Insurance companies have long shunned derivatives, on the premise that for an industry engaged in risk management, these products were just too complex. Besides, many assumed that they'd always be able to make money while sticking to conservative investment policies. However, once insurers started offering customers products as complex as derivatives, it became apparent to some of them that far from being too risky, derivative products were just what they needed in order to manage the different types of risks thrown up by these new products. Here some key industry players discuss how insurers are using derivatives today within the framework of conservative financial management.

Timothy Quinn
Managing director, TMG Financial Products

Despite the substantial size of the insurance industry, there are several factors that have inhibited the growth in derivative products utilization. In fact, equity and fixed-income derivatives offer considerable value in hedging, income generation and replication. As the industry has become more competitive, it has offered more interest-sensitive products to policy holders. To offset these diverse symmetric and asymmetric risks, derivative instruments should play an increasing role. Derivatives provide a variety of techniques to protect against interest rate fluctuations and shifts in the yield curve.

For example, caps and floors are used to minimize the impact of a rise or decline in rates, respectively. Interest rate caps are often used in a variety of applications, providing protection against resetting variable annuity credited rates in rising rate environments. To reduce the risk associated with structured settlements, spot or forward start floors against the 10-year or 30-year Constant Maturity Treasury (CMT) can be utilized. Other applications for the use of floors would be to hedge the call risk of corporate bonds and the prepayment risk of mortgage-backed securities.

Hedging applications with derivatives are as diverse as potential exposures. Call options on yield curve spreads, say, 10-year Treasury rate versus the 2-year Treasury, can be utilized to hedge against a steepening yield curve. An insurance company writing Single Premium Deferred Annuities (SPDA) policies may have a mismatch between a longer investment portfolio duration and the SPDA's shorter option-adjusted duration. To minimize the risk, the insurer may use yield curve swaps, paying LIBOR and receiving a floating rate equal to the CMT for five to seven years. This strategy allows the insurer to shorten duration and potentially offer more competitive new money annuity rates while maintaining net interest margins.

Derivatives can also be used for income generation and yield enhancement. A major application is the use of swaps linked with U.S. or foreign currency­denominated securities to create synthetic assets with greater return characteristics. Asset swaps allow investors to seek relative value in markets which may price less efficiently than traditional sectors while avoiding currency risk. Secondly, swaps are used to increase duration and yield. For example, receiving fixed under a longer maturity swap while paying fixed for shorter maturity increases the duration of a portfolio and results in receiving a fixed coupon at the longer end of the yield curve.

Swaps and options allow the user to either lock in or exercise a right of fixed rates that may be favorable under future rate environments. Equity-linked notes are structures that provide the purchaser a guaranteed rate of and a call option on the S&P 500 Index to allow a percentage participation in the accretion in the S&P 500. The options such as lookback, average, discreet and others are configured to generate potential income under a range of risk/reward characteristics.

In addition, insurers can generate income on caps structured to offset adverse market movements. For example, out-of-the-money caps on five-year and seven-year CMT or Constant Maturity Swap rates allow the insurer to limit the downside risk analogous to stop-loss reinsurance. This hedge can be used to cover the renewal rate for SPDAs, which compete with new money rates offered by competitors. If rates rise, income generated from caps on the five-, seven- and 10-year yields will allow the insurer to pay competitive renewal rates, effectively enhancing the return on the fixed-income investments, which back the annuities.

Typically, insurance companies attempt to replicate liability exposures with assets, which immunize the firm against rate risks. Insurance companies are increasingly employing sophisticated duration-matching techniques that measure duration at discrete time periods. On this basis, option-adjusted duration allows the portfolio manager to accurately match asset hedges against the liability risk profile. Derivatives offer the user extremely flexible tools to replicate the option features of insurance industry products. Swaps and options can often be structured to precisely offset the potential yield curve, reset or lapse risks of a product. On the asset side, these instruments can be used to mitigate exposures from callable bonds, mortgage-backed securities and duration mismatches.

Thomas A. McAvity Jr.
Former vice president, quantitative research, for Lincoln Investment Management, Lincoln National Insurance Co.

Some companies, including Lincoln National, have used derivatives effectively and approprately to hedge and manage risk for more than five years. If all insurers used derivatives in the same proportion as the top ten users, overall usage would be considerably greater. My friends in the dealer community feel that usage is growing in terms of the number of companies, the dollar volume and the quality of analysis and judgment employed.

