Fixed Annuity Asset/Liability Management: Presentation to the National Fraternal Congress of America Rad Smith, Director, Insurance Solutions Group Jean-Paul Sursock, Director, Global Risk Management Group April 30, 2009
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Fixed Annuity Asset/Liability Management: Presentation to the National Fraternal Congress of America
Rad Smith, Director, Insurance Solutions GroupJean-Paul Sursock, Director, Global Risk Management Group
April 30, 2009
2
It is impossible to fully hedge the insurer against FA liability risk using only cash bonds:Fixed annuities are not “bullets” – they contain options in the policyholders’ favorThe most highly convex cash asset portfolio will underperform liabilities of similar duration with embedded policyholder options (in some interest rate scenarios)
It is impossible for the insurer to make money in FAs if it tries to eliminate all interest rate risk:Like it or not, a large part of the potential profit of the FA business comes from assuming some interest rate risk
Insurers should focus on eliminating “tail risk” that presents too extreme a downside to the insurer
Eliminating “tail risk” likely requires the purchase of options. This insurance looks expensive to insurers because of their perspective on interest rate modeling:
Wall Street derivative traders need to understand that actuaries get paid to predict cash flows, which is a realized volatility conceptActuaries need to understand that Wall Street derivative traders hedge their books and price transactions using arbitrage-free market price assumptions, which is an implied volatility concept
Fixed Annuity ALM – Key Themes
1
3
3 Key Suggestions To Insurers Who Write FAs:
1. Tell the marketers and actuaries to design a product that is sane, and price it accordingly…
1. Don’t make mistakes on the easy stuff: get asset duration target “right” and don’t be short convexity needlessly in the asset portfolio
2. If at all possible, think creatively about risk management - it may be possible to combine FAs with other blocks of business to reduce risk management costs
3. Don’t wait until the house is burning to purchase fire insurance – insurers with the best ALM results typically take a contrarian perspective (they buy long-term protection against rising rates when rates are low, etc.)
OK, let’s start over and stick to what’s actually possible:
2
Duration Basics
5
Duration and Convexity Straight Forward
Duration / Convexity – Basic Definitions
Market yield
bond price
Durationslopechange in price for given change in yield
Convexitycurvature / second derivativedeviation from linear relationshippositive convexity “good” for asset, “bad” for liability
3
6
An “Ideal” Generic Asset Liability Portfolio
Extending Concept to Liabilities and Surplus
Current surplus – assets exceed liabilities at current rates
Matching duration of assets and liabilities similar
Maintain surplus over wide range of interest rate changes
yield
price
assetliability
4
7
Duration Mismatch
Portfolios With Asset/Liability “Issues”
Asset duration is too short
Insurer has a “bet” on rising rates, so surplus shrinks if rates fall
yield
price
assetliability
5
8
Negative Net Convexity
Portfolios With Asset/Liability “Issues” (cont.)
Large surplus at current rates
Durations matched at current rates
Assets have negative convexity, coupled with liabilities that have positive convexity:Asset duration shrinks as rates fall / rises as rates increase; liabilities just the oppositeSo surplus shrinks if rates change significantly in either direction
yield
price
asset
liability
6
9
Curve Dynamics and Impact on Insurers
A More Detailed Asset / Liability Portfolio Example
Insurers have directional exposure to both falling and rising rate environments
The negative impact of adverse yield curve movement manifests itself over several quarters
The structural risk profile of a fixed annuity block resembles a short strangle position. This is akin to a short position in both an out of money call and an out of money put
Insurers typically hedge their interest rate risks by utilizing a combination of swaptions, caps, and floors. These swaptions, caps, and floors are usually linked to CMS rates rather than UST rates for enhanced liquidity
Insurers who hedge usually do so periodically, either in line with balance sheet growth or when the risk profile of the block changes significantly (FA liabilities falling out of the surrender charge period is a frequent catalyst)
Economic Surplus
Value of Assets and Liabilities Value of Economic Surplus
Minimum Rate Guarantees100
40Callable Assets
AssetsLiabilities
Disintermediation 3080
20
Extendable Assets 1060
0
(10)40
(20)
(30)20
(40)
(300) (200) (100) 0 100 200 300
Yield Changes (bp)
Typical Insurance Company Profile
Interest Rate Risk Mitigation
7
Managing Duration Risk In Fixed Annuities
11
Two Methods in Practical Use
Measuring the Duration of Insurance Liabilities
Direct approachTreat liabilities as “bonds”Calculate liability valuesCalculate interest rate sensitivity directlyToo simplistic for more complex liabilities such as SPDAs
Indirect approachesModel liability structureWhat portfolio “matches” liability characteristics
The practical reality: most insurers use TAS or PTS to conduct stochastic modeling of their FA blocks
8
12
Determine an Asset Duration that Structurally “Matches” the Liabilities
Assumes a liability structurePolicy blockRange of scenariosPolicyholder behavior (lapse functions based on key rates, etc.)
