks and Primary Dealers

Documentation ISDA and two way CSA

Exposure Limits

1. Exposure limits applicable as per the IRDA Investment Regulations2. Exposure limits pertaining to single issuer, group and industry will be applicable3. No contracts to be entered with promoter group entities directly or indirectly4. Exposure to derivative instruments with underlying infrastructure instruments shall be treated as exposure to infrastructure sector

Size Cap Outstanding notional principal amount of the derivative should not exceed 100% of the book value of the fixed income investments (across all funds)

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INTEREST RATE SWAP | USE IN INSURANCEImportance in different lines of business

GENERAL INSURANCE NOT VERY IMPORTANT Interest rate risk is small as majority of products are short term

HEALTH INSURANCE NOT VERY IMPORTANT Interest rate risk is small as majority of products are short term

RETIREMENT BENEFIT IMPORTANT More important for DB than DC due to guarantee

LIFE INSURANCE

ANNUITY VERY IMPORTANT Interest rate risk is high due to long term nature.

PAR USEFULDiscretionary benefits can be used to manage the interest rate risk. However, swaps can still be used to match the guaranteed benefit.

NON PAR TRADITIONAL IMPORTANT

Can be used to meet the implicit guaranteed rate used in pricing. Very important for products with guarantees, but the size of this line of business is relatively small.

NON PAR VIP USEFUL Can be used to protect against reinvestment risk in future. However, this would also compromise the upside to the customer.

UNIT LINKED NOT VERY IMPORTANT

On the unit side, interest rate risk is borne by the customer. Non unit is quite small.

71 3 4 6 8 9 11 13 14 16 18 19 21 23 24 26 28 29

Years

Liab Discretionary CF

Liab Guaranteed CF

Asset CF

INTEREST RATE SWAP | USE IN INSURANCE To protect against reinvestment risk

Swaps can be used to guarantee a fixed income on the portfolio on future premiums and reinvestment of interest income

Example of a Par product where the premium income in initial years exceeds the corresponding outgoes

Liability net of premium is negative in initial years The strategy can be to hedge the guaranteed benefit and take risk only

on the discretionary part of the liability Disclosure requirements in case of a significant change in investment

philosophy

1 3 4 6 8 9 11 13 14 16 18 19 21 23 24 26 28 29Years

Liab Discretionary CF

Liab Guaranteed CF

Asset CF

- ACCRETING- DEFERRED- PLAIN VANILLA

EXCESS ASSETS

EXCESS LIABILITY

WITHOUT SWAP WITH SWAP

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INTEREST RATE SWAP | USE IN INSURANCE To match assets and liabilities

Swaps can be used to match the assets and liability more closely if• Bond of long enough term are not available• Swap tenor available is higher than bond terms available

This can be done by investing in a combination of short term bonds and deferred swaps, giving a combined payoff of a long term fixed bond

Example of cash flow matching of annuity - DEFERRED SWAPS

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61

Cash

Flo

w

Year

WITHOUT SWAPS

Bond CF Liability CF Difference

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61

Cash

Flo

w

Year

WITH SWAPS

Bond + Swap CF Liability CF Difference

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INTEREST RATE SWAP | USE IN INSURANCE To ensure meeting the minimum guaranteed rate

The swaps can be used to convert the fixed rate liability into floating rate liability

The company pays the floating rate and receives the fixed rate The company can invest its funds and the future receivables (premium

and investment income) in cash instruments and earn the floating rate Thus, the company ensures to meet the minimum guaranteed rate Instead of full matching up to the guaranteed rate, it can do partial

matching and take risk on the residual amount depending on its risk appetite - DEFERRED

- ACCRETING- PLAIN VANILLA

MIBOR +X bps

MIBOR

FIXEDASSET INSURER INVESTMENT BANKER

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INTEREST RATE SWAP | USE IN INSURANCE Other Uses

To change the asset characteristics without deleveraging existing assets

To optimize the SCR in the Solvency II calculations

To reduce the Cost of Guarantee and enhance value

To reduce the balance sheet volatility by hedging against fall in returns

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-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

2004 2006 2008 2010 2012 2014

G Sec OIS Spread

G Sec - 5 yr

OIS - 5 yr

Spread

-5,000

10,000 15,000 20,000 25,000 30,000 35,000 40,000 45,000 50,000

2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14

Noti

onal

Pri

ncip

al (R

s Bill

ions

)

IRS Trading Volumes

INBMK

MIBOR

INTEREST RATE SWAP | MARKET OVERVIEW The market is illiquid and immature

The only fixed income derivative market that trades actively is the OIS market

The INBMK market is highly illiquid OIS market is quoted up to 10 year but is liquid only up to 5 year After the 2008 financial crisis, the trading volumes had fallen significantly

and have stagnated at the lower levels The OIS and the Gsec rates rarely converge

