Investment banks push CPPI innovations

Creative thinkers are inventing new variations on Constant Proportion Protected Insurance to enable insurers to hedge guaranteed products and avoid the danger of a cash lock-out.

What is making a mainstream comeback in the world of insurers is Constant Proportion Protected Insurance (CPPI), which is an algorithm designed to hedge guarantees without using traditional options-based theory.

CPPI has been bouncing around the insurance market in Asia for several years, but no one really took an interest in it to hedge insurance-linked products until the market crashed in late 2008. Now it has gone full circle.

In a term-guaranteed product through the CPPI algorithm, there is an intermittent rebalancing between a risky and a risk-free asset, depending on the state of the market.

“The money is actively managed between the two on a daily basis,” explains one investment banker. “Once the market has established an upward trend, funds are reallocated. In a down-trending market, money from the risky asset is reallocated to the risk-free to achieve the term guarantee.”

Time-varying Proportional Portfolio Insurance (TPPI) is similar but is designed as an open-ended solution that will generally guarantee about 80% of the net asset value (but never 100%).

A downside of CPPI is the potential for a cash lock-out: if the market tanks, everything is shifted into the risk-free asset. In a term-guaranteed product, this results in all the money being locked up in a zero coupon, with no possibility of rebalancing. With a TPPI product, the risk-free asset would have a money-market characteristic which earns interest, meaning a rebalancing back into the risky asset would be a possibility at a future date.

Now there is a second generation of tools being developed by investment banks to make CPPI products more robust using volatility control overlays. These essentially reduce the probability of cash lock-out.

A third and latest generation introduces micro CPPI, which individualises the risk management tool to the individual policy level, with investment banks generating tens or even hundreds of thousands of CPPIs all at the same time.

Asked if he expected CPPI and micro-CPPI to grow in popularity, the banker says: “I can’t understand why it would not. With CPPI you have a known-known in terms of costs. With options you don’t. I believe micro-CPPI is the answer to VA.”

This trend towards CPPI in Asia is being driven by multinational insurers who need to comply with new risk and capital measures which come into effect at the end of next year under Solvency II in Europe.

Because CPPI calculates the level of guarantee required at any point in time – unlike, say, death benefits where you only work out your risk at the moment of death – the insurer can plan precisely on a risk-adjusted return basis.

One drawback for consumers is that they feel they have lost control of their investment choices when rebalancing occurs, and they resent being in a zero-coupon when cash lock-out happens (although micro does offer some flexibility).

“But it gives them more peace of mind,” says the banker. “If the market tanks, [insurers] are going to have the right amount of capital or buffers to provide the VA.”

A number of international insurers are known to be deep in discussions with regulators across Asia’s more mature markets to bring in the latest CPPI products. “We have got a handful of countries today in which we are right on the verge,” says the head of sales at one international insurer.

As an indication of how accepted CPPI is now as a VA solution, Chinese regulators recently issued draft regulations to allow insurers to hedge guarantees in capital protected products in one of two ways: using options, or CPPI.

“Investment banks are talking to a ton of insurance companies in China,” says a source. “I don’t think it is any secret that every insurer is looking at it right now.”

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