Assumes a reporting structure and objective functionGAAP or Stat Earnings (Statutory basis “Distributable Earnings” is a frequent focus)ROEWorst case outcomes
Solves for “matching” asset structureWhat duration portfolio results in– Least earnings volatility– Least tail risk– Best risk / return tradeoff
Many insurers use portfolio analytic systems (Derivative Solutions, etc.) to run analysis on assets and feed results back in to TAS and PTS
TAS/PTS used to generate yield curve scenarios, portfolio system used to better model cash flows on callable / prepayable / extendable assets
Actuarial Models Use An Indirect Approach
9
13
Policy Metrics Considerations
Measure liability duration directlySet explicit asset duration target
Single duration or Key rate targetsSwap / Treasury vs., credit duration
Accuracy of duration estimate Impact on reported financials and capital
Cost of matching Book value smoothing impact
Model assets and liabilities stochasticallyMinimize volatility
In net book interest rate marginIn ROE / EPS
Optimize return / risk tradeoffs
Complex modeling requiredOngoing monitoringTreatment of gains / losses
Book Metrics
Market Metrics
Duration Policy – Book vs. Market MetricsKey Considerations
10
14
Issue Solutions Available
30 year+ cash flowsHard to get matching duration assetsExposed to long end of curveLong dated reinvestment riskEven harder to get creditHow to discount
Treasury STRIPSStructured products (e.g., inverse floaters, PO mortgages)Derivatives
Interest rateCredit
Use equity to match “tail”Conservative pricing in “tail”
Long liabilities have high convexityMay have short convexity portfolioTight duration matching results in
Buying duration as rates fallSelling as rates rise
Fix duration targetAllow corridor duration mismatchConvexity Chasing
Availability of Assets
Long Duration Liabilities – Special Considerations Key Considerations
11
15
20 Year Compound ROE For Hypothetical Annuity / Structured Settlement Block
“Chasing Convexity” In Long-Duration Blocks Can Be Costly
11.5
11.0
12.0
13.5
13.012.5
L + 1.5L + 1.0
L + 0.5L
L - 0.5
L - 1.0
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
2.0%3.0%4.0%5.0%6.0%7.0%8.0%9.0%
GAAP ROE (Worst 10%)
GAAP ROE (Mean)
Dynamic strategies adjust portfolio duration to match liabilities
Maintain fixed portfolio duration
Simulated two types of duration strategy against an annuity / structured settlement liabilityFixed durationDynamic duration matching
ROE increase is meaningful for fixed strategiesAvoids buy high / sell low attribute of dynamic matching strategy
12
Illustrative Case Study – SPDA
17
“Vanilla” SPDA product
Five year initial guarantee, then annual resets
Seven year surrender charge period
3% minimum guarantee
Four year duration at issue
Duration grades down to two years after year five
10% GAAP ROE target
15 year modeling horizon
Verify ROE attainability by modeling 1000 random scenarios
SPDA ExampleA “Plain Vanilla” SPDA Product
Product Description
“Base” Investment Strategy
Profit and ROE Targets
13
18
Base Strategy Produces Expected ROE Approximately Equal To Target
ROE Performance – Single Cohort
0
50
100
150
200
250
300
3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0% 15.0%
Count
Distribution of 15-year ROE
ROE Distribution SummaryMean 9.84%Mean in Worst 10% of Scenarios 5.59%
14
19
Single Cohort – Can Improve Return / Risk Profile By Changing Duration
Impact of Changing Duration Strategy
4.0/2.0
4.5/2.0
5.0/2.05.5/2.0
3.5/2.0
3.5/3.0
4.0/3.0
4.5/3.0
5.0/3.05.5/3.0
7.0%
9.0%
11.0%
13.0%
15.0%
4.0%4.5%5.0%5.5%6.0%6.5%7.0%7.5%8.0%
GAAP ROE (worst 10%)
GAAP ROE (mean)
We examined impact of changing duration strategyInitial duration target (3.5 to 5.5 years)Ultimate duration target (2.0 and 3.0 years)
Extending ultimate duration improves average and worst case ROE
15
20
Minimum Risk Duration of About 3.0 Years – But Is This Optimal?
Asset Duration Risk/Return on “Going Concern” Block of SPDA
dur = 2
dur = 3
dur = 4
dur = 5dur = 6
5.0%
7.0%
9.0%
11.0%
13.0%
15.0%
17.0%
1.0%2.0%3.0%4.0%5.0%6.0%7.0%
GAAP ROE (mean)
GAAP ROE (mean worst 10%)
No liability duration directly calculated - model / simulate ROE distributions with asset portfolios of differing durations against a dynamic open book
Model indicates that asset duration(s) ofless than two years are “inefficient” from asset/liability perspectiveabout three years minimizes asset liability volatilitygreater than three years increase ROE volatility (but company paid for it)
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21
Should Liabilities Always Be Strictly Matched?
