Balance Sheet

The use of derivatives by insurance companies

Joseph Mariathasan,
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The use of derivatives by
insurance companies
Insurance companies represent a key market for derivatives salesforces,
and so it can be difficult to gain a clear overview of their benefits.
Dr Joseph Mariathasan leads us through the minefield of options open to
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insurance companies, and recommends the best way forward
NSURANCE COMPANIES come in
I many shapes and sizes and represent
some of the largest financial institu-
tions in existence. They often have a
wide variety of internal and external
funds under management as well as the
general corporate treasury activities of
managing complex cash flows. As a
result, they do have a large demand for
instruments that can aid the risk and cash
flow management of their activities. They
are therefore seen as a prime target by
derivatives salesforces throughout the
world.
Indeed, written material on deriva-
tive strategies, ranging from the simplest
to the most complex as well as the
downright weird, is sent to them by a
whole industry of highly paid profes-
sionals devoted to extolling the virtues
of derivatives in every possible manner!
There is often a tendency, however,
amidst all the verbiage, for the funda-
mental business rationales for using the
instruments to be hidden behind a wall
of hype and obfuscation, coupled some-
times with a great deal of naivety. It is
useful therefore for all parties concerned
to shift the emphasis towards setting the
use of derivatives within an overall
corporate strategy.
Large insurance companies can have
exposure to three main business areas;
namely, general insurance (property and
casualty), life assurance and investment
management. In simple terms, the life
and general insurance activities act as
sources of funds, through the premium
income that they generate, that have to
be managed in order to be able to meet
the future claims and in addition, gener-
ate profits for the shareholders. Further
funds also arise from the fact that the
regulatory and competitive environ-
ments dictate that insurance companies
need to maintain capital greatly in
excess of that required to pay off future
claims. This capital provided by share-
holders also needs to be managed. The
nature of the insurance business there-
fore gives rise to large funds under
management and, as a result, many com-
panies use the expertise of their in-house
investment departments to manage
external funds as well. The fund
management side for the insurance
funds can therefore be seen to be inti-
mately tied in with the requirements to
manage corporate cash flows normally
managed by separate treasury depart-
ments in non-financial corporates.
Why are derivatives used by
insurance companies?
While investment banks may be able to
run profitable trading books in
derivative products, that is not a
business objective of most insurance
companies. The use of derivatives of any
There is often a tendency for the
fundamental business rationales
for using derivatives to be hidden
behind a wall of hype
DERIVATIVES
type therefore needs to be justified on
the grounds of what advantages, if any,
they add to the management of the busi-
nesses, whether the corporate balance
sheets, the life balance sheets or external
funds. It is therefore worthwhile and
possibly essential to recapitulate on
what are the fundamental and essential
economic characteristics of ‘derivatives’
in general, namely:
■ The ability to gain or reduce an
exposure to an underlying asset without
paying or receiving the full market value
immediately. The simplest derivatives
that enable this to be done are futures or
forwards contracts. Futures contracts
are traded on exchanges which have
strict margining requirements that are
used to control the credit risk of the
counterparties. Forwards are economi-
cally identical but are traded over-the-
counter with a specific bank or securities
house and do not usually have margin-
ing requirements.
Buying a future or forward is eco-
nomically equivalent to borrowing the
funds to purchase an asset at current
prices, with the term of the borrowing
equal to the maturity of the futures
contract. Selling a future or forward is,
VOL 8 NO 1 | BALANCE SHEET | 29
 DERIVATIVES
conversely, equivalent to receiving cash
and placing the funds on deposit until
the maturity of the contract. Futures
contracts thus have the ability to gear an
exposure to an asset class very substan-
tially. The maximum gearing available
would be the ratio of the value of the
exposure divided by the initial margin
that the exchange demands. It is this
property that has generated large activi-
ty by speculators who wish to adopt a
leveraged exposure to the markets.
■ The ability to trade the exposure on
a basket of underlying stocks through
index futures and options more cheaply
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than dealing in the underlying stocks.
This is clear enough for stocks and
bonds, but even currency forwards can
also be thought of as a cheaper method
of switching exposures than the alterna-
tive of borrowing in one currency and
switching the funds to place on deposit
in another currency.
■ The ability, through the use of
options, to obtain a more complex
risk–return trade-off than
would be available through
underlying assets alone in a
simple manner.
The options salesforce
■ A fourth characteristic is
that certain types of deriva-
appears to have targeted
tives are off-balance-sheet
instruments. This effectively
too much of an effort at
means that use of these
derivatives, for example,
the fund manager level
interest rate swaps, would
not be seen in the presented
balance sheet, although they would be
disclosed in the notes to the accounts.
