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Coming out: are there hidden hedge funds in life insurers' balance sheets?

It is not surprising that hidden exposures to factors such as interest rates led to a series of unmanaged bets that have haunted insurers globally. In the United States, for example, the expectation that interest rates would remain stable or rise slowly resulted in severe spread compression in 2000 and 2001 and caused companies to often trade below book value.

What is surprising, however, is that the industry has not learned much from these sometimes near-disastrous experiences. In fact, until recently most insurers had taken little action to insulate themselves from such risks or to approach hidden bets more strategically.

Most life insurance chief financial officers are well aware of the effect that a 1% movement in interest rates would have on their Generally Accepted Accounting Principles operating income. Very few, however, can quantify the effect such a movement would have on the economic value of their assets and liabilities. The bar chart above, which compares the current regulatory framework with an economic view of risk, shows how true exposure to interest rate risk is understated.

Why do these hidden hedge funds exist in the first place? The short answer is that distributors and customers demand it. Both retail and wholesale customers require increasingly complex guarantees within products, and winning their business requires life insurers to take on the associated interest-rate risks.


Some of these genuinely cannot be "hedged." Policyholders are asking insurers to bear risks on their behalf, and in a competitive marketplace, insurers find it hard to refuse. Insurers can find themselves providing very long-dated liabilities that may hinder their ability to neutralize their asset-liability positions, as has happened in the U.S. terminal funding market.

On the asset side, insurers looking for increased returns have looked to mortgage-backed securities and other assets that, dangerously, have the opposite convexity to their liabilities (arising from their prepayment features), not to mention the misunderstood credit risk.

This situation is compounded by the fact that accounting and regulatory requirements for reporting and value creation have not kept pace with the market. Many of these measures do not reflect the underlying volatility to which life insurers are inherently exposed. Worse still, they may actually point in the opposite direction.

Reform efforts have made slow and uneven progress, resulting in a confusing and ineffective hybrid of economic mark-to-market measures and traditional book-value-based accounting measures.

For example, an analysis of a major North American insurer's accounting regime revealed that it made misleading distinctions between economically identical exposures to equities, while completely overlooking two-thirds of the overall exposure completely. (See chart on page 103.)

Sophisticated hedging programs for the equity risk generated by variable annuity living benefits are now commonplace, with most leading life insurers operating a mixture of dynamic and static hedging programs. However, an economic evaluation of a typical portfolio reveals that insurers are exposed to a greater spectrum of equity risk.

First, today's hedging programs for living benefits are not comprehensive. A focus on living benefits that fall under mark-to-market accounting ignores other living benefits, which generate identical economic exposures but different accounting exposures, such as income benefits or withdrawal benefits for life.

Second, living benefits typically generate only about one-third of total equity exposures. Other sources, including fee income and a mismatched defined-benefit plan, generate the remainder.

The net result of all this is that life insurers end up with an unruly combination of positions, many taken more or less unwittingly because of competitive pressures. This is how the hidden hedge funds are created.

These funds are managed ineffectively, if at all, because there is little understanding of how they affect economic value creation. The only real perspective available is that of accounting standards, which tend to correlate poorly or not at all with the economic reality.

This creates perverse incentives or overlooks potentially significant exposures.

Taking Action

Such a situation is clearly in need of improvement, but insurers have been slow to adopt new ways of thinking about their balance sheets and the hidden hedge funds they contain. But that is now changing. A string of major financial losses around the world has awakened the industry to the need for better balance sheet measurement and management.

The straw that finally broke the camel's back was the havoc caused in the European life insurance industry by the confluence of falling interest rates and bear equity markets in 2001 and 2002. Regulators were forced to step in, explicitly or implicitly, to prevent a trickle of insolvencies from turning into a torrent.

The situation gave rise to Solvency II, an updated set of regulatory requirements for insurance firms that operate in the European Union. Solvency II requires insurers to provide regulators with an economic view of their balance sheets, including a transparent, objective and mark-to-market analysis of their liabilities and an internal view of capital requirements.

