With the regulator having opened up new hybrid capital opportunities for insurance companies in the UK, investors keen to buy such securities, and the securitisation market having produced a novel capital raising solution for insurers, the pressure the industry has been under has eased.
Although insurance companies may no longer be able to play fast and loose with the products they offer in pursuit of market share, most of those that were guilty of such practices have been able to rebuild their capital bases.
However, while hybrid capital and securitisations may have been able to treat some of the symptoms of the pain that insurance companies have felt in recent years, they do not necessarily address the issues that caused the problems to arise in the first place.
Recognising this, insurance companies are, instead of just reaching for a pain-killer, putting themselves through thorough tests to ensure that they do not have any long term problems hidden on their balance sheet.
Chris Barter, managing director and head of the pension and insurance strategy group at Goldman Sachs, says that insurance companies are now taking a holistic approach to capital management.
"We are taking on capital advisory mandates where insurance companies will get a comprehensive review of their regulatory, rating agency, and economic capital position," he says. "We will look at every element of their business, both at operating company and at group level, to see where capital is being consumed and what the return on equity is on each of these capital blocks."
Depending on the results of this review, different actions will be recommended. "We will advise companies on a step-by-step programme going from releasing capital that is being wasted," says Barter, "all the way to redeploying capital into areas that generate equity value for shareholders. This might mean, for example, increasing embedded value or looking at ways of raising capital in the external markets.
"What we end up with is a series of top-down recommendations on how the insurance company should prioritise applying resources to achieving those capital targets."
Such capital advisory mandates are typical of the work that banks are now doing with insurance companies, and many have in recent years set up groups to tackle the problems that life insurance companies face.
The suite of recommended solutions usually comprises three areas.
"At the one extreme you have a rights issue," says one insurance coverage banker, "like the Pru did last year."
In October 2004 Prudential surprised the market by launching a £1bn rights issue. The firm said that it would use about £100m-£200m of the rights proceeds to meet the EU's Financial Groups Directive and about £800m-£900m to grow its UK business — although the shock announcement resulted in widespread speculation about any ulterior motives the company might have.
"A rights issue might be the right solution for a particular situation," says the banker, "but it should be the last resort. You don't really want to do it unless you are unable to address the problem in another way."
After raising core capital or issuing one of the new tiers of insurance company capital available under the new UK regime, securitisation is considered a second option.
"You have a kind of middle route that insurance companies can take," says the insurance banker, "recycling capital. Embedded value securitisations, for example, where you are releasing internal capital by using structured finance techniques, while at the same time you are tapping the external market."
While, following the disappointment of the National Provident Institution, this might also have been as something of a last resort, he says, it is now viewed as a smart move.
What insurance companies should be doing first, he argues, is releasing capital. "If an insurer is taking on a lot of market risk in a particular area where they have limited or not enough upside then they will release that capital by shutting down that risk," he says.
Others agree. "The big issue facing insurance companies now is partly, how do I raise capital and let me talk about innovative ways of raising capital," says a FIG DCM banker, "but almost as a prelude to that now is: how do I actually get rid of my requirement for capital to the greatest extent possible? Because if I can do that then that is an excellent position to be in."
The insurance landscape has changed dramatically in recent months with the introduction of a regulatory framework that encourages the industry to manage its credit, equity, interest rate, property and persistency risks in an economic or realistic manner. The benefit for an insurance company that does achieve an economic hedge is that it will achieve capital relief.
The starting point for many insurers has been the management of interest rate risk arising out of guaranteed annuity obligations (GAOs).
GAOs are essentially minimum guarantees struck at relatively high interest rate levels and which give rise to significant risk.
In the late 1990s, UK insurance companies typically hedged this GAO risk within a life book by implementing receiver swaptions struck at around 5%. This was because as interest rates declined life insurers were forced to reserve against increasingly low rates. They therefore sought protection from further falls in interest rates.
