Coping with low interest rates and high volatility

You might think that the global financial crisis killed all demand for structured products. But Francois de Supervielle, who is deputy head of Société Générale’s cross-asset solution group in Hong Kong, says customers — especially insurance companies — are asking for them again. Asia Pacific insurers face a difficult environment. Issues such as duration gap, negative interest spread and balance-sheet volatility have become prominent.

Changes in accounting rules may compound their difficulties. A new international standard, IFRS 9, to replace IAS 39, is in development and is expected to be published next year. Analysts say it probably will require changes to the way that insurance companies offset assets against liabilities.

Risk-based capital measures that assess the minimum amount of capital an insurance company needs are spreading across Asia. Even firms in places like Hong Kong, may need to adopt RBC if they have a foreign parent. European-owned insurers must prepare for the EU’s Solvency II directive to be implemented in 2012.

Simplicity returns

“We are not seeing investors coming back for very complex structures,” de Supervielle says. “But rather they are interested in structured products as a way to enhance yield.” Most of the interest is from insurance companies, eager to satisfy regulators that they’re safe, rather than from pension funds with no regulatory capital issues.

You can see why insurers are considering structured products. Bond rates have been falling for several decades, and that trend has accelerated in the past two years as central banks and governments in Europe and North America tried to stem the worst effects of the economic turmoil.

“Interest rates are low in many countries, and they have been getting lower and lower for government bonds,” de Supervielle says. “If you look at South Korea, KTBs are currently paying below 4%, coming down from 5.5% a year ago.”

Beijing is partly to blame. “The Chinese have been buying more Asian risk as they have been diversifying.”

Low interest rates play havoc with pension funds and insurers. A small change in the assumed discount rate can make an enormous difference to the potential size of future liabilities. The traditional approach — buying bonds to lock in a future income stream to match outgoings — may no longer look so easy. Plus, outside of Japan, there are few investment-grade longer-term bonds available to buy, and smaller insurers may not have enough in-house expertise to properly assess off-shore fixed-income investments. “In some countries you can hardly find a liquid corporate debt instrument with maturity above seven years,” says Karim Traoré, director of SocGen’s solutions for financial institutional for Asia Pacific.

In general, insurers must consider many more issues than in the relatively calm days before the financial crisis. When volatility was at low levels, life insurance companies could manage risks with much more confidence because hedging exposure to stormy markets was not an issue. The effect on profits was minimal. But then volatility surged to unheard of levels. Protection can be expensive. The VIX index, which measures the choppiness of the S&P 500 index, spiked to 60% during October 2008, shortly after Lehman Brothers collapsed.

More recently it has fallen back below 20%, but that is still well above its long-term average. Besides, it the VIX is only a short-term measure volatility. Insurers would no doubt be prudent to assume volatility may remain elevated for some time yet for shares, and in other asset classes such as commodities or bonds as well.

Traoré’s advice: “Take a step back, identify first the risks on the balance sheet, where it is coming from, where the volatility is hidden. Identify where you have convexity, is it positive or negative, whether it comes from the asset side or the liability side.”

Taiwanese insurers, for example, face the issue of negative convexity because they have invested in callable bonds. But Traoré says having controlled volatility on a balance sheet can actually be good. Volatility may be seen

as negatively correlated in the long term to equity risk.

The problem is really about concentration. Allocating too much money to products with negative convexity will magnify risk. In that case, good old-fashioned diversification is needed. Insurance companies can spread risk by investing in products that show positive convexity, which then show returns when volatility rises.

De Supervielle says tailored structured products are a solution to many of the concerns that life insurers need to address following the global financial crisis.

By working through a third-party, clients can access maturities and durations that they cannot find in domestic markets. With a structured investment solution, insurance companies can have a capital market partner issuing for them a ten-year or even longer private placement in their local operating currency. This allows them to shrink the duration gap as well as the convexity of their net asset. They can also conserve economic capital to help meet the requirements of regulators.

SocGen also sees a big potential market for variable annuities. They have proved popular in Japan, where traditional annuity rates have sunk in line with the slump in interest rates. Many lessons have been learned from the bad experience of US insurers and their policy holders.

“Nobody would recommend putting all your money into structured products,” de Supervielle says. “But it probably makes sense to allocate a portion of it to get higher return and with a level of risk well known and understood. The complexity of structured products has come down.”

He is tight lipped about putting figures on SocGen’s sales of such products to insurers. “The overall market for structured products is smaller than in 2007 at this stage, but the number of issues and challenges lying ahead of institutional investors are many and, as such structured solutions can be of great help,” he says.

The biggest market is probably north-east Asia but not China. “It’s not the most advanced country for structured products because of regulations that are very stiff, and the derivative markets are still developing,” de Supervielle says.