Many companies have been reluctant to be pioneers in using derivatives, given their lack of understanding of the surrounding methodologies and their concerns about the reactions of regulators, rating agencies, distributors and other constituents. Some corporate cultures and some executives discourage trying out a new tool because a bad outcome could make them or their company seem imprudent, even if the company believes that the strategy contemplated makes sense economically.

In the last three years leading regulators have learned a lot about derivatives and have been willing to move towards a more reasonable framework empowering insurers to use them prudently. Nevertheless, the fog has not fully cleared regarding using derivatives for replication as opposed to hedging. When Standard & Poor's introduced their measure of capital required to cover the risk of options embedded in mortgage-backed securities, I was pleased that they allowed for including derivatives hedges as an integral part of the portfolio.

For insurance companies and other financial institutions, I view derivative strategies as subordinate to the broader processes of asset/liability management, asset allocation and investment management. While derivatives can be useful and even essential for optimal performance in all three processes, I believe the more urgent challenge is to ensure that these processes are being done well, with the benefits of excellent supporting analysis and technology. A company contemplating the use of derivatives should first establish the policies and internal controls recommended for end-users in the Group of Thirty report and ensure that the people who contribute to the design and execution of the strategies have the requisite training and expertise.

One critical capability is simulating results jointly for an annuity or insurance product and the assets that back it for a set of interest rate scenarios. Through this method the company can visualize what scenarios cause results to drop below risk thresholds and experiment with alternative investment strategies, product designs and crediting rate strategies. The performance gap that remains can be the focus for a well-engineered derivative-based strategy. For a typical annuity writer, using derivatives like CMT caps and swaps as part of a well-engineered asset/liability strategy is probably the most important benefit to be gained from the derivatives market.

Hedging is the most important use of derivatives. Income generation can be a euphemism for writing covered calls on interest rates or equities. The income isn't being created for free; it is derived by accepting downside risk and by converting potential gains in value into option premium.

If we view an insurer as a portfolio of risks for which it earns premium, the optimal allocation will maximize total premium in relation to the effective risk to the company's value, earnings and other measures over multiple horizons. In this framework insurers may find it attractive to consider derivatives providing convenient access to risks that are uncorrelated or weakly correlated with the existing book of risks and offer juicy premiums in relation to downside risk. Credit derivatives may offer better value than an equivalent exposure to bonds if the customer on the other side of the trade has a business reason or asks to lay off some exposure. Likewise, reinsurance derivatives may offer sufficient premiums to warrant a place on the insurer's efficient frontier.

Jay Windsor
Portfolio manager, Principal Financial Group

I would say that each company within the life insurance industry has a mixture of different products. So it's hard to generalize about why the insurance industry as a whole uses, or doesn't use, derivatives. A company like Northwestern has different liabilities, or products, than we do. It's tough to make a generalization, but usually the liabilities on the balance sheet of life insurance companies are quite long, so they don't lend themselves to the short-term nature of these risk management tools, which are five years or less primarily. If you employ derivatives that are that are longer, you get into credit areas that involve substantial counterparty risk to financial institutions.

We never envisioned that the purpose of derivatives would be for arbitraging or for meeting risk-based capital guidelines. We've seen many structures designed to accomplish this, but we haven't done anything that resembles this strategy. Typically insurance companies have stock allocations in the small single digits. We are not interested in stock exposures that are much bigger than that. We're interested in reducing the allocation, not taking on more using derivatives.

We don't use derivatives for income generation, such as total return swaps or structured notes with embedded options. These structures are a double-edged sword. They offer additional investment yields, but they have embedded options that could whack you. We really don't like callable paper, since we already have a fair amount of negative convexity in our mortgage-backed securities. For now that's enough embedded options for us.

Derivatives have a role to play in managing risk in the portfolio. The line can get fuzzy between risk management and income generation. We are most solicitous about making this distinction. In other words, are derivatives to be used for risk management or income generation? It's not our intention to use these instruments for income; they play a larger role in hedging risk.

There are derivatives-based structures that bring with them a fair amount of spreads that includes total return swaps. That's something we haven't done. We don't see a real good match with most of the structures. But we're entertaining the idea. Education is a slow process, and our usage of derivatives has been a good match so far, but nothing in the total return or income-generation department has tripped our trigger.

Joseph Buff
Director, Industry Specialists Group, Merrill Lynch

There's been a lot of interest in total return swaps, which are like interest rate swaps. Insurance companies pay LIBOR and receive the total return on the S&P 500 Index, or they pay LIBOR and receive the total return on the National Council of Real Estate Investment Fiduciaries (NCREIF), which is a real estate trade association. Insurance companies can write derivatives against the index to leverage into equities.