While they would have to reserve against the difference between the 9% minimum rate that they had effectively guaranteed and prevailing market rate of 5%, rates as low as 3% were considered possible. A portfolio of 5% receiver swaptions meant that the most insurance companies would have to reserve would be 4%.
"By 2002 almost everyone had put this in place," says one banker. "You'd pay a large premium and have these assets on your book, this large portfolio of receiver swaptions struck broadly at 5%, because that was where the at the money was."
However, the new regulatory regime in the UK has meant that insurance companies have had to rethink such strategies.
|No quick fix for longevity|
One might have thought that the news we are all expected to live longer would be unanimously welcomed.
But while pension fund trustees are just as likely to share in the good news as the rest of us, they are also aware that increased life expectancy poses challenges for the funds they manage. Each extra year we live costs them money.
And insurance companies face similar problems.
Most immediately, the Financial Services Authority has said that insurance companies with "exposure to areas with greater underwriting uncertainty such as longevity and morbidity risks" can expect to be faced with tougher Individual Capital Guidance.
In November 2004 BNP Paribas, the European Investment Bank and PartnerRe set out a product that they hoped could address the problem for pension funds.
Cashflows on the "longevity bond" are linked to the proportion of the present 65 year old male population of England and Wales that survive. The more that survive, the higher the payment. The risks of the structure are borne by PartnerRe.
The first annual payment to investors is £50m, which will fall every year in line with mortality figures provided by the UK Government Actuary's Department. And according to calculations of the present value of cashflows at the time the deal was announced, the EIB could expect to receive around £540m for the annuity.
According to Tim Cox, life insurance and pensions structurer at BNP Paribas, the bond is an attractive alternative to other means of addressing longevity risk. "It is very much simpler," he says. "If a pension fund insures its annuity liabilities, there is an awful lot of due diligence for the insurer to do to understand exactly what risks they are taking over. In addition, it is disproportionately expensive for the extra risk the insurer is taking.
"The longevity bond offers a simple, cost-effective solution."
However, having begun marketing the concept in November, BNP Paribas is still touting the product to pension funds and has not yet reached the targeted size. Cox says that this is primarily due to protracted sign-off procedures for new products.
While welcoming the attempt to address the longevity problem, many observers are sceptical about the attractions of the bond.
One criticism is that the demographics of the members of the pension fund are unlikely to mirror exactly the group underlying the bond's cashflows. Another is that the bond combines risks and rewards that are dealt with by different parts of a pension fund's management, and that the longevity risk also comes at the price of an expensive asset.
But the biggest obstacle to the take-up of the longevity bond and indeed any attempt to address the longevity problem may be the difficulty in valuing the risk.
"If you think about it," says one banker, "you're trying to hedge the possibility that in 10, 20, 30 years from now people are living to 100, 110, 120 years old, so establishing a standard whereby you can measure that and can make it an instrument that behaves a little bit like a bond is very hard."
It therefore appears that longevity risk is something that insurance companies are going to have to learn to live with.
"The regulator has changed everything over the last 18 months," says Dawid Konotey-Ahulu, head of the European pension fund group at Merrill Lynch, "by introducing a system under which the amount of capital that you have to hold is determined not simply by whether or not you have a 5% strike on your receiver swaptions, but on a realistic — that is to say true economic — basis."
Under policy statement 04/16, insurance companies now have to hold capital to the extent that they are not realistically hedged. But if they are realistically hedged, they do not have to hold capital.
"That is a double-edged sword," says Konotey-Ahulu, "because on the one hand it very brutally highlights asset/liability mismatches within life companies. But on the other hand, it enables you to very dramatically impact your requirement for capital by using instruments which effectively rub out the mismatch risk."
Under the new realistic regime, insurance companies have to stress test their assets and liabilities to see how they behave under different events. And under such scrutiny, the "hedges" that insurers had previously implemented have been found wanting.
