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letter to the editor link

Published by The Times on February 12, 2000

Guaranteed Annuities - no excuse for not managing risk

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Sir: In "Court of Appeal rules against Equitable Life" (The Times January 22, 2000) you reported on The Equitable's policy of reducing final bonuses.

A decade or so ago, pension providers gave minimum interest rate guarantees to annuity policyholders. Market interest rates fell below these guaranteed rates making these guarantees valuable.

There has been much discussion as to who should bear the strain - policyholders or shareholders. But insurance company management should face up to the responsibility for failing to manage the inherent interest rate risk through the use of derivatives techniques explicitly or implicitly by lengthening the duration of their investments. The mismanagement of derivatives on a considerably smaller scale led to a spell at Changi jail for Baring's Nick Leeson and dismissals or resignations elsewhere.

The insurance companies rightly say that interest rates fell unexpectedly. But the problem arose not because of the fall in rates; but as a result of the collective failure to manage the embedded risks in the insurance policies sold to annuity policyholders. Instead of effectively saying: "You can't collect on your insurance policy because we did not know that you were going to claim on it", they should have been busy managing or laying off the risks. If that's the attitude of the insurance industry than I had better read the small print of my buildings policy in relation to floods and earthquakes!

As it happens, insurance companies have large holdings of fixed rate UK government bonds (gilts). The "unexpected" fall in interest rates has therefore led to substantial gains in these gilt portfolios. Given the "unexpected" nature of this fall, is the UK Treasury entitled to reduce the rates on the long term gilts held by these insurance companies? Of course not! When a bank provides a fixed rate mortgage to a borrower, it immediately goes into the derivatives market to protect itself against a rise in interest rates and therefore a rise in its funding costs. If rates rise, the bank will not tear up the fixed rate guarantee. If rates fall, there is a penalty imposed on borrowers who wish to get out of the deal.

Derivatives are not new. It is over two decades since futures and options arrived in the UK. And it is worth noting that a US Appeal Court has held directors liable for not hedging. It declared that "directors breached their duty in failing to .. become aware of essentials of hedging ... the primary cause of the gross loss was the failure to hedge."

Derivatives per se do have to be explicitly used. But ignorance of risk management techniques is no longer an excuse for failing to use them.

reply by C. P. HEADDON, General Manager, Finance & Appointed Actuary, The Equitable Life Assurance Society

14th March 2000

Sir: Mr. Headdon of The Equitable Life Assurance Society responded (Weekend Money Letters February 26) to my earlier letter "Guaranteed Annuities - no excuse for not managing risk" (Weekend Money Letters,
February 12).

I agree with many of Mr. Headdon's points even if others may not. He asserts that "the guaranteed annuity rate issue is about the amount of discretionary terminal bonus added at maturity reflecting earnings in excess of those needed to provide the contractually guaranteed benefits". The on-going court case arose because many of The Equitable's policyholders believed that under the guarantee, bonuses were to be received in addition to the guaranteed minimum rate. This may be a question of inadequate explaining by

Mr. Headdon says "derivative-based hedging .. would require a very active strategy. The costs of such a strategy should, in equity, be charged to the policies for whom protection is being provided". True. It is normal practice for insurance policyholders to pay insurance companies for insurance cover. In this case insurance companies provided interest rate insurance for no charge. But he continues: "and those costs would reduce the amount of terminal bonus." Here we are back to the nature of the guarantee provided.

Mr. Headdon also states: "Indeed, since the with-profits fund would have paid the derivative-writers' profit margins, there is an economic case for arguing that the attempt to hedge would, in fact, produce lower benefits." Fortunately for the still thriving insurance market, many would disagree with such a case. At a debate on 7th March "whose risk is it anyway" between speakers advocating captive insurance, derivatives, capital markets and traditional insurance, on a show of hands about eighty per cent of corporate
treasurers present voted for traditional insurance for their general insurance risk management. Nobody is obliged to buy home contents, comprehensive car, private health, travel or indeed life insurance. But many
do so and willingly pay others to manage such risks. On the other hand, many individuals self-insure. And corporations set up captive insurance companies which are fully owned by themselves.

The question of leakage of profit margins could have been addressed through the explicit or virtual setting up of a captive interest rate derivatives unit to manage the risks under the guaranteed rates policies. The beauty of the derivatives or re-insurance market is that one man's risk is another's diversification reward. Furthermore, there are many classes of borrowers that benefit from lower interest rates. Variable rate mortgages, bank, corporate or government bonds which included minimum interest rates could have been used as a source of interest rate insurance. Perfect hedging at a reasonable cost would, indeed, have been impossible. But risks could have been managed. And adding together lawyers' fees, the value of the loss of
reputation for "fair play", increased advertising spending and, inevitably, demutualisation fees we would get a figure far in excess of derivative-writers' profit margins.

There remain some interesting questions that I have yet to see answered. What valuation, at the time of marketing and sale, did insurance companies place on the interest rate guarantees provided ? Did they obtain external valuations of such guarantees in the derivatives or capital markets? What strategy did they put in place to manage the risks once they had chosen to self-manage them? What valuation did the insurance companies' auditors place on the liabilities inherent in these guarantees? And most interesting - what did the these auditors make of the nature of the guarantees provided at the time they were given?

Warren Edwardes

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