Guaranteed annuity options

In the Capital chapter, it states that an insurer can enter into a swaption to protect against an increase in its GAO liabilities. I'm trying to understand what's meant by "if interest rates fall, the change in the value of the swaption should match the change in the insurer's liabilities"?

 

Thanks so much, Lindsay. That helps a lot!

So, by entering into the swaption, the impact on the SCR would be:

• Reduction to market risk SCR component (interest rate)
• Increase to counterparty default SCR component

As a results, the risk margin would also reduce. There is no impact on the BEL (I'm assuming the swaption is not taken into account when valuing the cost of the GAO).

Is that right?

 

Hi

I think you need to take account of the portfolio of swaptions when valuing the cost of this GAO within the BEL. GAOs are a huge pain for insurers who sold them in the 80's, 90's and early 00's - in today's low interest environment these GAO policies are really valuable to policyholders (and costly to insurers). I would expect the swaptions to reduce the cost of guarantees component of the BEL. [Removed as stated this in error]

Working out the expected impact of changes on the SCR (and consequently the risk margin) is often tricky as there can be many moving parts going in offsetting directions. For the standard formula calculation:

• I agree that interest risk capital would decrease.
• I agree that counterparty default capital is likely to increase.
• I would expect a change in insurance risk capital (directions and size uncertain). This is because the original swaption portfolio would be matched to the best estimate view of liabilities. An insurance stress will change the profile of the liability cashflows meaning the swaption portfolio might not be as well matched anymore. (e.g. a reduction in lapse/retirement rates would mean that the GAO might be exercised later than expected when constructing the swaption portfolio). This could increase the cost of guarantee in the stress and the capital for that stress. Some stresses could work the other way and capital could reduce, but I find it difficult to tell without doing the calculations.
• Another consideration for the previous point is whether the insurer uses management actions. For example, a management action could be rebalance the swaption portfolio if the degree of matching breaches a defined limit/threshold.

When assessing the impact on risk margin, note that interest risk capital is explicitly excluded from the calculation (article 38(1)(i) of delegated regulation). It is difficult to determine the full impact on risk margin. My instinct is that the increased capital against the swaptions outweighs changes in capital for insurance risks and so I would expect the risk margin to increase.

Thanks
Amit

 

Why do you say that? Are GAOs sufficiently predictable liabilities (despite uncertainty around option take-up) to warrant the use of a matching or volatility adjustment?

If not, I'm not sure how a swaption would impact the BEL. Would the investment return simulations cap interest rates at the strike price (the guaranteed annuity rate)? I didn't think this was allowed because then you're effectively assuming a lower liability (BEL) without taking account of the derivative's default risk. I don't know whether my thinking is right though...?

Thanks for the help!

 

Thanks both - I made an error in suggesting that the BEL would change. Have edited my post above to reflect correction.

 

Thanks so much, Lindsay!!