Arguments AgainstArguments For
Measured liability duration could be wrong
On average paid to be net duration long –implied forwards are inefficient predictors of future interest rates in a steep yield curve environment
Cost of matching is real economics
Benefit of matching may be “less relevant”market value measure, which is less visible than book-value driven results
Prudent risk management
Capital model charges if mismatched
Insurer has no comparative advantage in takingduration mismatch risk
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22
Impact Of Varying Duration Target As Yield Curve Steepens / Flattens
Modeling A Dynamic Strategy
3.0
3.0 + dynamic
4.0
4.0 + dynamic
5.05.0 + dynamic
7.0%
9.0%
11.0%
13.0%
15.0%
2.0%3.0%4.0%5.0%6.0%7.0%8.0%
GAAP ROE (mean)
GAAP ROE (mean worst 10%)
When curve is flat there is little benefit to taking duration risk
But when curve is steep, company is paid to increase duration (i.e., “bet against the forwards”)
We compare fixed duration strategies to dynamic duration rules, which adjust duration based on slope of the yield curve:
Fixed – Maintain fixed durationDynamic – Lower duration by one year for each 100 flattening of curve
Most optimal strategy is duration of five years with steep curve, flatten as yield curve flattens
18
23
The Big Question: “Arbitrage-Free” vs “Real World” Assumptions
How Insurers “Set The Dials” on TAS and PTS Impacts How They View Risk and Hedging of Fixed Annuities
“Arbitrage-Free” – pricing must be consistent with market parameters
“Real World” – assumptions driven by desire for accurate projections of cash flows
Bank Trading Desk Actuarial ModelStarting curve Today’s 9/30/08?Use implied forwards? Yes MaybeImplied volatility Market (15% to >100%) 10% to 15%Mean reversion Yes YesValue of Cap/Floor $X $X – A LotValue of Swap Zero Not Zero
Net Result: Option-based hedges look expensive to insurers
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24
The Hedging Decision: What We’ve Seen Through The Years
Companies have to justify sacrificing current returns for future protection
Accounting concerns have been an additional impediment for hedging
Traditional regulatory / rating agency capital models don’t reward good ALM practices with lower capital requirements
Insurers Recognize the Benefits of Hedging but…
When do most insurers think about hedging? Either:a) when interest rates get low and minimum rate guarantees look like they might actually get in-the-money, orb) when the surrender charge period ends and liabilities look ugly in an ALM context
What are the implications?Insurers haven’t budgeted for costs of appropriate risk management in product pricingWhen they evaluate hedging, the cost is prohibitive relative to net spread earned on blockRisk-adjusted returns on SPDAs are likely much higher in early policy years and lower in later years (since many insurers don’t hedge and blocks get riskier as they age)
“Nuclear” liabilities have a way of focusing attention on hedges
20
25
Is Hedging More Likely in a Post Apocalyptic World?
Many VA writers have blown up, and they were (theoretically) pricing some risk management costs into policies (unlike FA writers)
Rating agencies are now focusing on ERM process and risk management is less of a choice
Regulatory pressure from C3 Phase I and Phase II is accelerating the need for in-time risk management
Equity analysts are putting risk management practices under the microscope
Will companies with lower profit margins due to higher costs from ERM trade at better multiples?Maybe. One industry leader, Allstate, raised the bar for everyone else last year when they released their second quarter results:
Now, Industry’s Risk Management Skills Under Greater Scrutiny by Constituents
“We have begun to implement the macro-hedging program using derivatives to partially mitigate the potential adverse impacts from potential future increases in risk-free interest rates, increases in credit spreads, and negative equity market valuations for our Property-Liability portfolio, with plans to introduce a program later this year for Allstate Financial.”…”The cost of the macro-hedging program
for one year is currently estimated to be approximately $85 million.”