The first point, namely the ability to
gear an exposure effectively, is not a
property that insurance companies, in
general, would be keen to take advan-
tage of, in contrast to so-called ‘hedge
funds’. Any gearing of assets beyond the
value of the cash available would usual-
ly represent an unacceptable level of risk
for any funds managed by insurance
companies. Generally, they would not
therefore have exposures to any asset
classes through the use of, say, futures,
that are greater than the funds available
in that portfolio. Foreign-exchange
hedging through the purchase or sale of
forex forwards comes into the same cat-
egory, since while these are used exten-
sively, they again are very unlikely to
30 | BALANCE SHEET | VOL 8 NO 1
represent an exposure greater than the
size of the underlying assets.
The greatest use of derivatives for
insurance companies lies through
exploiting the second characteristic
mentioned, namely the ability to change
exposures to asset classes (and curren-
cies) cheaply and rapidly through the use
of futures and forwards. Given the size
of funds under management by the
largest companies, exchange-traded
futures and currency forwards are gener-
ally found to have the required liquidity
to suit their requirements. They have
become well established and very useful
tools for switching between asset classes
or currencies, and managing cash flows
(i.e. the ability to gain or reduce expo-
sure rapidly to an asset class as cash
arrives or leaves a fund). The major
drawback arises from basis risk: the risk
that the futures contract may not be
100% correlated with the underlying
asset class for which it is a proxy.
However, for a long-term fund, the view
can be taken that basis fluctuations will
even themselves out.
The status of options
Options introduce a much more struc-
tured risk-and-return profile into any
pot of assets and liabilities. They are the
instruments that are of most interest to
investment banks, because clearly the
margins are much higher than when
banks act as a broker for a futures
exchange. Perhaps as a result, there has
been intense marketing of ever more
complex products with what sometimes
appears to be an ever increasing band-
wagon of advisors and traders attempt-
ing to explain and justify their use.
Conversely, for the end user, it can
be much harder to determine a fair value
for them as evidenced by, at times, very
large spreads between prices quoted by
competing market-makers.
There are really three areas where
options, in general, can be used in the
context of investment management for
insurance companies. These are:
■ The use by individual fund managers
of stock options in place of stock
purchases, and of index options in the
general management of their portfolios.
■ The transformation of wholesale
products into retail products through
products such as guaranteed return
funds.
■ The use of options at balance sheet
management level to manage the group
balance sheet of a non-life company, or
the solvency of a life fund, for example,
through the purchase of put options for
protection during what are perceived to
be particularly volatile periods.
The options salesforce appears to
have targeted too much of an effort at
the fund manager level. The problem it
has to overcome is that fund managers
tend to be steeped in the
analysis of stocks for deter-
mination of relative values.
As a result, there is not so
much demand for having the
added complication of deal-
ing in derivatives of the
stocks themselves, which
have a complex risk–return
distribution. The options
salesforce is more comfort-
able adjusting exposures to
stocks through adjusting the amount of
the stock held rather than through the
use of a derivative instrument. Its prob-
lems lie not in finding a mechanism for
turning a view on a stock into a prof-
itable trade, but rather, what its view on
a stock should actually be.
The arguments put forward by
option brokers implicitly assume that
fund managers can achieve an outper-
formance over the long term through a
strategy of buying and/or selling
options, over and above the outperfor-
mance they are hired to achieve through
their stock picking skills. Such a strategy
actually involves the fund manager in
taking a view not on the direction of
stock prices, but on their volatility.
To put it another way, a fund using
options on a regular basis needs to be
 Not many fund management
houses would claim to be able to
find staff who can second guess the
market in estimates of volatility
viewed in relation to another with simi-
lar market views that does not. A strate-
gy of writing covered calls may increase
income, but at the expense of capital
gain. If the options were priced fairly,
then this should not, by itself, lead to the
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portfolio outperforming because the loss
of capital gain from those stocks that
rose would offset the extra income from
writing covered call options. Clearly the
question then becomes how well can
fund managers predict volatility versus
the market view, compared with their
view of price versus the market view.
While fund management houses can aim
to hire staff able to analyse fundamental
value, not many would claim to be able
to find staff who can second guess the
market in estimates of volatility.
The second use of options has, per-
haps, a sounder business rationale.
Transforming wholesale products into
retail products is something that has
proved very popular during the last
decade, as seen by the success of numer-
ous guaranteed-return funds. Highly
structured option products can have a
vital place here. The actual business
activity can be thought of as a whole-
saler selling a product to another institu-
tion with a retail distribution arm, who
then processes the raw material into a
form that is attractive to the retail cus-
tomer.
Thus, guaranteed return equity
products may be attractive at the retail
level because they can, at times, offer
yields not vastly worse than bank/build-
ing society deposits, but with the added
spice of exposure to equities with no
principal risk. The alternative of pur-
chasing a basket of equities and buying
a put would clearly be too complex and
too expensive to consider in small sizes.
Other products that attract retail
interest are lending products such as
fixed-rate mortgages or capped mort-
gages, although such products have
traditionally been offered only by build-
ing societies and banks. All of these
products are essentially retail driven.