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WHY MARKET IS NOT GROWING | AVAILABILITY Tough to find a suitable product

Term to maturity

The OIS market is illiquid for terms after 5 years

Hard to find instruments beyond 10 years

Although banks would be willing to hedge their floating liability against insurer’s fixed liability, banks are looking at short term horizon (3 – 5 years) while insurer requirements are much longer (15 – 20 years)

In contrast, in a market like UK, swaps are available with duration of 30 - 50 years

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WHY MARKET IS NOT GROWING | BASIS RISK Residual risk remaining after product discovery

Cash investment to pay floating rate The underlying OIS curve is used to determine the swap rates In case the insurer enters into a swap to receive fixed and pay floating, it needs to invest in short term assets to hedge its floating liability

• If the insurer remains invested in long term G Secs, the spread between OIS curve and G Sec curve can result in losses

• Even if the insurer invests in short term instruments, there remains a slight spread between the OIS and the money market rates

In the event of sale of the asset, winding up may be very costly due to the spread between swap and Gsec rates

Amount to be hedged Future premium amount depends on future persistency rates The amount hedged might turn out to be higher / lower than the

actual requirement

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WHY MARKET IS NOT GROWING | COMPLEXITIES - 1 Complex product to manage

Board Approval Need for detailed pre approved policy from Board Should cover authorized products, ensure adequate staff resources and establish management responsibilities

Infrastructure requirements Investment Management Systems to be prepared to manage derivatives Initial expenses to be incurred in setting systems and processes and staff

Risk Management Policy Identification of potential risks, suitable measurement parameters, suitable VaR level, and risk limits Decisions to be discussed in ALCO and IC

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WHY MARKET IS NOT GROWING | COMPLEXITIES - 2 Complex product to manage

Monitoring and rebalancing / regular MIS Board review at least once a yearQuarterly report to IRDA

Demonstrating that swap is used only for hedging purposes Hedge effectiveness needs to be proved Hedging instrument should cover the risk within 80% – 125%

ISDA Documentation / CSA Agreement ISDA documentation requirement Need to enter into a two way CSA agreement to reduce Credit risk Can be expensive and time consuming

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WHY MARKET IS NOT GROWING | COMPLEXITIES - 3What is an IRS?

Credit Exposure CalculationFuture Credit exposure based on tenor dependent conversion factorsWith periodic collateral exchange under CSA agreements, conversion factor of tenor 1 year or less should be used

Accounting and Disclosure Accounting as per AS 30 and disclosure as per AS 31 and AS 32 Disclosure on nature and terms of outstanding derivatives and potential losses on counterparty failure

Audit Requirements Prior approval from the concurrent auditor about adequacy of systems and processes to handle derivatives

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WHY MARKET IS NOT GROWING | COUNTERPARTY RISK Risk and Issues in management

In case of counterparty default, there might be losses and also the cost of entering into a new hedge

Collateralisation requires exchange and investments of collateral on a regular basis

Insurer not allowed to borrow funds, acceptance of cash collateral amounts to borrowing

In case of using bond collateral, the market value will be volatile

Diversification hard to achieve for insurers with the limited swap market

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WHY MARKET IS NOT GROWING | OTHER ISSUES Who takes the first plunge ?

Derivatives can be too risky if not properly used – need to convince the Board

Natural hedges between different lines of business Indian insurance industry is relatively immature and so product mix can

change quickly Effect of new business on interest rate risk For new business, need to enter new contracts on a regular basis Information asymmetry between insurer and banker about each

other’s needs Too costly in the beginning as no standardized market Swap spread could be volatile causing MTM losses on unwinding BASEL 3 norms for banks – effect on bank’s risk appetite

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WHY MARKET IS NOT GROWING | ALTERNATIVES Caps, floors and swaptions provide a more suitable hedge

LIMITATION OF SWAP ALTERNATIVE INSTRUMENT

It does protect against the loss due to unfavorable movement in the interest rates, but also sacrifices the gain in the case of a favorable movement

Swaption, which gives the insurer an option to enter into the swap only if the risk is biting

It protects against large as well as small change in interest rate whereas for an insurer, it is only the big changes in the interest rate that is more crucial to be protected against

Caps and Floors which protect against a large movement in the interest rate and leave the risk of small interest rate shifts with the insurer

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INTEREST RATE SWAP | TAKE AWAYSSummary

Swaps can be used extensively by insurers to reduce the interest rate risk in its business

More important for annuities, non par and retirement products but less useful for the big products ULIPs and Par

Supply constraints in the Indian market in terms of volume of trades and the maturity of the swap

Complex management makes it even tougher to initiate dealing in swaps

Alternative products like caps, floors and swaptions more suited to meet insurer needs

Institute of Actuaries of India

Questions / Suggestions ?Rishabh Prakash prakash.rishabh@gmail.com

Ramnath Shenoy ramnath.shenoy@gmail.com