Source: Allstate Corp, 10-Q, August 06, 2008
21
Interest Rate Risk ManagementRisk Solutions GroupApril 2009
Confidential Presentation
27
The various asset classes in an insurer’s portfolio exhibit meaningfully imperfect correlation, which contributes to overall portfolio diversification
Correlations Between Asset Classes
1.00
0.33
0.33
-0.17
0.19
-0.10
-0.07
-0.27
0.52
0.97
0.97
0.33
1.00
0.90
0.63
0.56
0.34
0.38
0.56
0.38
0.39
0.33
0.33
0.90
1.00
0.79
0.76
0.50
0.54
0.69
0.33
0.33
0.27
-0.17
0.63
0.79
1.00
0.71
0.74
0.76
0.91
-0.10
-0.17
-0.23
0.19
0.56
0.76
0.71
1.00
0.76
0.77
0.56
-0.06
0.14
0.10
-0.10
0.34
0.50
0.74
0.76
1.00
1.00
0.63
-0.41
-0.11
-0.16
-0.07
0.38
0.54
0.76
0.77
1.00
1.00
0.64
-0.37
-0.07
-0.13
-0.27
0.56
0.69
0.91
0.56
0.63
0.64
1.00
-0.15
-0.25
-0.30
0.52
0.38
0.33
-0.10
-0.06
-0.41
-0.37
-0.15
1.00
0.54
0.60
0.97
0.39
0.33
-0.17
0.14
-0.11
-0.07
-0.25
0.54
1.00
0.99
0.97
0.33
0.27
-0.23
0.10
-0.16
-0.13
-0.30
0.60
0.99
1.00
US Gov
US
Gov
Muni
Mun
i
Inv Grd
Inv
Grd
High Yld
Hig
h Y
ld
ABS
AB
S
CMBS
CM
BS
Mtg
Mtg
Equity
Equ
ity
P&C
P&
C
Life
Life
Annuity
Ann
uity
-1
-0.8
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
At left we show the correlation of monthly performance across an insurer’s various asset classes and liabilities over the past 5 yearsMany of an insurer’s asset classes are highly correlated –for example, high yield corporate fixed income securities have had a 91% correlation with equity on a monthly average basis over the past 5 yearsHowever, an insurer’s assets and liabilities are not highly correlatedOn the next slide we examine how these correlation effects reduce portfolio risk
Correlation and Diversification
22
28
3.5 4 4.5 5 5.5 6 6.54.5
5
5.5
6
Variability of Return (%)
Tota
l Net
Ass
et R
etur
n (%
)
12bn Equity TRS
8bn Equity TRS 22bn CDX
10bn CDX 25bn Pay Fixed Sw ap
12bn Pay Fixed Sw ap
4bn Equity TRS
Current Assets
An insurer can alter the risk profile of its asset portfolio, at some cost, by introducing macroeconomic hedges
By introducing macroeconomic hedges into an insurer's asset portfolio, the company can alter its risk profile; however, hedges come at some cost
We consider three different derivative hedges which an insurer might introduce:
A short position in the CDX index, which protects an insurer against credit widening in exchange for a running premiumAn equity total return swap, which limits an insurer’s risk exposure to the equity markets but also forces an insurer to sacrifice returnsA pay-fixed swap, which reduces the duration of an insurer’s asset portfolio, but causes the company to incur a negative carry
We show the risk impact of these hedges at right
The CDX hedge has the most favorable cost/risk tradeoffThe pay-fixed swap is not attractive, as it increases overall variability in return
Portfolio Hedging Alternatives: Cost vs. Risk
Overview Marginal Impact of Macro Hedges
23
29
3.5 4 4.5 5 5.5 6 6.5 7 7.5 8 8.54.5
5
5.5
6
6.5
7
Variability of Return (%)
Tota
l Net
Ass
et R
etur
n (%
)
mgline 12/17/08 3:07 PM
19% US Gov 39% Muni 31% Inv Grd 12% ABS
3% US Gov 28% Muni 52% Inv Grd 17% ABS
Current Allocation 4% US Gov 24% Muni 37% Inv Grd 5% High Yld 8% ABS 7% CMBS 10% Mtg 5% Equity
9% Muni 29% Inv Grd 20% High Yld 22% CMBS 20% Equity
9% Muni 52% Inv Grd 23% ABS 15% CMBS 2% Equity
3 3.5 4 4.5 5 5.5 6 6.5 73.5
4
4.5
5
5.5
6
6.5
Variability of Return (%)
Tota
l Net
Ass
et R
etur
n (%
)
mgline 12/17/08 3:09 PM
-25% ABS
-25% Inv Grd
-25% Muni
-25% US Gov
-25% Mtg
-25% Equity
25% CDX
25% Cash
-25% CMBS
-25% High Yld
An enterprise risk management framework can extend beyond hedging alone, taking into consideration the risk/return tradeoffs associated with asset reallocation
Beyond Hedging: ERM and Asset/Liability Management
Asset Management: Marginal Impact Optimizing Asset Allocation
On the previous slides we have looked at the cost/risk impact of marginal derivative hedges on an insurer’s portfolio
It is possible to extend this risk management analysis to include not just hedging but also asset and liability management, and to compare the impact of various hedging strategies with the impact of basic asset reallocation
With more detailed information about the present market values of various instruments in an insurer’s portfolio, Barclays Capital can help to analyze hedges, portfolio reallocation, and capital structure/liability management transactions in one risk reward framework, and find strategies that maximize the potential for risk adjusted return
Inefficient reallocations:Increase risk and reduce returns
24
30
Hedging strategies can be designed to effectively hedge capital under C-3 Phase I. In addition, economic capital is protected from disintermediation risk
SPDA Case Study
Rationale
Caps are widely used by insurance companies to hedge against high rates
Out-of-money strikes reduce the cost of hedging meaningfully while maintaining the desired hedging effectiveness under C-3 Phase I scenarios
