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Use of financial futures by life insurers.

Use of Financial Futures by Life Insurers

Introduction

The volatile interest rates of the late 1970s and early 1980s and the continuing deregulation of the financial services industry have led life insurers to reevaluate the nature of their assets and liabilities. A number of new products have been introduced, including universal life, interest-sensitive whole life and variable universal life. These new products have dramatically altered the nature of insurer liabilities. In addition, considerable attention has been given to evaluating the interest rate sensitivity of assets and the degree of asset/liability mismatch. Some specific methods in this area include asset/liability matching, immunization and various hedging strategies using interest rate or financial futures.

In recent years financial futures have been receiving increasing attention as a valuable asset management tool for financial institutions, including life insurers. Basically, a financial futures contract is an agreement between two parties for future delivery of a specified financial asset at a price established at the inception of the agreement. The value of the futures contract tends to move in line with changes in the value of the underlying financial asset. Hence, by making appropriate transactions in the futures market, either buying or selling contracts, the insurer can alter its cash market exposure to interest rate risk. Futures transactions have the advantage of being less costly than transactions in the cash market.

Several studies have identified possible applications of financial futures by life insurers (see Edmonds et al., 1983; Gottlieb, 1985; Szala, 1986). However, only recently has any attempt been made to determine the extent to which life insurers are actually using financial futures (see Figlewski, 1987). This article, based on the results of a questionnaire, attempts to assess the extent to which financial futures are being used by life insurers.

Methodology

The source of information for the study is a questionnaire mailed in late October 1987 to the chief investment officers at 390 United States life insurers. Completed questionnaires were received from 118 of the insurers for a response rate of 30.2 percent. The form of the questionnaire closely follows one used by Booth, Smith and Stolz (1984) in a study of use of interest rate futures by banks and savings and loans. A recent study conducted with the support of the American Council of Life Insurance (ACLI) surveyed insurers on similar issues (Figlewski, 1987). That study was directed at 50 of the largest insurers belonging to the ACLI and, therefore, provided little information with regard to the perceptions of smaller insurers. The current study expands the sample size to include both large and small insurers allowing investigation of economies of scales in the use of futures.

The anonymous questionnaire consisted of four sections and used closed-end and Likert scale questions. The first section collected information on characteristics of the insurer, such as asset size, stock or mutual and A.M. Best rating. In the second section users provided information regarding applications of futures, types of contracts used, degree of involvment by corporate departments and limitations to implementation of futures programs. The third section collected information from nonusers regarding their assessment of possible applications of financial futures and barriers they have encountered in implementing a futures program. The final section solicited responses from users and nonusers regarding their perceptions of financial futures as an asset management tool. The survey design allows comparison of investment practices between futures users and nonusers in the life insurance industry, as well as cross-industry comparison with banks and savings and loans (see Booth, Smith and Stolz, 1984).

Results of the Study

The size of the 118 responding insurers in terms of admitted assets is summarized in Table 1. With respect to corporate structure, 58.6 percent of the respondents were stock insurers and 41.4 percent were mutuals. Most of the responding insurers were highly rated by A.M. Best, with 86.4 percent rated either A+ or A. Slightly more than 8 percent of the insurers listed in Best's Insurance Reports are mutuals and approximately 40 percent of those listed are rated either A+ or A. Comparison of these percentages suggests that the response group is somewhat weighted to the larger insurers in the industry.

Only 23 (19.5 percent) of the responding insurers were currently using financial futures. The number of users, although low, is slightly higher than the 16.8 percent of banks and saving and loans that Booth, Smith and Stolz (1984) found to be using financial futures at the time of their survey.

For the life insurers that responded, the likelihood of usage was related to size. Only three of the 48 insurers (6 percent) with admitted assets under $250 million indicated current use of financial futures and 11 of the 55 insurers (20 percent) with assets between $250 million and $5 billion reported use. However, nine of the 15 insurers (60 percent) with assets over $5 billion reported they were currently using financial futures. The relationship between use of financial futures and size is significant at the .0001 level, with a chi-square statistic of 21.058 (two degrees of freedom).

This result strongly suggests economies of scale for the use of financial futures by life insurers. However, the relationship between size and usage may also be a result of differences in the type of products offered by, and therefore liabilities assumed by, life insurers of varying size. Booth, Smith and Stolz (1984) also found a strong positive relationship between use of financial futures and asset size of banks and savings and loans.

Actual and Potential Uses of Financial Futures

Table 2 provides a list of seven possible applications for financial futures. Insurers currently using financial futures were asked to indicated which of the applications have been or are being used. Nonusers were asked to indicate which of the seven possibilities they though might represent potentially valuable applications for financial futures. The respondents could indicate as many of the seven applications as they felt applied. The table presents the percentage of users and nonusers indicating each application, as well as the chi-square statistic for statistically significant difference between the responses of users and nonusers.

The most frequently stated application of financial futures by current users is to lock in a current yield for an anticipated inflow of cash in the near future. The second most common application for users is to hedge against the depreciation of fixed-income assets as interest rates rise. Hedging the yield spread on a guaranteed investment contract (GIC) or forward commitment and adjusting the duration of assets in order to reduce the asset/liability mismatch are also common applications of futures by current users. Fewer nonusers indicated item (5) as a potential application than did users. This may result from the fact that users tend to be larger insurers that are more likely to be involved in GIC or forward commitment markets. Therefore, the nonusers would not perceive item (5) to be a particularly important application of futures.