"If you hold a 5% receiver swaption against a 9% guaranteed annuity option liability, then on a mark to market basis when you stress test both the liabilities and the assets they behave in very different ways," says Konotey-Ahulu.
This is because on a mark to market basis the 9% liability has a much higher interest rate sensitivity than the 5% receiver swaption. As an example, a 1% drop in interest rates might push up an insurer's liabilities by £500m, while the portfolio of swaptions may rise in value by only £250m.
Meanwhile the 9% liability to the policyholder, which can effectively be modelled as a 9% receiver swaption, is much less sensitive to changes in volatility than the 5% receiver swaption being held as a hedge.
Konotey-Ahulu says that the regulator's new realistic regime has effectively tightened the definition of "hedging".
"If you asked an insurance company if they were hedged in 2000 then they would say yes or no depending on whether or not they had bought a portfolio of swaptions," he says. "Now, holding a basket of swaptions may mean that you have partially offset your interest rate risk, but are overcompensated for volatility risk. That means that you have a mismatched hedge — not enough interest rate protection, too much volatility."
Many insurance companies are therefore restructuring their existing hedges to increase their interest rate sensitivity and reduce their volatility.
A market-based perspective
But while declining interest rates may have given insurance companies headaches, they have faced other problems that have demanded new solutions.
"Essentially dealing with interest rate risks is a prototype for the business we are about," says one banker, "because that process of rebalancing the hedge is applicable not just to GAOs. You've also got equity issues, credit issues and others where you have to adjust your hedge."
And this variety of issues cannot simply be dealt with in isolation. "The kind of trade that we would implement would involve first of all involve looking at your liabilities," says the banker, "and to the extent that it is an interest rate liability with perhaps an equity component, where the interest rate risk is contingent on the level of the equity markets, for example, the hedge that you put in place needs to reflect that hybrid nature."
Konotey-Ahulu at Merrill Lynch says that his team has dealt with the hybrid issue of interest rate, volatility and equity mismatches by implementing such a hedge.
The problem is exacerbated by the fact that when most of the liabilities insurance companies are facing were created — namely the policies were written — such factors were never considered.
"Some of the benefit structures are immensely complicated," says one banker, "because when these promises were made to policyholders no one granted them with a view to ever analysing them within a market-based framework. It was all done if it made sense from a business perspective."
However, such issues are now high on the list of an insurer's priorities. "The starting discussion that we now have with the CFO is: how do I mitigate risk and shut down my requirement for capital? Only after that is there a discussion on how best to raise capital against the risks that will inevitably remain."
As well as dealing with their life books, insurance companies also have to address the risks in their defined contribution pension schemes under the Individual Capital Assessments that have been introduced as part of the new capital adequacy regime for the industry.
Friends Provident was the first to address the issue, doing so in December 2003 with Merrill Lynch creating the solution.
"That was the first pension fund risk mitigation transaction within the context of a life company," says Konotey-Ahulu, "and it has worked perfectly. The market has moved adversely and their liabilities have risen, but the hedge has moved to the same degree."
There have, however, been refinements to the hedge since it was put in place. "We provide the client with daily or weekly input on how the hedge is behaving," says Konotey-Ahulu. "It is a very detailed aftercare programme that we have, so we are at their beck and call. If they want analysis on how the market has moved and how the hedge has performed then we'll turn that around very quickly.
"We'll adapt the hedge as well," he adds, "so if the underlying demographics have changed a year on from implementing the hedge, we will alter it accordingly."
Despite the obvious need for pension funds to address such issues, bankers do not always find it easy turning a proposed solution into practice.
"In a pension fund it is very complicated because you have to get a whole cast of characters on-board," says one banker. "You've got the trustees and then you've got the CFO, treasurer and chief executive, and their agendas can be quite different. Then you've got the investment consultants, the scheme actuary and the asset manager as well.
"They then all have to agree — within a very complex accounting, regulatory and economic environment — on what needs to be done using a portfolio of derivatives, which traditionally pension funds don't use."