The forward starting feature can further reduce the hedging cost with limited impact on hedge benefit
CMS is the most liquid reference index
Highly flexible structure that can be tailored to match the liability rate risk
Economic Capital – Implications
Hedging rising rate scenarios can also protect against economic capital deterioration resulting from disintermediation risk
– In sustained high rate scenarios, insurers may experience higher surrender rates stemming from competition from bank CD and money market products
– Insurers may be forced to sell assets in rising rate scenarios at a loss to cover surrender values
– Buying out-of-the-money protection for high rate scenarios can be a way to shore up these losses
25
31
As shown in our case study below, hedging could save approximately 1% of capital, which equates to approximately 3% of capital for firms managing to 300% RBC ratios
SPDA Case Study
The Capital % can be viewed as the amount of reserves that must be held in relation to the size of the liability
In other words, for a $10bn block of fixed annuity liabilities, an insurer would hold $281mm in reserves, or approximately $843mm if managing to a 300% RBC ratio
By reducing the required capital by 1.00%, or 3.00% (again if managing to a 300% RBC), the savings of regulatory capital in dollars amounts to approximately $300mm
Hedging rising rate scenarios can also protect against economic capital deterioration resulting from disintermediation risk
Base Case With Out-of-Money CapRanking Scenario # Capital % Weights (%) Scenario # Capital % Weights (%)
5 12 3.47% 2% 3 2.49% 2%6 2 3.39% 4% 33 2.47% 4%7 4 3.34% 6% 28 2.39% 6%8 26 3.19% 8% 48 2.38% 8%9 6 3.02% 10% 39 2.35% 10%10 21 3.01% 12% 21 2.10% 12%11 5 2.82% 16% 4 1.86% 16%12 41 2.59% 12% 49 1.56% 12%13 49 2.58% 10% 30 1.48% 10%14 33 2.40% 8% 46 1.26% 8%15 28 2.37% 6% 6 1.20% 6%16 27 2.25% 4% 25 0.93% 4%17 18 2.22% 2% 19 0.78% 2%
Wtd. Average 2.81% 1.83%
0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%5.0%
1% 2% 3% 4% 5% 6% 7% 8%
Avg 5-yr Treasury Rate
Cap
ital (
%)
0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%5.0%
1% 2% 3% 4% 5% 6% 7% 8%
Avg 5-yr Treasury Rate
Cap
ital (
%)
___________________________1. All numbers are post-tax and net of the hedge premium
Overview
By layering on a forward starting OTM cap, substantial capital relief can be obtainedCaps are widely used by insurance companies to hedge against high rates and out-of-money strikes reduce the cost of hedging meaningfully while maintaining the desired hedging effectiveness under C-3 Phase I scenarios
26
32
Interest Rate Market Considerations
Rates remain near all-time lows but are beginning to trend upward
Unprecedented government intervention in the capital markets and financial system could have an inflationary effect on interest rates
Volatility in the interest rate market remains at heightened levels
Market-implied forwards predict both short-term and longer-term rates to rise steadily over the coming years (see table at right)
There is also historical precedent that rates will rise dramatically following periods of declining rates and heightened volatility (see chart below)
Commentary Forwards and Barclays Rate Forecast
Q2 09 Q3 09 Q4 09 Q1 10 Q2 10 Q3 10 Q4 10
Mkt Implied 5ySwap Forwards 2.50% 2.63% 2.75% 2.86% 2.97% 3.07% 3.16%
5y Tsy 1.50% 2.00% 2.30% 2.90% 2.90% 2.90% 2.90%
10y Tsy 2.40% 3.00% 3.50% 4.30% 4.30% 4.30% 4.30%
5y Swap 2.12% 2.77% 3.17% 3.82% 3.82% 3.82% 3.82%
10y Swap 2.69% 3.44% 4.09% 4.89% 4.89% 4.89% 4.89%
Historical 5y Treasury Yield – Sell Off Analysis Since 1968
1%
3%
5%
7%
9%
11%
13%
15%
17%
May-68 Feb-72 Oct-75 Jul-79 Mar-83 Dec-86 Sep-90 May-94 Feb-98 Nov-01 Jul-05 Apr-09
12
3
5
6
10
4
7 8
11
9
No. Start Date End Date Duration Change No. Start Date End Date Duration Change1 Aug-68 Dec-69 1.3yrs 291 bp 7 Aug-86 Oct-87 1.1yrs 346 bp2 Mar-71 Jul-71 0.4yrs 229 bp 8 Mar-88 Mar-89 1.0yrs 213 bp3 Oct-73 Aug-74 0.9yrs 211 bp 9 Oct-93 Jan-95 1.2yrs 333 bp4 Dec-76 Feb-80 3.2yrs 853 bp 10 Oct-98 May-00 1.6yrs 284 bp5 Jun-80 Sep-81 1.3yrs 741 bp 11 Mar-08 Jun-08 0.2yrs 155 bp6 Mar-83 May-84 1.2yrs 410 bp
27
33
Options with longer-dated expiries continue to show value compared to shorted-dated trades due to lower implied volatilities out the curve
Capitalizing on the Volatility Surface
Volatility remains near all-time highs across expiries and maturities. But considerable value still remains in certain parts on the surface
Longer-dated expiries have considerably less implied volatility directly impacting the premium
Realized volatility has been high, and is expected to remain so due to uncertainty regarding monetary policy, fiscal policy, and the economic outlook
Implied volatility has moved higher in tandem with realized volatility. Additionally, realized and implied volatility have repeated their historical tendency to spike in periods in which rates decline rapidly, as both lower rates and higher volatility are signs of market stress
Commentary Swaption Implied Volatility Surface (1)