Types of Futures Contracts Used and the Degree of Involvement

by Corporate Departments

Life insurers currently using financial futures were asked to indicate which types of contracts were being used. A listing of the types of contracts and the percentage of respondents indicating use of each type of contract is presented in Table 3. T-note and T-bond futures are by far the most commonly used contracts. This is not surprising given the medium to longer term maturity structure of most life insurer assets and liabilities. Also, these contracts trade in two of the deepest futures markets available. Options on futures and stock index futures are being used by close to one half of the respondents.

Table 4 summarizes the responses of users with respect to the degree of involvement by corporate departments in the insurer's financial futures activity. A Likert scale was used for the degree of involvement with one representing "significant involvement" and five representing "no involvement." The table presents the mean response for each department.

The highest degree of involvement was reported for the investment staff, with no respondent ranking the degree of involvement by this department below three. The accounting staff and senior management were ranked next with similar levels of involvement indicated. Finally, the actuarial staff and special units were ranked as having little involvement in the financial futures activity of respondents.

The low level of reported involvement by actuarial staff in the financial futures activity of current users may suggest that more needs to be done to integrate liability management with asset management. That is, perhaps the liability managers, the actuaries, could be involved more in asset management activities, such as the use of financial futures. However, because the questionnaire was sent to the chief investment officer, a bias toward assessment of the degree of involvement of the investment staff relative to other departments might be expected.

Impediments to the Use of Financial Futures

Both users and nonusers were questioned regarding problems of implementing and administering the use of financial futures. Users were asked to indicate which of four different problems they had encountered, while nonusers were asked which problems they had encountered or would anticipate encountering. The percentages of users and nonusers indicating each of the four problems are given in Table 5, along with chi-square statistics for significant differences between users and nonusers.

Educating management in the use of futures was ranked as the single most important problem by both users and nonusers. Nonusers had significantly more problems from a lack of qualified personnel to implement the program than did users. Also, a significantly higher percentage of nonusers listed resistance from the Board of Directors as a problem than did users.

Booth, Smith and Stolz (1984) asked the same four questions of banks and savings and loans and the responses obtained were very similar to those of life insurers. Nonusers in their study also reported a lack of qualified personnel more frequently than did users. They reasoned that this result might be explained by the size disparity between users and nonusers. A similar rationale probably explains the difference between users and nonusers among life insurers and provides additional support for the existence of scale of economies to the use of financial futures.

Perceptions Regarding the Use of Financial Futures

Finally, both users and nonusers were asked to give their opinions of several statements regarding the use of financial futures. A Likert scale was used for each statement with response number one indicating "strongly agree" and response number five indicating "strongly disagree." Table 6 presents the seven statements and the mean response for each statement for users and nonusers. The values of the t-statistic for significant differences between group means is also given in the table.

Responses to statements (3) and (5) suggest that users perceive a much stronger benefit to the use of financial futures than do nonusers. Users appear to feel strongly that proper use of financial futures can reduce financial risk facing their companies and that the benefits of using futures outweigh the costs. Not surprisingly nonusers are relatively neutral with regard to the value of using futures. There is relatively strong disagreement with statement (7), suggesting that respondents feel that the nature of their business does expose them to interest rate risk. The reaction of users is significantly stronger than for nonusers.

Summary

The results of the survey suggest that larger life insurers tend to make more use of financial futures than do smaller insurers. This finding may to some extent reflect differences in the types of products offered by various insurers. However, other responses by nonusers regarding lack of qualified personnel and problems educating management suggest that significant scale economies for the use of financial futures do exist.

The low level of reported involvement by actuarial staff in the financial futures activity of users may suggest that more integration of asset management with liability management is needed. Also, hedging and interest rate risk are concepts that may still be poorly understood in the life insurance industry. One respondent suggested that if the company wanted to eliminate risk it could simply buy Treasury bills. Obviously, this response indicates a lack of understanding of asset/liability mismatch and interest rate risk.

Finally, it appears from the survey that users see significant utility in the use of financial futures. As life insurers develop a better understanding of financial futures and their applications, involvement will continue to expand.

References

[1] Booth, James R., Richard L. Smith and Richard W. Stolz, 1984, "Use of Interest Rate Futures by Financial Institutions," Journal of Bank Research, 15: 15-20.

[2] Edmonds, Charles P., John S. Jahera, Jr. and Terry Rose, 1983, "Hedging the Future," Best's Review (Life/Health), 84(5): 30-32, 118.

[3] Figlewski, Stephen, 1987, "Survey of Life Insurance Company Use of Financial Futures and Options," American Council of Life Insurance, Report, September 29, 1987.

[4] Gottlieb, Paul M., 1985, "Authorized Hedging Strategies for Insurance Companies: Status in California, Connecticut, Illinois and New York," Insurance Counsel Journal, 52: 304-310.

[5] Szala, Ginger, 1986, "Barriers Insurance Companies Still Face in Using Futures," Futures: The Magazine of Commodities and Options, 15(3): 64-65.

Robert E. Hoyt is Assistant Professor of Risk Management and Insurance at The University of Georgia.
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Author:Hoyt, Robert E.
Publication:Journal of Risk and Insurance
Date:Dec 1, 1989
Words:2199
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