The approach taken to insurance clients at Royal Bank of Scotland (RBS) could stand as a test case for the bank's strategy of focusing on core markets and core areas of expertise.
As RBS moves away from businesses deemed ‘non-core', its reputation with insurers in the UK, particularly for rates and inflation, stands strong. In turn, because UK insurers are among those facing the greatest complexities under Solvency II, the bank has had ample opportunity to put its market knowledge to work.
Clients point to the bank's ability to combine strategic and tactical approaches - offering clear updates on regulatory developments alongside a deep understanding of supply and demand in the rates and inflation market, and the ability to execute trades at competitive prices. Several insurers praise in particular the firm's annual analysis of the UK life market, in which RBS conducts a detailed review of the regulatory filings of UK life companies to assess how they are reacting to key trends in the sector.
"We value, and seek to maintain, our knowledge and understanding of insurers' business models, and identify this as a key source of our strength when it comes to developing relevant solutions," says Keith Law, vice-president, RBS Structured Solutions.
An example is hedging the additional exposure to interest rates created by the solvency capital requirement (SCR) and the risk margin on the Solvency II balance sheet - a puzzle insurers have been grappling with over the past year. Many are reluctant to hedge against rates falling further, viewing this as a risk that seems unlikely to crystalise. At the same time, doing so would leave them exposed to the risk of rates rising when calculating capital requirements.
We seek to maintain our knowledge and understanding of insurers' business models
RBS spotted an opportunity to help control this exposure with reference to supply-demand imbalances in the swaption market. Insurers can buy high-strike payer swaptions to reduce the duration of the hedge if rates rise, which means taking the other side of a trade typically put on by pension schemes as part of their own rate hedges. "The volume of these instruments traded has created an imbalance in the market, allowing insurers to benefit if they are able to take the opposite side of the trade," says Andrew Kenyon, vice-president, RBS Insurance Solutions.
Likewise, the bank was able to help another client with the super-replication of its portfolio. For insurers that are duration-matched, this means adding convexity to the assets so they are protected against rates both rising and falling.
Elsewhere, continental European insurers continued their quest to lock in unrealised gains on government bonds, but with a new twist. RBS helped one insurer to hedge the credit spread of its portfolio of Italian government bonds when the company became concerned about possible contagion from the Greek bailout negotiations in the summer, using an asset swap spread lock.
This is a forward contract that allows the client to lock in the asset swap spread of a reference asset. The cash amount on settlement is equal to the change in the present value of the bond position as a result of changes in the asset swap spread. The trade enables the client to lock in the price of the bond at the point of sale but realise the profit at the time of settlement, helping to manage practices common in continental Europe whereby insurers are required to distribute profits to policyholders as soon as they arise.
Meanwhile, in the inflation business, the bank's corporate client base gives it an enhanced view of flow in the inflation market, enabling it to offer axes to pension and insurance clients, rather than relying solely on the wholesale market. The bank regularly acts as the hedge manager for the UK debt management office, including on the longest-dated gilt yet to be issued.
In the first quarter, this helped RBS identify a trading opportunity for its insurance clients. As interest rates had fallen and markets became less liquid, unhedged implicit floors in medium-term notes sold by banks to insurers had become valuable. At the same time, RBS saw that some banks were short increasingly valuable 0% floors from CMS10-linked principal protected notes. These notes had typically been sold to continental insurers to hedge lapse risk.
"The implicit floor in the notes was not originally hedged by some banks so they were running large short positions, which didn't become an issue until rates fell substantially," says Robin Thompson, head of asset-liability management solutions at the bank. As forward rates moved lower and dealers adjusted their models to accommodate the possibility of negative rates, books had to be rebalanced. That meant dealers had to buy vega, which caused implied volatility levels to spike and liquidity to dry up.
Identifying this market stress, RBS was able to provide insurers with the trading idea of selling 10y10y 0% floors or receiver swaptions to take advantage of the situation. "RBS combines strong market knowledge with a good understanding of what rate and inflation strategies will add value to our investment portfolios," says one client that traded this idea.
Looking forward to 2016, Kenyon says: "Once firms have clarity over their Solvency II positions, they will need to consider how they manage the overall stability of their balance sheets. We expect continued interest in hedging solutions for SCR and risk margin, and continued risk reduction from with-profit funds still exposed to gilt-swap spread risk.
"Annuity writers will finally have clarity over how they're going to operate within the matching adjustment framework. And the optimisation of liquidity and management of non-compliant assets will be an ongoing process requiring detailed analysis and innovative solutions," he says.