___________________________1. Volatility surface as of April 20, 2009.
Option ExpiryUnderlying Maturity
1M
6M
2Y
4Y
7Y
15Y
Spot
1W 1M 3M 6M 9M 1Y18
M2Y 3Y 4Y 5Y 7Y
10Y
15Y
20Y
30Y
0%
20%
40%
60%
80%
100%
120%
100%-120%
80%-100%
60%-80%
40%-60%
20%-40%
0%-20%
28
34
Indicative Pricing and Time Decay Analysis(1)
Indicative Pricing – Payer Swaptions
___________________________1. Pricing as of March 17, 2009.
Indicative Pricing – 10yCMS Caps
Time Decay Analysis – Payer SwaptionsTime Decay Analysis – 10yCMS Caps
Structure Expiry Maturity ATMF 6.0% 7.0% 8.0%
3y10y Mar-12 Mar-22 3.89% 187 bp 114 bp 69 bp
5y10y Mar-14 Mar-24 4.01% 254 149 113
6y10y Mar-15 Mar-25 4.01% 268 158 126
Structure Start Date Maturity ATMF 6.0% 7.0% 8.0%
3y7y Mar-12 Mar-19 4.31% 304 bp 218 bp 162 bp
5y5y Mar-14 Mar-19 4.35% 232 170 129
6y4y Mar-15 Mar-19 4.35% 187 139 107
After establishing an insurer’s main goals and exposures, Barclays Capital can customize the analysis below
Valuation Date
Tenor Strike Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14
3y7y 7% 218 bp 88% 72%
5y5y 7% 170 91% 80% 66% 51%
6y4y 7% 139 92% 82% 71% 57% 41%
Valuation Date
Tenor Strike Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14
3y10y 7% 114 bp 63% 22%
5y10y 7% 149 95% 79% 52% 20%
6y10y 7% 158 97% 90% 74% 48% 18%
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35
Rate and Volatility Sensitivity – CMS Caps (1)
5y5y 10yCMS Cap – 7% Strike
___________________________1. Pricing as of March 17, 2009.
3y7y 10yCMS Cap – 7% Strike
6y4y 10yCMS Cap – 7% Strike
Volatility Shift
Rate Shift 25% 20% 15% 10% 5% 0% -5% -10%
500 bp 4,417 bp 3,522 bp 2,750 bp 2,195 bp 1,639 bp 1,295 bp 1,066 bp 941 bp
400 bp 4,023 3,159 2,417 1,811 1,343 999 750 576
300 bp 3,586 2,770 2,071 1,500 1,057 725 473 269
200 bp 3,115 2,364 1,724 1,204 802 500 273 103
100 bp 2,615 1,949 1,387 934 588 333 154 41
0 bp 2,089 1,530 1,063 692 414 218 89 20
-100 bp 1,539 1,108 753 477 274 137 53 12
-200 bp 971 688 459 284 159 77 30 7
-300 bp 402 280 183 112 62 30 12 4
Volatility Shift
Rate Shift 25% 20% 15% 10% 5% 0% -5% -10%
500 bp 3,288 bp 2,597 bp 1,998 bp 1,507 bp 1,133 bp 871 bp 701 bp 613 bp
400 bp 3,045 2,373 1,791 1,314 950 687 502 377
300 bp 2,763 2,120 1,566 1,114 767 511 323 174
200 bp 2,444 1,845 1,333 917 598 363 192 66
100 bp 2,089 1,552 1,096 730 452 251 112 27
0 bp 1,700 1,243 860 555 328 170 67 14
-100 bp 1,276 918 623 392 224 110 42 9
-200 bp 820 582 388 239 133 64 24 6
-300 bp 346 241 158 96 53 26 10 3
Volatility Shift
Rate Shift 25% 20% 15% 10% 5% 0% -5% -10%
500 bp 2,647 bp 2,084 bp 1,593 bp 1,190 bp 883 bp 670 bp 533 bp 464 bp
400 bp 2,471 1,920 1,440 1,047 747 532 383 284
300 bp 2,261 1,730 1,272 897 610 400 248 129
200 bp 2,016 1,519 1,093 746 481 288 148 48
100 bp 1,738 1,290 908 601 368 202 88 20
0 bp 1,427 1,042 719 463 271 139 54 10
-100 bp 1,080 777 526 330 187 91 34 7
-200 bp 700 497 331 204 113 54 20 5
-300 bp 297 207 135 82 45 22 9 2
As Barclays’ forecasts higher rates by year end, insurers should be sensitive to the timing of its hedge execution in an effort to minimize cost
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36
CMS Cap v. Swaption Considerations
Indicative CMS Cap and Swaption Pricing(1)
-100 bp
0 bp
100 bp
200 bp
300 bp
400 bp
500 bp
600 bp
700 bp
800 bp
-100 bp 100 bp 300 bp 500 bp 700 bp 900 bp
6.0% 1y10y Option PV of Cap less SwaptionFor a fixed dollar hedging budget it is possible to buy a larger notional of swaptions vs. CMS caps
However in the case of an extreme rate increase, CMS caps can become a more attractive hedge as the present value of the cap will be notably higher than that of the swaption (see chart at right)
In less dramatic rate spike scenarios, swaptionscan provide the same protection as CMS caps at a much lower upfront cost
Commentary
Curve Shift
PV of Cap less Swaption
5y CMS Caps Payer Swaptions Ratio of Cost of Cap to Cost of Swaption
Strike 1y5y 1y10y 5y5y 5y10y Strike 1y5y 1y10y 5y5y 5y10y Strike 1y5y 1y10y 5y5y 5y10y
