Supplément bilingue de L'Agefi Hebdo du 2 décembre 2010

The fall in interest rates has automatically increased some liabilities

le 02/12/2010 L'AGEFI Hebdo

Asset managers and investment banks argue in favour of implementing hedges, but those may seem expensive.


hanges in interest rates naturally have an impact on investors’ assets, of which their bond portfolios. But they also have an effect on pensions institutions liabilities and therefore on the balance sheets of those companies that consolidate the results of their defined pension schemes, in application of IAS 39 on recognising and measuring financial instruments. "Numerous pension funds were banking a year ago on higher interest rates with, subsequently, a reduction in their liabilities,notes Erwan Boscher, Head of ALM (asset and liability management) Solutions at Axa IM. As a result, they did not protect themselves against the scenario of a continuing fall in rates, which was the case, and their solvency has therefore deteriorated." These liabilities are valued at their market value as regard to inflation and interest rate changes. Future flows, that is to say payments to beneficiaries, are linked to anticipated inflation, implicit inflation, deduced from financial instruments, such as inflation-linked government bonds or 10-year inflation swaps, for example. However, as the risk of inflation is under control at the current time, the interest rate risk is more critical. IAS 39, which relates specifically to pensions funds, recommends the use of an accounting rate which is consistent with the rate of top-rated bonds, i.e. in practice AA rated bonds. However, if the average duration of an institution’s liabilities is 20 years, its benchmark will be the 20-year swap rate, which by falling by more than 100 basis points in less than one year (from 4 % in October 2009 to 2.70 % at the beginning of September 2010) caused an increase of more than 20 % in its liabilities.

Flexible strategies

This situation of a deteriorating solvency, in a context when the markets have not been particularly favourable for revaluating assets, calls for prudence, which means implementing hedging strategies, especially as the companies are few weeks away from annual accounts closing. But these strategies are flexible. The duration of assets can be very precisely aligned with that of liabilities, thereby neutralising gains and losses linked to rate changes. However, in order to take advantage of certain opportunities, therefore not to be permanently hedged, swap options can be used. These swaptions enable institutions, in exchange for the payment of a premium, to activate the hedge on demand. "An asset management company is likely to manage this strategy via a combination of swaps, swaptions and bonds, to even put in place a systematic approach to the management of interest rate exposure, based on trigger thresholds depending on interest rate levels and the institution’s solvency" notes Erwan Boscher. These rules can even be adjusted by asset managers depending on their macroeconomic expectations.

Solvency II imposes numerical values

These strategies are above all put in place by institutions whose solvency has already deteriorated and which prefer to opt therefore for a conservative policy. On the other hand, Jean-Marc Boyer, CEO of the Pasteur Mutualité Group, considers that, as regards his institution, "the group’s comfortable hedge ratio (capital in relation to the regulatory requirements in terms of the solvency level) gives it considerable leeway, leaving it free to choose not to hedge its interest rate sensitivity". He notes however that it will not be possible to ignore this question because Solvency II will require insurers to calculate the impact of interest rate changes (with a predefined shock of an identical level on assets and liabilities) on assets and liabilities, that is to say their net sensitivity to interest rates. In exchange, the directive will authorise the use of derivative products, but only for hedging purposes. "It is a possibility which, for our part, we have not used, since the long-term hedging market (around 20 years) is not very liquid and such hedging is therefore very expensive, notes Jean-Marc Boyer. In addition, as hedges are inappropriate from an accounting point of view, we prefer to ask the manager of our UCITS to use them directly within funds if necessary."

But in this sector and in particular in the life insurance segment, institutions are facing an additional risk, namely that of investors redeeming their contract, since in the event of higher interest rates policyholders may be tempted to redeem their contract to obtain higher yields on other products. This would automatically result in capital losses on the bond portfolios of insurance companies. "This risk of redemption options being exercised needs to be assessed, specifies Ludovic Antony, Director ALM Modeling for Insurance at SG CIB.It depends on the behaviour of policyholders, in reaction to the company’s distribution policy. Although this policy is based on market parameters, it also depends to a large extent on the reserves built up in the past and the hedges put in place." However, the current low level of interest rates could represent an interesting entry point to hedge this risk. "Although the current volatility remains relatively expensive, the risk of an increase above a predetermined maximum rate is lower today, which reduces the cost of hedging", analyses Ludovic Antony. Numerous solutions exist for meeting the hedging objectives of these institutions, within the limits of a specific pre-determined budget.

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