A New Tool to Manage the Impact of Spread Compression on Index Annuities
Credit Suisse teams up with Salt Financial on a risk management strategy for insurance products being crushed by low interest rates
Friday, December 11, 2020
By Michael Shari
The COVID pandemic has caused a crueler drop in sales of fixed index annuities (FIAs) than insurers have seen since the Great Recession, creating a new opportunity for inventive managers of strategies that use derivatives to manage the risk of investing in the equity market.
According to the Life Insurance Marketing and Research Association (LIMRA), the top 20 carriers of FIAs sold $36.17 billion of the annuities in the first three quarters of 2020, barely half the $71.37 billion reported for the 2019 period.
This is hurting insurers that sell these products, mainly to retirees and managers of retirement accounts, according to sources at Standard and Poor's and at Credit Suisse and Salt Financial, which have come up with a strategy that uses high-frequency intraday pricing to invest in index options for FIAs.
The causes are two-fold: Low interest rates are causing spread compression that cuts into profits; and fears of infection have put a stop to the face-to-face meetings through which FIAs were traditionally sold to clients.
In response, the banks that have traditionally sold options and other derivatives that insurers use to build FIAs are working with risk managers to find innovative ways to use derivatives in FIAs. These products purportedly mitigate the downside risk of investing in an index and are still profitable for the insurers.
However, insurers are reluctant to purchase new risk management products that banks are developing in-house because they are perceived as “black boxes” with insufficient transparency.
Focus on Index Cost
Determined to stay in the FIA market, Credit Suisse responded to what Tre' DePietro, director of insurance derivatives and financing at CS in New York, says was a perception among some insurance carriers that there was more transparency in collaborations between banks and index providers working together than in in-house black boxes.
“We wanted to focus on something different - the cost of the index itself,” DePietro says.
CS and Salt Financial developed a new Quantitative Investment Strategies (QIS) product that DePietro and Salt CEO Tony Barchetto say responds to the budgetary concerns of insurance carriers by lowering the cost of providing index options in FIAs while maximizing returns.
Their strategy, DiPietro claims, will “increase substantially” the sales of FIAs and, in turn, revenue for insurance companies by making the annuities more attractive to retirees and other buyers. The attractiveness lies in an improved participation rate, which is the percentage of the gain in an index that an insurance company credits to an annuity. The key was in determining the level of volatility risk that the product was intended to manage.
“When you buy an option in the QIS strategy, the payment on that option is a perfect hedge,” DePietro says. “If you buy an option on the CS Salt Index, the payment that the option purchaser will get will be the exact payout of that index.”
Newly Designed Strategies
The product was announced on November 5, with a press release stating, “Their [CS and Salt] association is expected to result in the development of newly designed systematic strategies harnessing Salt's intellectual property on risk regime identification and volatility control mechanism.”
The offering employs Salt's truVol technology to invest in index options, and it adds a futures overlay. DePietro and Barchetto declined to discuss in detail how the QIS product works or name the index that it tracks, citing its proprietary nature.
They did say that it offers superior risk-adjusted returns. To illustrate this point, Salt claims that its truVol model for the S&P 500 Total Return Index has a Sharpe ratio of 0.79%, compared with “historical volatility” of 0.54%.
Although Salt did not design truVol to be market neutral, QIS is hedged with bespoke options on the index it tracks. Lowering the volatility target is one of the methods truVol uses to lower the options cost. Clients have already signed up for it, they said, declining to identify them.
“TruVol allows you to work with a lower volatility target yet be more efficient in harvesting returns,” Barchetto says.
Pullback in FIAs
The impact of interest rates and volatility in the equity market can be unpredictable. In March, FIA sales actually rose, according to a LIMRA report, even as the equity market was in the midst of a historical decline, and the 10-year Treasury rate had fallen by 115 basis points from January 13 to March 31.
Yet the drop in FIA sales this year has had at least a “marginal” impact on insurers' bottom lines, says Carmi Margalit, analytical manager for life and health insurance, Standard & Poor's Global Ratings. Thus far, the measurable impact has not warranted lower outlooks or ratings for insurers, though S&P is keeping a watchful eye on it.
“A couple of companies surgically decided to step back from that market, so there is less supply. A few companies stayed in the market,” Margalit says.
During the first nine months of 2020, the FIA market leaders were Athene Annuity & Life Co. and Allianz Life of North America, with $3.98 billion and $3.90 billion in sales, respectively, according to LIMRA. Those leading during the same period in 2019 - Jackson National Life, at $11.0 billion, and AXA U.S., $8.59 billion - were not even among the top 20 a year later.
For more insurers to see FIAs as being worth the risk of managing them, it will take more than “a shiny new product” developed by banks and indexers, Margalit contends. In other words, interest rates will have to rise - a step that would undoubtedly be preceded by other developments, such as the widespread distribution of a COVID vaccine and a dramatic improvement in employment levels.