ATMF 398 bp 854 bp 457 bp 883 bp ATMF 248 bp 473 bp 404 bp 714 bp ATMF 1.60 x 1.81 x 1.13 x 1.24 x
ATMF +100 242 bp 567 bp 319 bp 635 bp ATMF +100 99 bp 191 bp 262 bp 454 bp ATMF +100 2.44 x 2.97 x 1.22 x 1.40 x
6% 123 bp 361 bp 228 bp 473 bp 6% 12 bp 32 bp 146 bp 256 bp 6% 10.25 x 11.28 x 1.57 x 1.85 x
___________________________1. Indicative pricing as of February 6, 2009.
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5yCMS Cap Structures and Indicative Pricing
Hedge CMS Cap CMS Cap Corridor Average Strike CMS Cap Knock-in CMS Cap Compound CMS Cap
Strike Forward + 200 bppa Forward + 200 bppa and Forward + 500 bppa
Average of previous four quarterly readings of 5y CMS
+ a margin:1y3y: +77 bppa3y4y: +36 bppa
Forward + 200 bppa, Knocking-in at Forward + 500
bppaForward + 200 bppa
Underlying 5y CMS 5y CMS 5y CMS 5y CMS 5y CMS
Payout Description
Pays, on a quarterly basis, observed CMS at beginning
of period minus strike, if positive
Same as previous cap, except periodic payout is
capped at 300 bppa
Pays, on a quarterly basis, observed CMS at beginning of period minus [average of previous four quarterly CMS
observations + margin], if positive
If CMS rises above the knock-in level, pays, on a quarterly
basis, observed CMS at beginning of period minus
strike, if positive
An option on the vanilla CMS Cap. Buyer pays a small premium for the right to
purchase vanilla CMS cap at a pre-determined premium in 1-
year's time
Price 1y3y: 75 bp3y4y: 176 bp
1y3y: 59 bp3y4y: 112 bp
1y3y: 75 bp3y4y: 176 bp
1y3y: 44 bp3y4y: 134 bp
Initial Prem. / Exercise Prem.1y3y: 46 bp / 55 bp3y4y: 109 bp / 120 bp
Benefits
- Simplest payout profile- Most liquid- Better payout profile than swaption
- Cheaper alternative to cap - Cheaper alternative to cap- Cheapens vanilla cap by isolating risk of rapidly rising rates
- Pay the additional premium only if necessary- If adverse outcome is not realized, will result in substantially less premium outlay
Considerations - Relatively expensive - Payout is capped in very high rate scenarios
- Ineffective in a slowly rising rate scenario
- Provides no payout in less extreme upward rate moves
- If monetized or retained after 1 or 3 years, total premium outlay will be greater than vanilla cap
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Sources for Market Data and Pricing
39
Bloomberg Swaption Market ScreensClients can access live swaption market data including pricing and volatility through Bloomberg
BARX Swaption Market Menu BARX USD Swaption Market Screen
Type: BOPT <GO> Type: BOTS <GO>
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Application: US Derivatives Market Monitor
Location: Interest Rates > Market Monitors > US Derivatives
Key Feature: Click on orange carrot to expand a monitor or data in blue to view Time Series Chart
Market Monitor
Derivatives on Barclays Capital Live
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Application: Time Series Plotter
Location: Interest Rates > Analytic Tools > Time Series Plotter
Key Feature: Derivative Charting and Historical Analysis Tool
Times Series Forwards
Derivatives on Barclays Capital Live
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42
Application: Time Series Plotter
Location: Interest Rates > Analytic Tools > Time Series Plotter
Key Feature: Regression Analysis
Derivatives on Barclays Capital LiveTimes Series Forwards
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DisclaimerThis document has been prepared by Barclays Capital, the investment banking division of Barclays Bank PLC ("Barclays"), for information purposes only. This document is an indicative summary of the terms and conditions of the securities/transaction described herein and may be amended, superseded or replaced by subsequent summaries. The final terms and conditions of the securities/transaction will be set out in full in the applicable offering document(s) or binding transaction document(s).
