Institute of Actuaries of India
USE OF INTEREST RATE SWAPS IN INSURANCE
WHY THE MARKET IS NOT GROWING?
Rishabh Prakash
Ramnath Shenoy
Guide
Anuradha Lal
Indian Fellowship Seminar
Indian Actuarial Profession
Serving the Cause of Public Interest
 Interest Rate Swaps – Overview
 Interest Rate Swaps – Types
 Interest Rate Swaps – Regulation
 Interest Rate Swaps – Use in Insurance
 Interest Rate Swaps – Market Overview
 Why the market is not growing
 Take Aways
2
Interest Rate Swap
 A contract between two parties to exchange a series of two different
sets of interest payment
 Based on a notional principal amount which never gets exchanged
 Frequency and term of payments are same for both sides of payment
 Payments made in the same currency
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“Plain Vanilla” Interest Rate Swap
A series of fixed interest payment is exchanged with a series of floating
interest payment
Zero Coupon Swap
Each individual payment under plain vanilla IRS is traded separately
Amortising Swap
Notional principal reduces in a predetermined way
Accreting Swap
Notional principal increases in a predetermined way
Deferred Swap
Swap commences at some future date
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Allowed
Instruments
Forward Rate Agreements, Interest Rate Swaps, Exchange traded Interest Rate
Futures
Derivatives must be used only for hedging purposes, specifically for
1. Reinvestment of maturity proceeds of existing income investments
Allowed Purpose 2. Investment of interest income receivable
3. Expected policy premium income receivable of the underwritten insurance
contracts in Life and Pension & Annuity business
Allowed
Commercial Banks and Primary Dealers
Counterparties
Documentation ISDA and two way CSA
Exposure Limits
1. Exposure limits applicable as per the IRDA Investment Regulations
2. Exposure limits pertaining to single issuer, group and industry will be
applicable
3. No contracts to be entered with promoter group entities directly or indirectly
4. Exposure to derivative instruments with underlying infrastructure instruments
shall be treated as exposure to infrastructure sector
Size Cap
Outstanding notional principal amount of the derivative should not exceed 100%
of the book value of the fixed income investments (across all funds)
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GENERAL INSURANCE
NOT VERY
IMPORTANT
Interest rate risk is small as majority of products are short term
HEALTH INSURANCE
NOT VERY
IMPORTANT
Interest rate risk is small as majority of products are short term
RETIREMENT BENEFIT
IMPORTANT
More important for DB than DC due to guarantee
VERY
IMPORTANT
Interest rate risk is high due to long term nature.
ANNUITY
PAR
LIFE
INSURANCE
USEFUL
Discretionary benefits can be used to manage the interest rate
risk. However, swaps can still be used to match the guaranteed
benefit.
NON PAR
TRADITIONAL
IMPORTANT
Can be used to meet the implicit guaranteed rate used in pricing.
Very important for products with guarantees, but the size of this
line of business is relatively small.
NON PAR VIP
USEFUL
Can be used to protect against reinvestment risk in future.
However, this would also compromise the upside to the customer.
UNIT LINKED
NOT VERY
IMPORTANT
On the unit side, interest rate risk is borne by the customer. Non
unit is quite small.
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 Swaps can be used to guarantee a fixed income on the portfolio on
future premiums and reinvestment of interest income
 Example of a Par product where the premium income in initial years
exceeds the corresponding outgoes
 Liability net of premium is negative in initial years
 The strategy can be to hedge the guaranteed benefit and take risk only
on the discretionary part of the liability
 Disclosure requirements in case of a significant change in investment
philosophy
- ACCRETING
EXCESS
LIABILITY
EXCESS
ASSETS
Liab Discretionary CF
- DEFERRED
- PLAIN
Liab Discretionary
CF VANILLA
Liab Guaranteed CF
Liab Guaranteed CF
Asset CF
Asset CF
WITH SWAP
WITHOUT SWAP
Years
1
3
4
6
8
9
11
13
14
16
7
Years
18
19
21
23
24
26
28
29
1
3
4
6
8
9
11
13
14
16
18
19
21
23
24
26
28
29
 Swaps can be used to match the assets and liability more closely if
• Bond of long enough term are not available
• Swap tenor available is higher than bond terms available
 This can be done by investing in a combination of short term bonds and
deferred swaps, giving a combined payoff of a long term fixed bond
 Example of cash flow matching of annuity
- DEFERRED
SWAPS
WITHOUT SWAPS
Liability CF
Difference
Bond + Swap CF
Liability CF
Difference
Cash Flow
Cash Flow
Bond CF
WITH SWAPS
1
3
5
7
9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61 1
Year
3
5
7
9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61
Year
8
 The swaps can be used to convert the fixed rate liability into floating rate
liability
 The company pays the floating rate and receives the fixed rate
 The company can invest its funds and the future receivables (premium
and investment income) in cash instruments and earn the floating rate
 Thus, the company ensures to meet the minimum guaranteed rate
 Instead of full matching up to the guaranteed rate, it can do partial
matching and take risk on the residual amount depending on its risk
- DEFERRED
appetite
-ACCRETING
- PLAIN VANILLA
MIBOR
ASSET
MIBOR +X bps
INSURER
FIXED
INVESTMENT
BANKER
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 To change the asset characteristics without deleveraging existing assets
 To optimize the SCR in the Solvency II calculations
 To reduce the Cost of Guarantee and enhance value
 To reduce the balance sheet volatility by hedging against fall in returns
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 The only fixed income derivative market that trades actively is the OIS
market
 The INBMK market is highly illiquid
