Some investors fear derivatives; regulators more so.
It's why much of the focus since the global financial crisis has been on bringing them onto regulated exchanges and getting them cleared through central counterparties. It's also why references to them can occupy a lot of space on many of the disclaimers seen on investment materials, especially if directed at retail investors.
Paul Carrett, the chief investment officer of Asian insurer FWD Group, thinks differently and says they can help insurance companies, who are by their nature long-term investors, to be more of a stabilising force during times of market dislocation.
“We have strong conviction regarding the usefulness of derivatives – sometimes they are more efficient transactionally,” Paul Carrett, the chief investment officer of FWD Group, told AsianInvestor. “We think derivatives are an important part of the financial markets so we like as much flexibility to use them when it makes sense.”
“In short, we want [the] flexibility to enter into risk-reduction transactions,” he said.
For example, using derivatives in the options market has allowed Carrett to reduce interest rate risks and currency risks.
“I am sure if you look across the industry, the biggest use will invariably be currency hedging. We want to be buying bonds where we find the best value, where the best reward for the credit risk we take is,” he said.
“Sometimes the most efficient and the least disruptive execution can be found in derivatives markets,” Carrett added.
And as FWD’s balance sheet gets bigger following its expansion throughout Asia, it is possible that the insurer will use these hedging tools even more, albeit on an opportunistic basis, he said.
FWD Management Holdings has announced its plan to acquire MetLife Hong Kong back in June.
So with a new risk-based capital regime due to come into force in 2022, Carrett said he hopes the new rules maintain an insurer’s flexibility to invest using derivatives.
The new regime has brought local insurers to review risks in their balance sheets over the past few years through two impact studies, with the last and final one launched in August. As hedging instruments, derivatives could potentially help reduce risk charges by offering protection to insurers’ investments.
“We would not want to see [new] risk-based capital [rules] disadvantage an investor’s ability to access the same investment in one form over another,” he said. “It just doesn't lead to good market outcomes.”
Were he a regulator, Carrett said, he would make sure insurers are equipped with the necessary expertise and systems to manage these assets before they participate.
Such sentiments have not fallen entirely on deaf ears.
The Insurance Authority of Hong Kong has amended the proposed rules to recognise derivatives hedging for capital relief, said Thibaut Ferret, senior solutions director for Asia Pacific at Aberdeen Standard Investments.
“For low-rated bond exposure, derivatives might be used to decrease the credit spread duration while keeping a long interest rate duration to match liabilities,” Ferret said. “This approach would allow insurers to enhance both the credit spread and interest rate risk capital charges.”
The combined capital charge of using a derivative and the asset class being hedged could end up lower than the risk charge for the asset class only, Ferret said.
However, the rules proposed to date also indicate that insurance firms will have to meet certain conditions on the derivatives instruments and the associated market risk exposure to be eligible for any relief.
KEEP IT SIMPLE
Though Carrett said he has no plan to overreach and prefers using derivatives of the plain-vanilla variety.
“The reasoning is simple: they are the most transparent, they are the most liquid, and the most cost-efficient to use,” he said.
Even though FWD might have sophisticated strategies with sophisticated management objectives, the team will “invariably use vanilla instruments.”
“We have an investment team that's heavily dominated by former bankers, and as such we have no inclination to pay excessive transaction costs for complex derivatives,” Carrett said.
Structured notes, for example, has been something that FWD stays away from, as should insurance companies in general, he said.
“We have an aversion to invest in structured notes, the reason being that sometimes the most esoteric derivatives can be put into those notes and that's not interesting to us,” he said.
The regulator seems to recognise the extra risks involved when investing in complex derivatives, too.
“If the insurance company cannot apply a look-through on a complex derivative to indicate the different market risk exposure, then the capital charge for the derivative exposure could reach 50% by default,” Ferret said.