Financial Risk Management of Insurance Enterprises

1. Financial Risk Management of Insurance Enterprises Interest Rate Caps/Floors

2. Options on Interest Rates • Last time, we discussed the basics of options • Today, we apply our knowledge to options on interest rates • These are caps and floors • We will see that insurance enterprises can greatly benefit from caps and floors

3. Cap/Floor Terminology • Strike rate is the rate which determines any cash flows of the cap or floor • Similar to the strike price or exercise price • Underlying index is the interest rate that we want protection for or are speculating on • Notional amount is the principal to which the interest rate will be applied to determine payoffs • Up-front premium is the amount the buyer must pay to own the cap/floor

4. How Caps Work • Unlike a call or put option, a cap has multiple potential payoffs determined by a settlement frequency and a maturity • At each settlement date, if the underlying index is below the strike rate, no payments are exchanged (aside from the premium) • If the underlying index exceeds the strike rate, the seller of the cap must pay:

5. An Example of a Cap • A borrower has issued a floating rate note and is paying LIBOR quarterly over the next three years • By purchasing a cap with a 10% strike rate, quarterly settlement frequency, a maturity of three years, and a notional amount equal to the amount of the note, the borrower can hedge its exposure to increasing LIBOR

6. Using a Cap to Hedge Borrowing Costs • As borrowing costs exceed the strike rate, the cap cash flows offset further increases in the underlying index • Net effect is that interest expense is “capped” at 10% • This is why the option is called a “cap”

7. How Floors Work • Again, there are multiple settlement dates • At each settlement date, if the underlying index exceed the strike rate, no payments are exchange (again, the premium is paid) • If at a settlement date, the underlying index is below the strike rate, the seller of the floor must pay:

8. Hedging An Asset’s Return • If a security is earning a floating rate, the exposure is a drop in interest rates • Buying a 6% floor puts a minimum value on the net return • Thus, the name “floor”

9. Cap Values • From our previous discussion, how does cap values change with respect to changes in: • Strike rate (as X increases, cap value decreases) • Current interest rate (as rates increase, cap value is higher) • Maturity (as T increases, cap value increases) • Index volatility (as F increases, caps increase) • Notional amount (value increases as amount at risk increases) • Settlement frequency (value increases as potential number of payments increase)

10. The Up-Front Premium • Premiums are based on percentage of notional principal • This premium can be viewed as providing an annuity of interest rate protection • One policy per settlement period • Net result of paying premium • Pay higher interest rate each period for protection against risk exposure (cap) • Receive lower interest for protection against low interest rates (floor)

11. Methods to Lower/Eliminate the Up-Front Premium • All methods give something back to lower up-front premium • Interest rate collar • Protection against downside paid for by giving away some of the upside • Interest rate corridor • Cap protection disappears in extreme scenarios • Participating Cap/Floor • Premium paid when cap is not in the money

12. Interest Rate Collar • Sell floor to finance cap or sell cap to finance floor • Net result is that interest expense will be between strike rates of cap and floor • Can reduce premium to zero • Can even make profit

13. Interest Rate Corridor • Pay for cap 1 by selling cap 2 which has a higher strike rate • Sale of 2nd floor would have lower strike • Protection disappears if rates move a lot • Cannot reduce premium to zero

14. Participating Cap • Pay for cap by making payments when interest rate is below the cap • Participation percentage is paid by cap “buyer” when rates decrease • When index is above strike rate, same settlement as before • When index is below strike, buyer pays: Participation % x(Strike-Index)x(Days/360) x(Notional Principal) • As participation goes to 100%, it is a swap

15. Participating Cap(60% Participation)

16. Cap-Floor Parity • Interest rate put-call parity is called cap-floor parity • Suppose a collar strategy where strike rates on floor and cap are equal • This locks in a fixed payment equal to the strike rate • This is essentially a fixed rate payor swap • If this equivalent fixed swap rate is the market swap rate, then the collar strategy has zero cost (initially)

17. Example 1 • In the early 1980s, life insurers experienced disintermediation. Policyowners took out loans against their cash value at low rates and invested in higher yielding assets. • As interest increased, the insurer had to take losses on their bond portfolios • Life insurer could hedge this risk using interest rate caps • Payment on cap would be used to pay for withdrawals

18. Example 2 • Defined benefit pensions assume that contributions will earn an amount which will provide benefits in the future • If the return on the assets is below the assumed return, the benefits are at risk • Pension fund can buy a floor so that in periods of low returns, they will receive payments from the floor option

19. Next Time • Use of derivatives by US insurers • What else insurers should be doing • Reminder: Exam #1 is one week from today!