Structured Products Asia Awards 2016
With record low interest rates in Japan continuing to dampen insurance companies' desire to launch variable annuity products in recent years, foreign currency fixed indexed annuities (FIAs) have taken centre stage.
However, these products create basis risks that attract capital charges for insurers. Enter Societe Generale Corporate and Investment Banking (SG CIB), which stepped in to create the first reinsurance product for insurers' FIAs, which reduced their capital charges and allowed insurers to continue writing the popular products.
"SG CIB has a strong derivatives platform and has long been an active player in the structured reinsurance business with Japan life insurance companies. Their unique setup allows them to provide hedging for hybrid insurance products that carry a combination of derivative and insurance risks. This allows them to be a key player within the insurance solutions space," says a source at one Japanese insurer.
FIAs provide investors with full or buffered downside protection but cap the client's potential upside. So, for example, an investor might want to track the performance of the Australian dollar swap rate. The investor would pay ¥100 (A$1.28), and receive a maximum of ¥125 in five years' time, converted into Australian dollars.
This requires the insurer to buy an Australian dollar asset as a hedge, for example a corporate bond. But while the insurer is guaranteeing a return in the Australian dollar swap rate, the bond yield differs from this, creating a basis risk. This basis is required to be capitalised under Japan's insurance regulation framework, and it is this extra capital charge that SG CIB is reinsuring.
"If the insurer buys a fixed rate bond, this is a perfect hedge except for the credit risk. What we insure is the additional required capital for the variation between the bond yield and guaranteed swap rate," says Hideaki Takahashi, head of sales for Japan, global markets at SG CIB in Tokyo.
The bank executed its first reinsurance trade in February this year, and has sold around A$1 billion of cover.
The equity Uridashi business has been down across the Street thanks to the poor performance of the Nikkei index, which fell around 25% between December 2015 and February 2016. These investments usually take the form of a knock-in, knock-out (Kiko) product - if the underlying increases by 5% or 10% the investor gets the principal back plus a high coupon, but if it decreases by a certain amount it starts to eat into the principal.
While the Nikkei index-linked products were safe as the downside barriers were set at around 50% of spot, some Uridashis linked to individual stocks hit their barriers. This required some risk management when spot was around barriers on individual products, but unlike in 2012 when the index-linked products were near their barriers, not all houses were hedging the same product at once, so no losses were incurred.
SG CIB kept investors interested by launching new products designed for the more difficult equity environment. For example, it created a product called a memory Kiko, where the underlying is a basket of stocks. While a typical Kiko would require all stocks in the basket to be above the upside knock-out point on the reference date, the memory product allows each stock to cross the barrier in its own time.
"Let's say one stock is above the knock-out in six months, so this event is memorised. And then in another six months two more stocks are above the knock-out level. Then we define this as a knock-out event. All stocks don't have to be above the knock-out at the same time, so this increases chance of knock-out event," says Takahashi.
Clients are particularly impressed by SG CIB's ability to offer equity structured products in smaller sizes, as low as $1 million. This is a deliberate strategy pursued by the bank for two reasons. First, it makes hedging easier, which allows the bank to develop new features quickly, or add extra asset classes to boost yield. Second, high-net-worth investors like to diversify their investments, so instead of putting $5 million into one product, SG CIB's smaller sizes allow it to buy five products at $1 million each.
On the currency side, the bank has continued to sell power reverse dual currency (PRDC) structures to high-net-worth investors in Japan. In simple terms, PRDCs constitute a carry trade in which foreign currency interest rates are paid on a yen-denominated notional amount. If the target currency stays high relative to the yen, investors receive juicy coupons - typically for a period of one or two years before the notes are called. But if the yen appreciates, investors could face as much as 20 years with no coupon payments.
While the US dollar has traditionally acted as the foreign currency, its growing strength versus the yen has led to a move toward other currencies such as the Australian or New Zealand dollar.
SG CIB was also active in the credit space, trading $600 million notional of credit-linked notes (CLNs) and first-to-default structures between June 2015 and May 2016 - a roughly 60% increase on the previous year.
With credit spreads tight, CLN maturities had to be pushed out to around 10 years to be able to offer a sufficiently high coupon on the products. Clients worried about credit risk, however, so SG CIB introduced callability features. These mean that if spreads tighten, leaving the product out-of-the-money to the issuer - SG CIB - then it can redeem the note at par. "We are buying optionality and paying a higher coupon," says Takahashi.
The French bank also offered CLNs where the coupon is paid in a foreign currency, which proved popular with private banks. "We have been constantly using SG CIB for public and private offerings. They offer competitive prices on those products. And if our clients want to buy back bonds sold in the past, they provide good liquidity as well. Their aftercare is very good," says a source at a one private bank in Tokyo.
The week on Risk.net, July 14–20, 2017Receive this by email