Success for the institution depends more
on its own marketing arm being able to
determine if a competitive product can
be devised and sold than the activities
of the central staff associated with
managing assets and risk.
Balance sheet management is an
activity that really gets derivatives mar-
keters excited, since insurance compa-
nies who do wish to protect any balance
sheet exposures would have to deal in
very large nominal sizes. However, for
such an institution, the risk–return pro-
file itself may well not be defined in fine
detail with any certainty. In simple
terms, the greater the solvency (i.e. the
size of shareholders’ funds relative to the
size of the business), the greater the risks
the company can run and still be able to
protect the interests of its policy holders.
Conversely, companies with low solven-
cies need to take less risk and here they
may see an option-type pay-off profile as
a way of taking on more specific asset
exposure with less downside risk.
Purchasing put options from invest-
ment banks may be seen as the only
(though expensive) way of achieving
this, unless they are willing to and have
the skills to replicate the option profile
through a dynamic futures-based hedg-
ing strategy. If equity markets rise more
than the option premium plus any rise in
the alternative choice of cash or bonds,
say, the firm would be better off, gaining
access to a rising asset class that it would
The greater the solvency, the
greater the risks the company can
run and still be able to protect the
interests of its policy holders
otherwise not have had the risk-absorb-
ing capacity to take on. If equities fall,
the firm would have only lost the premi-
um. Another area where options can
play a part in balance sheet management
is in managing implicit options present
in previous business undertaken by the
institution. Recent publicity given to the
problem of guaranteed annuities sold by
many UK institutions in the past, at
rates significantly higher than current
bond yields, is a good example of this.
The idea of using put options as a
main plank in an ongoing investment
strategy has sometimes been advocated
for not only the shorter-term insurance
funds, but also long-term pension funds
in particular by many investment banks
and advisors, in the light of minimum
funding requirements for pension funds.
The argument against such a strategy on
a consistent basis for any type of fund is
that frequent purchases of put options
would only cause the firm to outperform
in the long term if the investment
managers time the purchase of options
with something better than a random
choice.
Over the long term, if the firm had a
policy of continually purchasing options
on equities, it would face the problem
that fairly priced equity options reflect
the market consensus view of the proba-
bility of the market rising. Unless one
argues that this is consistently lower
than the actuality, the firm would be no
better off in performance, and would
actually be worse off in terms of trans-
action costs and potentially large
adverse market impact whenever the
options are bought or sold. While it
would be true that the volatility of the
firm’s results would also be reduced, this
can be achieved through replacing some
of the equities with bonds or cash in a
cheaper manner.
For large institutions with relatively
high solvency levels, the requirements
VOL 8 NO 1 | BALANCE SHEET | 31
 DERIVATIVES
Balance sheet management oppor-
tunities do exist and trades can be
large but very infrequent
are to deal in large sizes to adjust the
risk–return profile in a broad rather
than a highly structured sense. As a
result, the institution is driven towards
the use of highly liquid futures and for-
wards markets to adjust risk exposures
rather than through dealing at the other
extreme, in small amounts of esoteric
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highly structured over-the-counter
option products. Having a portfolio of
highly structured option products
bought at different times would end up
blurring the very feature that the prod-
ucts have to offer, namely their highly
structured nature. The resulting portfo-
lio would end up being a very expensive
mish-mash of products with a convolut-
ed risk–reward profile. The conclusion
that one tends to draw from this is that,
while the more highly structured prod-
ucts may be very interesting and prof-
32 | BALANCE SHEET | VOL 8 NO 1
itable for the investment bank selling the
product, they are actually not of great
use for balance sheet management of a
large institution.
A final, more specialised use of
option-type products can conceivably
arise in digesting an acquisition. This
can produce a limited role for the use of
options over a short, well-defined
period. Clearly, the structures are very
dependent on the details of the acquisi-
tion and acquisitions are not exactly
everyday occurrences, so that there is
little in the way of general points that
can be made.
Conclusion
To summarise, large insurance compa-
nies need to fit the use of equity and
bond derivatives within an overall
coherent financial management policy.
Straightforward futures and forwards
contracts have proved to be the most
versatile and useful form of derivative.
While option-based strategies can be
essential for producing structured retail
products, they do not fit so easily into a
day-to-day role in managing conven-
tional performance driven funds.
Balance sheet management opportuni-
ties do exist and trades can be large but
very infrequent. Brokers and investment
bankers can maximise their effectiveness
by better understanding the experience
and views of such institutions and
thereby stand a much better chance of
developing a mutually beneficial
business. ■
Dr Joseph Mariathasan can be
contacted on +44 (0)171 809 6142.
Dr Joseph Mariathasan is
director of Product
Development at Morley
Fund Management and is
also secretary of the
Asset & Liability
Management Association
(ALMA) of the UK.