 OIS market is quoted up to 10 year but is liquid only up to 5 year
 After the 2008 financial crisis, the trading volumes had fallen significantly
and have stagnated at the lower levels
 The OIS and the Gsec rates rarely converge
12.0%
Notional Principal (Rs Billions)
IRS Trading Volumes
G Sec OIS Spread
10.0%
50,000
8.0%
45,000
40,000
35,000
30,000
25,000
INBMK
20,000
MIBOR
15,000
6.0%
G Sec - 5 yr
4.0%
OIS - 5 yr
2.0%
Spread
0.0%
10,000
-2.0%2004
5,000
-
2006
2008
2010
2012
2014
-4.0%
2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14
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Term to maturity
 The OIS market is illiquid for terms after 5 years
 Hard to find instruments beyond 10 years
 Although banks would be willing to hedge their floating liability against
insurer’s fixed liability, banks are looking at short term horizon (3 – 5
years) while insurer requirements are much longer (15 – 20 years)
 In contrast, in a market like UK, swaps are available with duration of 30
- 50 years
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Cash investment to pay floating rate
 The underlying OIS curve is used to determine the swap rates
 In case the insurer enters into a swap to receive fixed and pay
floating, it needs to invest in short term assets to hedge its floating liability
• If the insurer remains invested in long term G Secs, the spread
between OIS curve and G Sec curve can result in losses
• Even if the insurer invests in short term instruments, there remains
a slight spread between the OIS and the money market rates
 In the event of sale of the asset, winding up may be very costly due to
the spread between swap and Gsec rates
Amount to be hedged
 Future premium amount depends on future persistency rates
 The amount hedged might turn out to be higher / lower than the
actual requirement
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Board Approval
 Need for detailed pre approved policy from Board
 Should cover authorized products, ensure adequate staff resources and
establish management responsibilities
Infrastructure requirements
 Investment Management Systems to be prepared to manage derivatives
 Initial expenses to be incurred in setting systems and processes and
staff
Risk Management Policy
 Identification of potential risks, suitable measurement parameters,
suitable VaR level, and risk limits
 Decisions to be discussed in ALCO and IC
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Monitoring and rebalancing / regular MIS
 Board review at least once a year
Quarterly report to IRDA
Demonstrating that swap is used only for hedging purposes
 Hedge effectiveness needs to be proved
 Hedging instrument should cover the risk within 80% – 125%
ISDA Documentation / CSA Agreement
 ISDA documentation requirement
 Need to enter into a two way CSA agreement to reduce Credit risk
 Can be expensive and time consuming
15
Credit Exposure Calculation
 Future Credit exposure based on tenor dependent conversion factors
 With periodic collateral exchange under CSA agreements, conversion
factor of tenor 1 year or less should be used
Accounting and Disclosure
 Accounting as per AS 30 and disclosure as per AS 31 and AS 32
 Disclosure on nature and terms of outstanding derivatives and potential
losses on counterparty failure
Audit Requirements
 Prior approval from the concurrent auditor about adequacy of systems
and processes to handle derivatives
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 In case of counterparty default, there might be losses and also the cost
of entering into a new hedge
 Collateralisation requires exchange and investments of collateral on a
regular basis
 Insurer not allowed to borrow funds, acceptance of cash collateral
amounts to borrowing
 In case of using bond collateral, the market value will be volatile
 Diversification hard to achieve for insurers with the limited swap
market
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 Derivatives can be too risky if not properly used – need to convince the
Board
 Natural hedges between different lines of business
 Indian insurance industry is relatively immature and so product mix can
change quickly
 Effect of new business on interest rate risk
 For new business, need to enter new contracts on a regular basis
 Information asymmetry between insurer and banker about each
other’s needs
 Too costly in the beginning as no standardized market
 Swap spread could be volatile causing MTM losses on unwinding
 BASEL 3 norms for banks – effect on bank’s risk appetite
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LIMITATION OF SWAP
ALTERNATIVE INSTRUMENT
It does protect against the loss due to Swaption, which gives the insurer an
unfavorable movement in the interest option to enter into the swap only if
rates, but also sacrifices the gain in the risk is biting
the case of a favorable movement
It protects against large as well as
small change in interest rate whereas
for an insurer, it is only the big changes
in the interest rate that is more crucial
to be protected against
Caps and Floors which protect against
a large movement in the interest rate
and leave the risk of small interest rate
shifts with the insurer
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 Swaps can be used extensively by insurers to reduce the interest rate
risk in its business
 More important for annuities, non par and retirement products but
less useful for the big products ULIPs and Par
 Supply constraints in the Indian market in terms of volume of trades
and the maturity of the swap
 Complex management makes it even tougher to initiate dealing in
swaps
 Alternative products like caps, floors and swaptions more suited to
meet insurer needs
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Institute of Actuaries of India
Questions / Suggestions ?
Rishabh Prakash prakash.rishabh@gmail.com
Ramnath Shenoy ramnath.shenoy@gmail.com