Financial Risk Management of Insurance Enterprises

1
Financial Risk Management of Insurance Enterprises

• Interest Rate Caps/Floors

2
Options on Interest Rates

• Last time, we discussed the basics of options
• Today, we apply our knowledge to options on
  interest rates
• These are caps and floors
• We will see that insurance enterprises can
  greatly benefit from caps and floors

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Cap/Floor Terminology

• Strike rate is the rate which determines any cash
  flows of the cap or floor
• Similar to the strike price or exercise price
• Underlying index is the interest rate that we
  want protection for or are speculating on
• Notional amount is the principal to which the
  interest rate will be applied to determine
  payoffs
• Up-front premium is the amount the buyer must pay
  to own the cap/floor

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How Caps Work

• Unlike a call or put option, a cap has multiple
  potential payoffs determined by a settlement
  frequency and a maturity
• At each settlement date, if the underlying index
  is below the strike rate, no payments are
  exchanged (aside from the premium)
• If the underlying index exceeds the strike rate,
  the seller of the cap must pay

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An Example of a Cap

• A borrower has issued a floating rate note and is
  paying LIBOR quarterly over the next three years
• By purchasing a cap with a 10 strike rate,
  quarterly settlement frequency, a maturity of
  three years, and a notional amount equal to the
  amount of the note, the borrower can hedge its
  exposure to increasing LIBOR

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Using a Cap to Hedge Borrowing Costs

• As borrowing costs exceed the strike rate, the
  cap cash flows offset further increases in the
  underlying index
• Net effect is that interest expense is capped
  at 10
• This is why the option is called a cap

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How Floors Work

• Again, there are multiple settlement dates
• At each settlement date, if the underlying index
  exceed the strike rate, no payments are exchange
  (again, the premium is paid)
• If at a settlement date, the underlying index is
  below the strike rate, the seller of the floor
  must pay

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Hedging An Assets Return

• If a security is earning a floating rate, the
  exposure is a drop in interest rates
• Buying a 6 floor puts a minimum value on the net
  return
• Thus, the name floor

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Cap Values

• From our previous discussion, how does cap values
  change with respect to changes in
• Strike rate (as X increases, cap value decreases)
• Current interest rate (as rates increase, cap
  value is higher)
• Maturity (as T increases, cap value increases)
• Index volatility (as F increases, caps increase)
• Notional amount (value increases as amount at
  risk increases)
• Settlement frequency (value increases as
  potential number of payments increase)

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The Up-Front Premium

• Premiums are based on percentage of notional
  principal
• This premium can be viewed as providing an
  annuity of interest rate protection
• One policy per settlement period
• Net result of paying premium
• Pay higher interest rate each period for
  protection against risk exposure (cap)
• Receive lower interest for protection against low
  interest rates (floor)

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Methods to Lower/Eliminate the Up-Front Premium

• All methods give something back to lower up-front
  premium
• Interest rate collar
• Protection against downside paid for by giving
  away some of the upside
• Interest rate corridor
• Cap protection disappears in extreme scenarios
• Participating Cap/Floor
• Premium paid when cap is not in the money

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Interest Rate Collar

• Sell floor to finance cap or sell cap to finance
  floor
• Net result is that interest expense will be
  between strike rates of cap and floor
• Can reduce premium to zero
• Can even make profit

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Interest Rate Corridor

• Pay for cap 1 by selling cap 2 which has a higher
  strike rate
• Sale of 2nd floor would have lower strike
• Protection disappears if rates move a lot
• Cannot reduce premium to zero

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Participating Cap

• Pay for cap by making payments when interest rate
  is below the cap
• Participation percentage is paid by cap buyer
  when rates decrease
• When index is above strike rate, same settlement
  as before
• When index is below strike, buyer pays
  Participation x(Strike-Index)x(Days/360)
  x(Notional Principal)
• As participation goes to 100, it is a swap

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Participating Cap(60 Participation)
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Cap-Floor Parity

• Interest rate put-call parity is called cap-floor
  parity
• Suppose a collar strategy where strike rates on
  floor and cap are equal
• This locks in a fixed payment equal to the strike
  rate
• This is essentially a fixed rate payor swap
• If this equivalent fixed swap rate is the market
  swap rate, then the collar strategy has zero cost
  (initially)

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Example 1

• In the early 1980s, life insurers experienced
  disintermediation. Policyowners took out loans
  against their cash value at low rates and
  invested in higher yielding assets.
• As interest increased, the insurer had to take
  losses on their bond portfolios
• Life insurer could hedge this risk using interest
  rate caps
• Payment on cap would be used to pay for
  withdrawals

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Example 2

• Defined benefit pensions assume that
  contributions will earn an amount which will
  provide benefits in the future
• If the return on the assets is below the assumed
  return, the benefits are at risk
• Pension fund can buy a floor so that in periods
  of low returns, they will receive payments from
  the floor option

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Next Time

• Use of derivatives by US insurers
• What else insurers should be doing
• Reminder Exam 1 is one week from today!