Buy-side Awards 2016
During the financial crisis, the unexpected rise of long-dated gilt yields above swap rates created a windfall for UK insurers where they had liabilities matched with swap-based assets.
"Most people saw it as a result of markets breaking down and something that would normalise in the future," says Michael Eakins, managing director and co-head of UK rate sales at Goldman Sachs, based in London. So, naturally, they acted to lock in the gain, using swap spreadlocks – effectively the same as switching from swaps to holding gilts.
It seemed a good idea at the time. But times change. Seven years later, as Solvency II approached, firms faced precisely the opposite scenario, with the prospect of having to discount liabilities using swap rates.
"You have still got the gilt-swap basis risk, but it's now the other way round," Eakins says.
Insurance clients sought to unwind these trades since as early as 2014 in preparation for the new regime. However, in several cases, companies remained far from completing the task or simply held big gilt portfolios, regardless of any swap spreadlocks.
You get a sense of this from regulatory filings, which show at least 18 UK insurers with gilt holdings as high as 30% in with profits portfolios. All firms with gilts or gilt-based assets – including those with swap spreadlocks in place – face basis risk under the new regime.
The "obvious option" is to sell gilts, Eakins says: "But that isn't a trivial thing to do. The governance issue alone is huge. It might take six months to reduce the position meaningfully." Firms then have to ask themselves what to invest the proceeds in. That means time-sapping investment committee approvals and possible further delays.
Firms started with receiver swaps, but that gives you exposure to rates going up. When you calculate your SCR, you have to stress rates up as well as down. So if you just have a receiver swap in place and rates go up, you have a negative mark to market, and you have to hold capital for that
Michael Eakins, Goldman Sachs
As an alternative, Goldman is understood to have transacted reverse spreadlocks with several clients where the insurer pays on a total return swap against gilts and receives fixed on a swap of matching maturity. The trades can be rolled every six to 12 months.
"These reverse spreadlocks can be balance-sheet-intensive trades for banks, because they are derivatives based on real asset underlyings and the trade notionals can be pretty big," says Eakins.
In terms of managing the unwinding of spreadlocks that were put in place under the old regulatory regime, insurers had to manage the balance between avoiding the need to unwind material risk when there was limited market liquidity – such as in December 2015 – versus needing to maintain these hedges in place until the very last minute, as they were critical under the old regime.
Some insurers managed this balancing act by agreeing a specific schedule with their asset managers in terms of pre-agreeing quantums of risk that could be processed through the market, and Goldman is understood to have been a key participant in these trades.
Another element of the switch to Solvency II that has tested the mettle of UK insurance has been hedging the solvency capital requirement (SCR) and the risk margin in particular. "Senior management started to realise they would have to sign off on dividends, reinsurance or other corporate events, and might find a sudden fall in rates eroded coverage ratios," Eakins says.
In those circumstances, insurers can rely on transitional recalculations. The UK's Prudential Regulation Authority signalled these would be allowed in the aftermath of the UK referendum decision in June to leave the European Union, and they have been used across the industry. But seeking and securing such approval takes time.
The alternative is to hedge the risk margin – at least in the most adverse scenarios. "Firms started with receiver swaps, but that gives you exposure to rates going up. When you calculate your SCR, you have to stress rates up as well as down. So if you just have a receiver swap in place and rates go up, you have a negative mark to market, and you have to hold capital for that," Eakins says.
Swaption strategies have been the hedging instrument of choice. In some cases, firms have adopted a collared strategy, as used for managing equity exposures to reduce the day-one quantum of premium paid. Firms effectively buy insurance against a rate fall, but fund that position by selling insurance on a rate rise – a technique borrowed from the liability-driven investment space.
Of course, Goldman, too, has to adapt to the effects of regulation. There has been a growing trend among banks, asset managers and insurers to transact on cash-only CSAs – including for novations of old swaps to face special-purpose vehicles in matching adjustment repack trades.
Some insurers have been unready to start posting cash, however, so Goldman – like other banks – has put in place so-called sunset credit support annexes (CSAs) with certain clients. The insurer can continue to post cash and gilts for a period – say, two years – but makes a commitment to start posting cash from then on. In return, they receive favourable pricing compared with the pricing they would be offered under an unchanged CSA.
Such arrangements are part of a wider suite of options Goldman has made available to its clients to help in managing the pressures of collateral requirements with moves to central clearing.