This document shall not constitute an underwriting commitment, an offer of financing, an offer to sell, or the solicitation of an offer to buy any securities described herein, which shall be subject to Barclays’ internal approvals. No transaction or services related thereto is contemplated without Barclays‘ subsequent formal agreement. Barclays is acting solely as principal and not as advisor or fiduciary. Accordingly you must independently determine, with your own advisors, the appropriateness for you of the securities/transaction before investing or transacting. Barclays accepts no liability whatsoever for any consequential losses arising from the use of this document or reliance on the information contained herein.
Barclays does not guarantee the accuracy or completeness of information which is contained in this document and which is stated to have been obtained from or is based upon trade and statistical services or other third party sources. Any data on past performance, modelling or back-testing contained herein is no indication as to future performance. No representation is made as to the reasonableness of the assumptions made within or the accuracy or completeness of any modelling or back-testing. All opinions and estimates are given as of the date hereof and are subject to change. The value of any investment may fluctuate as a result of market changes. The information in this document is not intended to predict actual results and no assurances are given with respect thereto.
Barclays, its affiliates and the individuals associated therewith may (in various capacities) have positions or deal in transactions or securities (or related derivatives) identical or similar to those described herein.
IRS Circular 230 Disclosure: Barclays Capital and its affiliates do not provide tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication (including any attachments) cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor.
BARCLAYS CAPITAL INC., THE UNITED STATES AFFILIATE OF BARCLAYS CAPITAL, THE INVESTMENT BANKING DIVISION OF BARCLAYS BANK PLC, ACCEPTS RESPONSIBILITY FOR THE DISTRIBUTION OF THIS DOCUMENT IN THE UNITED STATES. ANY TRANSACTIONS BY U.S. PERSONS IN ANY SECURITY DISCUSSED HEREIN MUST ONLY BE CARRIED OUT THROUGH BARCLAYS CAPITAL INC., 200 PARK AVENUE, NEW YORK, NY 10166.
NO ACTION HAS BEEN MADE OR WILL BE TAKEN THAT WOULD PERMIT A PUBLIC OFFERING OF THE SECURITIES DESCRIBED HEREIN IN ANY JURISDICTION IN WHICH ACTION FOR THAT PURPOSE IS REQUIRED. NO OFFERS, SALES, RESALES OR DELIVERY OF THE SECURITIES DESCRIBED HEREIN OR DISTRIBUTION OF ANY OFFERING MATERIAL RELATING TO SUCH SECURITIES MAY BE MADE IN OR FROM ANY JURISDICTION EXCEPT IN CIRCUMSTANCES WHICH WILL RESULT IN COMPLIANCE WITH ANY APPLICABLE LAWS AND REGULATIONS AND WHICH WILL NOT IMPOSE ANY OBLIGATION ON BARCLAYS OR ANY OF ITS AFFILIATES.
THIS DOCUMENT DOES NOT DISCLOSE ALL THE RISKS AND OTHER SIGNIFICANT ISSUES RELATED TO AN INVESTMENT IN THE SECURITIES/TRANSACTION. PRIOR TO TRANSACTING, POTENTIAL INVESTORS SHOULD ENSURE THAT THEY FULLY UNDERSTAND THE TERMS OF THE SECURITIES/TRANSACTION AND ANY APPLICABLE RISKS.
Barclays Bank PLC is registered in England No. 1026167. Registered Office: 1 Churchill Place, London E14 5HP. Copyright Barclays Bank PLC, 2008 (all rights reserved). This document is confidential, and no part of it may be reproduced, distributed or transmitted without the prior written permission of Barclays.
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