With the prospect of interest rates beginning to rise as the economic recovery gathers pace, lapse risk has emerged as a major concern for insurers. Faced with the possibility that clients might surrender their policies en masse and seek higher returns elsewhere, insurers have been looking to structured products for protection.
One solution is the sovereign bond repack, whereby the insurer swaps the default risk and associated coupons of a sovereign bond for a structured coupon engineered by an investment bank and supplied through a special-purpose vehicle. The structured coupon would typically pay a fixed rate for five to 10 years before switching to a rate linked to the constant maturity swap (CMS) curve.
Societe Generale and Crédit Agricole Corporate & Investment Bank (CIB) have been jostling for market share in repacks, with each transacting around €1 billion ($1.1 billion) since the fourth quarter of 2014. Competition has also spurred innovation as banks devise inventive ways of offering CMS exposure in a more efficient manner than their competitors.
"In the current environment, CMS [exposure] can be seen as expensive so insurance companies are trying to find ways to make their hedging strategies more cost-effective. This means taking on some risks that they are comfortable with," says Lionel Nodari, financial institutions sales at Crédit Agricole CIB in Paris.
Crédit Agricole CIB takes the award for deal of the year after structuring a particularly innovative solution for a large French life insurance company in the form of a 25-year French inflation-linked bond repack with a range accrual feature. The deal allowed the insurer to obtain an enhanced fixed coupon as long as the spread between CMS 10-year and year-on-year French inflation is above –20 basis points on the designated monthly observation dates.
The use of an inflation-linked bond as collateral enabled clients to further optimise the overall structure
"In the long term, insurers want protection against lapse risk and that's why they seek exposure to the CMS curve. However, if you think of the current level of the 10-year swap rate, it is not offering an attractive return and there is no immediate risk of long-term rates rising in the eurozone. So we have a fixed rate over the first 10 years to reduce this potential negative carry. With our fixed-rate coupon, the insurer receives 1.45% as long as the spread between CMS 10-year and year-on-year French inflation is greater than -20bp," says Régis Benichou, head of structuring for Europe, the Middle East and Africa and global head of pricing at Crédit Agricole CIB.
Pre-crisis, contingent fixed coupons were very much in demand, typically linked to a certain level on the Euro Stoxx 50, but this is the first time a repack has included a barrier contingent on the spread of swap rates and French inflation. Furthermore, Crédit Agricole CIB exploited a rare opportunity to lock in the structure at a favourable level for the insurer.
"At the time of the transaction, we were witnessing negative real rates: the 10-year swap rate was below the year-on-year French inflation rate, while historically, since 1999, this spread has been above -20bp more than 99% of the time," says Benichou.
The deal was executed in March when the spread was at –10bp and inflation forwards were exceeding long term nominal rate forwards - an outlier event which allowed Credit Agricole to construct the range accrual feature at lower cost to the insurer. The spread widened to +95bps as of October 2015 and the outlook remains favourable to the insurance client.
"There are two possible outcomes. If quantitative easing in the eurozone is successful, this will cause both inflation and real rates to increase on the back of positive growth. If it is unsuccessful, eurozone inflation will likely remain lower than the 2% target," says Samy Beji, global head of structuring at Crédit Agricole CIB. Either way, the historical positive spread between CMS 10-year and year-on-year inflation is likely to hold.
"The use of an inflation-linked bond as collateral enabled clients to further optimise the overall structure. Given our leading position in trading and distribution of French inflation linkers, our capacity to source the collateral was key for the investor" adds Jacques Topiol, global head of inflation trading at Crédit Agricole CIB.
This allowed the bank to be more competitive with the floating portion of the coupon. The cap on the CMS 20-year is raised from 6% to 10% from the fifteenth year onwards, helping to minimise the risk the insurer would miss out in a rising rates scenario.
"Crédit Agricole was the first to create this product," says the head of fixed income at the insurance firm. "It was a technical innovation to include a structured coupon fixed at a very attractive rate - we achieved a pick-up of 30bp compared to a plain vanilla repack. The risk of real rates staying negative and the coupon not accruing is low, and even if this did occur it would mean our bond portfolio would become more valuable anyway. We also like the structure because it gives us exposure to CMS 20-year, which enjoys a spread of between 30bp and 50bp above CMS 10-year. Crédit Agricole is very creative, innovative, and proactive in contracting us with new structures."