Companies also use the reverse approach to total return swaps to enhance the balance sheet and income streams. Many insurance companies desire income as opposed to capital gains. The income is needed to fund liabilities. Companies are motivated into using tools that generate income, such as total return swaps. If companies have equity on the books, they enter into a swap and pay out the return in order to receive the income instead. They do this without having to trade the equity investment. Also, if they want more foreign equity exposure, they can enter into an equity swap. Or if companies own foreign stocks, they buy puts on the stock index or whatever is the closest thing that mimics the investment. This adds risk control to the investment.

Some sophisticated companies don't use derivatives because they may add cost to their investment operations. Risk management is needed, and some are considering using them now. Some firms lack the internal "shop" of systems and staff expertise, and use outside brokers or consultants to support their derivatives business. This way, they can buy rather than build the infrastructure needed to support the derivatives business. Insurance companies outside the U.S. are using derivatives or have considered using derivatives to hedge their liabilities and inflation exposure.

Currently, insurance regulators like the National Association of Insurance Commissioners (NAIC) are looking at replication strategies and are continuing the movement to rationalize and perhaps liberalize derivative rules.

Yogesh Attre
Vice president, Salomon Brothers

Given that life insurance companies are in the risk management business, it is ironic that more insurance companies are not active in financial risk management. For a $3 trillion industry, the use of derivatives is a drop in the bucket. First, there are some sophisticated companies in the insurance industry that have significant experience at hedging and yield enhancement with derivatives. Second, few people who grasp the relationship between derivatives and insurance liabilities and investments, can communicate and convince senior insurance investment professionals of the value that derivatives can add. Third, many states allow only limited uses of derivatives, and insurance regulators have not yet permitted replication strategies using derivatives.

Consequently, many insurers have not yet invested in the resources needed to build their derivatives expertise to a comfort level, and a few insurers perceive as too high the cost of derivatives to "reinsure" their balance sheet or income statements. Most mutual insurance companies will adopt GAAP accounting in 1996, which should raise the visibility of marking-to-market bonds and financial risk monitoring and management. It could be a chicken-and-egg issue between marketers and insurance company users of derivatives.

Given various restrictions on insurers' use of derivatives, some insurance companies have successfully extracted significant value from fixed-income and equity derivatives. Volatile trending interest rates over the past few years ought to encourage more insurers to monitor and manage structural risk more actively. This is especially important since optionality is increasing in insurance liabilities while the supply of, and insurance investment in, more structured securities is rising.

Yield spreads on spread assets have compressed much more during the 1990s than liability prices have risen. This has influenced insurers to step up their derivatives usage to generate more investment income and/or protect their financial asset/liability management strategies to balance active portfolio management, risk management and spread maintenance for optimal liability persistence.

Ravi Dattatryea
Senior vice president, Sumitomo Bank Capital Markets

Derivatives are an ideal tool for the insurance industry in general and life companies in particular. The main reason is that their liabilities, that is, insurance contracts, traditionally contain numerous implicit and explicit option-like characteristics. Currently popular investments, such as "physicals" or outright cash instruments, unfortunately are too simple in their risk behavior and do not provide a satisfactory cover for the complex liabilities. The resultant gap should be and can be bridged by use of appropriate derivatives.

There are two main obstacles to the effective use of derivatives by life companies: regulation and accounting, in that order. Many regulators are not comfortable with letting insurers use derivatives. The feeling in the industry is that the regulators, not the insurers, are not up to speed in the latest capital market techniques and tools, and the issuers are paying the price with the resultant lack of flexibility and power that would be afforded by derivatives.

Accounting is another issue. Again, unless mark-to-market accounting, which is the most fair approach in my opinion not withstanding its many drawbacks, is universally adapted, the accounting rules will result in both errors of omission, not using useful tools, and commission, using ineffective methods.

The situation is that a handful of life insurers are using derivatives for hedging and are enjoying the benefits. These people happen to be the best in the industry, and therefore have the confidence of their upper management. They know, for example, that no amount of fixed-income positions will hedge a SPDA portfolio as efficiently as CMT swap. The also know that the newer accrual swaps are a better hedge for SPDAs. They have understood enough about the advantages that they have taken the additional steps to obtain regulatory approval, and have figured out how to handled the accounting issues. These are the steps you to take to be player.