The management of North American insurers initially stood on the sidelines and watched events unfold in Europe. However, their balance sheets are equally susceptible to hidden and poorly managed bets, and the value of the information and insight now available to their European peers has become obvious. With life insurance becoming a globally competitive market, North American insurers cannot afford to ignore the fact that their European rivals are now playing by a different, and arguably better, rule book.

A growing number of North American life insurance executives now appreciate the shortcomings of existing earnings and capital metrics and are seeking ways to better understand their value chain and optimize risk-return decisions. Oliver Wyman estimates that around 40% of the North American industry's overall liabilities are being assessed on an economic mark-to-market basis today, and that an additional 10% will be quantified on this basis by the end of 2008.

To date, there has been little external disclosure of these figures. This is not surprising, given that insurers are still working on improving the robustness of these figures, understanding how they differ from the existing GAAP and statutory balance sheets and formulating an external communication strategy to their external stakeholders.

Part of the challenge for the industry is that insurers who wish to manage their economic earnings and risk are punished by excessive volatility in their reported GAAP income statements. (See chart on page 104.)

Moving Targets

Insurers who wish to actively manage their macroeconomic bets (or neuter them, as the case may be) often find themselves penalized in terms of GAAP-adjusted operating income, which perversely becomes more volatile. The misalignment between the accounting result and the underlying economic result is enough to make even the most earnest of CFOs reconsider the trade-off between meeting quarter-to-quarter earnings targets and creating shareholder value over the long term.

Ultimately, it will take time to make the leap from today's accounting-dominated world to one where firms can manage according to the underlying economics. But despite the potential for short-term pain, the industry should ultimately benefit from more transparency when it comes to balance sheets and a more measured approach when it comes to position-taking, rather than haphazard creation of hidden hedge funds.


With the leaders forging ahead, laggards can no longer afford to watch and wait. The transition to measurement and management on an economic basis will be complex and perhaps protracted. It's all the more important that those firms who don't already have initiatives under way should start on a concerted program of work now.

The first step is to identify the hidden positions and gain a comprehensive, regularly updated understanding of their behavior and interaction with relevant risk factors. For example, economic balance sheets need to capture the mark-to-market impact of changing rates on liabilities.

Next, firms must articulate a risk-return strategy--in other words, decide which bets to take. Which risks can't be hedged? Does a bet support a core competency, make good use of capital or help smooth out results? Will investors understand and value this activity?

Finally, the organization and its stakeholders must be aligned with the new strategy. They must understand the way in which the firm's decisions now reflect the trade-off between accounting standards and economic realities.

Many firms are still at the beginning of this process, but it is worth starting work on the last step as soon as possible. The shift to measurement and management on a true economic basis represents a seismic shift in the way the industry creates value for shareholders. It will take time and a substantial educational effort for its implications to be fully appreciated by stakeholders, particularly as it pertains to the trade-off between GAAP earnings and the creation of economic value.

Moreover, it is only a matter of time before investors begin demanding to know exactly how the industry deploys capital and generates shareholder returns. Only executives who really understand where their risks and returns lie will succeed in answering them.

* The Situation: New and complex life products call for sophisticated hedging programs to handle the equity risk.

* The Significance: Only 40% of North American life insurers' overall liabilities are being assessed on an economic mark-to-market basis.

* What Needs to Happen: Life insurers need to shift to measuring and managing their general accounts assets on a true economic basis.

Contributor Rainy Tadros is a partner in Oliver Wyman's insurance practice in New York. He can be reached at
Aggregate Equity Risk
In Aggregate for a Leading
U.S. Insurer

Required economic capital
(As of Dec. 2006)

Operational risk 10%
Equity risk 12%
Market risk
excluding equity 38%
Credit risk 26%
Insurance risk 14%

Sources of risk in required economic capital

Fee stream from
variable annuities
and third-party
mutual funds 22%
VA guarantees 33%
DB pension plan 25%
Direct equity and
equity-like exposure in
general account 20%

Source: Oliver Wyman analysis

Note: Table made from pie chart.
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Article Details
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Author:Tadros, Ramy
Publication:Best's Review
Geographic Code:1USA
Date:Aug 1, 2008
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