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New approaches to hedging market risks

Life insurers need more capital in the current interest-rate environment, with interest-rate and spread risks among the main drivers. Under Solvency II, both of these risks must be actively managed and substantially hedged, and Munich Re has new types of reinsurance solution that offer many advantages over financial instruments.

08.06.2016

As the saying goes, “time is a great healer”. In the past, this adage was effectively the main pillar of financial management in traditional life insurance. One of the most important concepts was the spreading of risk over time by active management of valuation reserves and using the bonus policy to create a cushion (through the reserve for unallocated bonuses in Germany, for example). However, the limitations of the concept have become increasingly apparent as the period of low interest rates shows no signs of coming to an end.

Wanted: New management instruments

The historically low interest rates – together with the arrival of Solvency II – now leave little room for active balance sheet management. The need to meet partially conflicting requirements creates a problem for life insurers.

The market-consistent discount rate under Solvency II can result in substantial increases in their reserves, but generally the growth in the market value of their investments often does not fully compensate for the increase. At the same time, they need a considerable amount of capital specifically to cover interest-rate and spread risks.

In the current interest-rate environment, national and international accounting regulations are also imposing repeated increases in reserves, but the rules differ from the valuations required by Solvency II.

Though insurers could utilise unrealised gains on their assets to compensate for additional costs, in practice their use may be restricted by the regulations on policyholders’ participation in gains on investments. Furthermore, a sudden rise in interest rates can result in a drop in unrealised gains such that the required amount for strengthening the technical reserve might no longer be covered by sufficient assets.

Traditionally, these asset-liability management challenges have been managed on the assets side using structured financial instruments. However, the current situation is more difficult in that, unlike in the past, the market-consistent valuation of liabilities has to be taken into account – both for Solvency II and for the national rules for creating additional reserves in the balance sheet. In addition, it is apparent that there are fewer possibilities for covering these requirements using financial instruments. There are a number of reasons for this – investment banks, for example, are increasingly loathe to offer life insurers tailor-made financial solutions because they give rise to high capital costs under Basel III.

The alternative: Innovative reinsurance solutions

How can insurers improve their management of the Solvency II capital requirements and tailor it more to their own needs? Munich Re asked itself this question some years ago and has now developed non-traditional reinsurance solutions that make it possible for companies to do precisely that. By transferring specific market risks to the reinsurer, they can stabilise their existing valuation reserves or technical provisions as required – improving both their solvency ratio and available own funds. Unlike capital market products products, our solutions affect the liabilities side and are aimed at optimising the accounting effects as well as achieving a financial benefit. The basic structure of reinsurance for market risks is relatively straightforward. The mainstay of any structure is reinsurance on a funds-withheld basis that, as usual, transfers the biometric risks to the reinsurer. What is new is that the same mechanism can now be used to reinsure market risks such as the future development of interest rates.

How it works: A simple mechanism with many design options

The best way to illustrate how it works is to compare it with traditional reinsurance. By means of reinsurance on a “funds-withheld basis” Munich Re assumes the full liability for the ceded share of the portfolio and in this way also the obligation to accumulate the guaranteed interest on the ceded reserve. In addition, the reinsurer typically returns a large portion of the biometric margin by means of a high profit participation. For assuming the guarantee rate obligation, the cedant pays a fixed deposit interest rate under a traditional treaty. This is where the new solutions come in. The deposit interest is not linked to the guaranteed interest rate, but is matched precisely to the insurer’s economic needs depending on the market interest rate – needless to say in compliance with supervisory and accounting regulations (see Fig. 1).
Life insurers need more capital in the current interest-rate environment, with interest-rate and spread risks among the main drivers. Under Solvency II, both of these risks must be actively managed and substantially hedged, and Munich Re has new types of reinsurance solution that offer many advantages over financial instruments. © Munich Re
Fig. 1: Reinsurance on a funds-withheld basis including market risk cover
Biometric risks are transferred to the reinsurer in the usual way via reinsurance on a funds-withheld basis. New: the same system can now be used to cover capital market risks. For example the cedent's future interest liabilities, receiving a variable deposit interest rate linked to market rates in return.
Depending on the insurer’s needs, there are many possible structures. For example, the deposit interest rate can be linked directly to current capital-market interest rates. This enables the insurer to significantly reduce its interest-rate risk under Solvency II because its net position is then independent of future fluctuations in interest rates, and it always receives the guaranteed interest rate from the reinsurer in return. Another example: the deposit interest rate can also be linked to the return on a reference portfolio that mirrors the insurer’s investments as closely as possible. The reinsurance contract would then smooth out the investment result, so that, for example, the Solvency II spread risk could be reduced depending on the design of the reinsurance. In both examples, the reinsurance has a direct positive effect on the valuation of options and guarantees.

Important side effect: Options and guarantees

From a primary insurer’s view, traditional life insurance products often incorporate high policyholder participation on the realised investment income, whenever this exceeds the guaranteed interest rate. However, if the return is less than the guaranteed interest rate, the deficit is borne solely by the insurer. This one-sided arrangement obliges companies to post additional reserves for Solvency II purposes. While expected future gains need to be split between insurer and policyholder, losses are recognised fully on the company’s account (see Fig. 2). In the context of a stochastic simulation, this requires higher reserves.
Life insurers need more capital in the current interest-rate environment, with interest-rate and spread risks among the main drivers. Under Solvency II, both of these risks must be actively managed and substantially hedged, and Munich Re has new types of reinsurance solution that offer many advantages over financial instruments. © Munich Re
Fig. 2: Payout profile for total claims of policyholders and insurance company
This means that, even in the current situation of very low returns, scenarios in which significantly more income could be earned on investments also have to be taken into account. A reserve corresponding to the “time value of options and guarantees” (TVOG) is already required under Solvency II to cover the future policyholder participation that would theoretically arise. This rule still applies even if returns above the guaranteed interest rate can hardly be expected in the medium term from current investments (or the anticipated reinvestments). The problem can be addressed with a non-traditional reinsurance solution. The way it works is that Munich Re carries the risk of adverse developments in the capital markets and in return shares in the upside if higher investment results are achieved. The positive effect of this solution is the long-term stabilisation of profits, for both the policyholders and the insurer. If investment profits are too low, the insurer benefits from full interest relief. This reduces the volatility in the investment result and in particular permits an appreciable reduction in the reserves for the TVOG, thus strengthening own funds.

Considerable potential for use in other areas

We have seen that non-traditional reinsurance solutions can be used to produce targeted effects in asset-liability management. However, the potential of the solutions goes well beyond partial immunisation against future capital market developments to reduce risk capital requirements and the burden resulting from the valuation of options and guarantees under Solvency II. The model also enables duration to be reduced on the liabilities side or existing valuation reserves to be kept at their current level so that they are available in future for the financing of reserve increases due to changes in interest rates. This is currently a problem, for example, in Germany and Austria, where an additional interest reserve has to be created over the coming years. With an appropriate reinsurance solution, an insurer can finance the build-up of the additional interest reserve quickly and conveniently without having to rely on uncertain future valuation reserves. The solutions, tried and tested in practice, open up many more possibilities for financial management and create new flexibility for investments. This potential should not be left untapped. You can count on Munich Re as your partner as we together explore the new approaches we can offer.

Munich Re Experts
Thomas Grüntker
Senior Consultant Financial Solutions
Antonia Schaubmair
Antonia Schaubmair is responsible for developing and marketing non-traditional reinsurance solutions for the German and Austrian markets in our Financial Solutions Life Unit.
Günter Schwarz
is a senior consultant in our Financial Solutions Life Unit, where he develops individual reinsurance solutions for financial risk management.
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