Swaps! Apr2018 P1 Q4 ii)

Hi Forum,

I'm a bit confused by this answer and I just want to see if someone can help me get my head around what's happening.
The question asks:

In the examiners' report answer is the following..

and im having trouble interpreting and understanding this.

I thought through the answer as follows:

• The stated problem is that the liabilities are sensitive to interest rate changes. I guess that this means that there are some long term liabilities and when interest rates fall these liabilities are discounted by lower interest rates and so the present value of the liabilities increases. I'm guessing that the increase in liabilities is larger than the increase in asset values otherwise the assets would already be offseting the liabilities and there would not be a problem. If the assets already move much more than the liabilities then I would say that the issue was that the assets are sensitive to interest rates, not the liabilities.
  
• Therefore the insurer is exposed to the risk of low interest rates.
• Therefore the insurer would naturally take the leg of the swap where they would be paying out at a floating rate of interest and receiving a fixed rate of interest. This way when interest rates are low they would benefit and this would offset the problem with volatile liabilities.
• So if future interest rates are lower than expected then the insurer is now holding a swap contract where they pay only low floating rate values but they are still receiving the same fixed rate values. Surely this contract looks great to the insurer and has positive value?
• So I would say that the value of the swap INCREASES when rates are low, and that this helps to offset the increasing value of liabilities (by adding volatility to the assets in order to more closely match. the assets already increase in value but not by enough!)

To me the examiner's answer looks like it deals with a problem with a volatile asset portfolio and not liabilities that are sensitive to interest rates. I'm also not sure I understand what they mean by "making the impact less volatile on the liabilities side". Surely the swap doesn't affect the liabilities? it just affects the assets which may end up better matched against the liabilities?
Or are we talking about discretionary liabilities? in which case this still feels odd to me given the set up of the question?

Any help or pointers would be appreciated.

 

Hi,

I actually think you have the right sort of idea.

Part ii of the question makes reference to the liabilities. I'd therefore be inclined, initially, to talk about the swap with respect to the liabilities.

As you say, a reduction in interest rates would increase the value of the liabilities.

An insurer who wanted to remove the risk of declining rates could enter into a swap arrangement where they received the fixed leg and paid the floating leg. The swap would increase / fall in value when rates fell / increased, and would offset partially, fully or by more the opposite movement in the value of liabilities. It would depend on how well the swap performed as a hedge for the liabilities.

The overall impact on the company (ie after allowing for the other assets held) will depend on how well matched the assets ('swap' plus other assets) and liabilities are.

A swap that has a positive / negative value can be considered an asset / liability.
The swap will have a negative value for the insurer were rates to increase.

Hope that helps.

 

Thanks both.
Happy to know that my understanding seems to be okay.