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The Applications of Derivative
Products for Insurance Companies
Investment and Risk Management
ChingLan Lee
Chief Investment Officer
AEGON Life, Taiwan
July 15, 2006
Investment and Risk Management
Investment Policy
Portfolio Limits
Risk manager
Product
manager
Investment
manager
2
Investment Objectives
• To achieve a portfolio yield that is at least
sufficient to support product pricing, to reward the
risk taken, and
• To do so without taking inordinate credit, market,
or liquidity risk
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Product Liabilities
•
•
•
•
•
•
Traditional life, long-term health
Variable universal life
Variable annuity
Interest sensitive annuity
Short-term products
Other products
4
Required Investment Yield
• The primary objective is to achieve the required
investment yield, while striving for a diversified
portfolio and taking prudent levels of risk.
• “Required investment yield” is defined to be the
portfolio yield that, along with expected results in
mortality, lapse, expense, and other key margin
sources, will support desired future returns on
capital on in force business.
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Liability Duration
• Effective duration v.s. modified duration
• Minimum guarantee credited rate v.s. prevailing
market rate
• Single premium v.s. renewal premiums
• Positive convexity of liabilities v.s. negative
convexity of assets
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Product-Driven Portfolio Guidelines
• In light of the product description, investment
requirements, and reserve balances, the
investment portfolio should be constructed to
achieve the required minimum investment yield
of the company, while abiding by certain
investment guidelines.
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One of the guidelines -
Use of Derivatives
• Clearly stated objectives, acceptable risk profiles,
and prescribed monitoring requirements
• Pertinent accounting treatments should be
researched and understood
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Investment Portfolio
• Asset liability match - Core portfolio
• Return enhancement – Active management
Active
trading
Alternatives
Core Portfolio
Options
strategy
Alpha
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More than assets hedge
Under low interest rate environment, there are more
needs to enhance investment yield by using
derivatives
• Assets Hedge – allowed and defined by
regulation
• Return Enhancement – recently allowed and
defined
• Liabilities Hedge – TBA
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Asset Hedge and Return
Enhancement
Derivatives
Strategy
Options
Long call
Asset
Hedge
ˇ
Long put
ˇ
Short call
ˇ
Short put
Return
Enhancement
ˇ
ˇ
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Asset Hedge and Return
Enhancement - continue
Derivatives
Strategy
Futures
Long
IRS
Asset
Hedge
ˇ
Short
ˇ
Pay fixed
ˇ
ˇ
Receive fixed
CDS
Pay
Receive
Return
Enhancement
ˇ
ˇ
IRS: interest rate swap, CDS: credit default swap
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Liabilities hedge
• FSC planned to adopt a new” Insurance
Supervisory System” (Solvency two) which was
under study and discussion with insurance
companies and other insurance institutions. The
earliest possible implementation time will be in
2008 and companies may need to set up more
reserve. (June 14, 2006 Commercial Daily)
Note: Once implemented, insurance companies will need to
enhance their investment risk management and set up
more efficient risk control mechanism.
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Liabilities hedge - continue
• The gap between assets and liabilities - 1
The minimum guarantee v.s. market interest rate
Single premium - hedged by spot curve
Recurring premium - hedged by forward curve
If there is no efficient forward curve to hedge
future cash flow, change the product mix.
Regulation should re-define the hedge.
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Liabilities hedge - continue
• The gap between assets and liabilities - 2
If liabilities duration is longer than assets’, and if
effective duration matters, the duration gap will
cause HUGE under-reserve.
• Derivative will help – for example, receive fixed
IRS could extend assets duration
• However, it, to certain extent, did not comply with
the regulation
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Wrap-up
• To meet the requirements of reserve and capital
adequacy under “new supervisory system”,
insurance companies need to enhance their
investment risk management and set up more
efficient risk control mechanism.
• The use of derivatives will not only for assets
hedge and enhancing investment return, but also
for liabilities.
• More change of regulation would be needed.
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Thank you
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