2008 annual report contains multiple admissions that the variable annuities were not hedged and that it cost shareholder's dearly
But they are now on top of the issue and they are hedging new business
2007 annual report does acknowledge risk of a sustained equity market decline but all talk of variable annuities trumpets their abilities in the product and how quickly it was selling
Next up: Metlife
Tuesday, March 31, 2009
Monday, March 30, 2009
WSJ on life insurers
the Wall Street Journal weighs in on insurers and the risks they are carrying
just a quick survey of indices and the insurance cos gives us a good idea of what their betas are really like:
Risk management failure? Perhaps - or management actively decided to take this risk. Looks like it is time to rummage back through the annual reports to find out if shareholders were warned that these risks were being taken. After all, if we expect oil & gas and gold mining companies to reveal their hedges of future production, shouldn't we expect the same of lifecos?
just a quick survey of indices and the insurance cos gives us a good idea of what their betas are really like:
| 6m | 1y | 6m Beta | |
| S&P500 | -32% | -40% | 1 |
| DOW | -31% | -38% | |
| Manulife | -71% | -71% | 2.2 |
| Sun Life | -53% | -64% | 1.7 |
| MetLife | -62% | -64% | 1.9 |
| Prudential | -75% | -76% | 2.3 |
| Hartford | -81% | -90% | 2.5 |
Risk management failure? Perhaps - or management actively decided to take this risk. Looks like it is time to rummage back through the annual reports to find out if shareholders were warned that these risks were being taken. After all, if we expect oil & gas and gold mining companies to reveal their hedges of future production, shouldn't we expect the same of lifecos?
Thursday, March 26, 2009
Mark-to-Market (MTM)
MTM in theory makes perfect sense - it gives a sense of real-time measurement of value.
In practice, it is a completely different story. First of all, how relevant is MTM on assets when liabilities are not really marked-to-market. What do I mean? Let's talk about 2 aspects of liability MTM: interest rates and mortality tables.
Interest Rates: are the cashflows being discounted off a MTM curve? What curve should that be: a generic corporate bond curve, or could we consider that obligations of the pension are really obligations of the corporation and discount each corporation's pension liabilities off that corporation's credit curve?
While the latter makes intuitive sense (and creates more work), it results in the peversions we witnessed throughout 2008: financials in the US were recognizing huge gains from their liabilities when their credit spreads exploded.
With either choice we may be discounting liabilities using a bond curve that is not achievable for the asset managers in the real market due to duration, issuance size constraints or credit diversification constraints. Derivatives may be employed to circumvent some of these issues, which I will address in a separate post.
Mortality: Anybody who discusses mortality MTM is out of their mind. By its very nature these tables are constructed using time series data which eliminate outliers. This is best illustrated by an example: if too many people died in 2008 versus what we would have predicted by extrapolating historical death rates, we may want an extra few years of data before determining that a particular trend (say declining death rates) has come to an end. Or perhaps we are on the cusp of discovering a cure to a disease; how would we factor that into our mortality tables?
So, maybe MTM is not all it is cracked up to be. Have a look at this post on asset MTM.
In practice, it is a completely different story. First of all, how relevant is MTM on assets when liabilities are not really marked-to-market. What do I mean? Let's talk about 2 aspects of liability MTM: interest rates and mortality tables.
Interest Rates: are the cashflows being discounted off a MTM curve? What curve should that be: a generic corporate bond curve, or could we consider that obligations of the pension are really obligations of the corporation and discount each corporation's pension liabilities off that corporation's credit curve?
While the latter makes intuitive sense (and creates more work), it results in the peversions we witnessed throughout 2008: financials in the US were recognizing huge gains from their liabilities when their credit spreads exploded.
With either choice we may be discounting liabilities using a bond curve that is not achievable for the asset managers in the real market due to duration, issuance size constraints or credit diversification constraints. Derivatives may be employed to circumvent some of these issues, which I will address in a separate post.
Mortality: Anybody who discusses mortality MTM is out of their mind. By its very nature these tables are constructed using time series data which eliminate outliers. This is best illustrated by an example: if too many people died in 2008 versus what we would have predicted by extrapolating historical death rates, we may want an extra few years of data before determining that a particular trend (say declining death rates) has come to an end. Or perhaps we are on the cusp of discovering a cure to a disease; how would we factor that into our mortality tables?
So, maybe MTM is not all it is cracked up to be. Have a look at this post on asset MTM.
Monday, March 23, 2009
Fixed Income
Clearly by waiting until the market indicated the correct position we dodged a mega-bullet: the biggest single day move in Treasuries since 1962 on Wednesday. How significant is the announcement from the Fed? Have they effectively sold puts on longer-term Treasuries? The short answer is "yes".
What are the risks of this plan? By strong-arming banks into lending the Fed has basically undertaken to support the entire banking system. The money-printing press is in full swing and that once again encourages bad borrowing. At least bankers memories aren't short enough that they would engage in bad lending....again.
And of course when that war against deflation has been won (and we will not know when) US Treasuries will be revalued a la currencies in a post-Bretton Woods world.
What are the risks of this plan? By strong-arming banks into lending the Fed has basically undertaken to support the entire banking system. The money-printing press is in full swing and that once again encourages bad borrowing. At least bankers memories aren't short enough that they would engage in bad lending....again.
And of course when that war against deflation has been won (and we will not know when) US Treasuries will be revalued a la currencies in a post-Bretton Woods world.
Melt-up?
It appears we have seen the great melt-up / short-covering and the S&P struggled twice at the 805 level. As they say, third time is a charm - so do not be too surprised if we try to break that level; I am much more worried if we cannot, because I think it forbodes another test of the bottom.
Tuesday, March 17, 2009
Europe - the next shoe to drop?
I have always maintained that the situation for European banks must be as dire as that in the US and yet the ECB has done little compared to the Fed to help out the banking sector. Here comes Paul Krugman, echoing those same sentiments.
The real question is: what are the trading implications? What positions can be enacted to best take advantage of this? Short EUR/USD? What about against a cross like being short EUR/AUD or EUR/CAD? I would prefer the latter, if only that the US Dollar Index seems to be rolling over (see chart below, where uptrend has broken and MACD divergence with higher price but lower MACD).
The real question is: what are the trading implications? What positions can be enacted to best take advantage of this? Short EUR/USD? What about against a cross like being short EUR/AUD or EUR/CAD? I would prefer the latter, if only that the US Dollar Index seems to be rolling over (see chart below, where uptrend has broken and MACD divergence with higher price but lower MACD).
What about fixed income trade in Europe? Like fixed income in the US, historical volatility is dropping hard and signals like ADX and Bollinger Bands indicate that it should break soon. The only problem is that in this environment it is unclear which way it breaks (I am biased toward lower prices, higher yields).
Caution dictates waiting until the market tells us what our position should be.
Caution dictates waiting until the market tells us what our position should be.Monday, March 16, 2009
Overhaul of Risk Management?
In the wake of the financial crisis, what percentage of banks are revamping their risk management process?
0-20, 20-35, 35-50, 50-65, 65-80, 80-100???
In a recent study, 90% of banks are looking into risk management practices while only 42% expect to make any changes. Where does that leave the 48% who are looking into it, but not making any changes? I can tell you: boardroom and executive education.
How many times have we heard of executives who panic when a trader exceeds their VAR on the downside once a quarter? Or, more frightening yet all too common in the heady days of 2005-07, the executives who ignore repeated VAR threshhold violations because they occur to the upside? Everybody complains how useless VAR is, and, believe me, I am no huge fan of VAR; but most of the negatives of VAR stem from a lack of understanding of its limitations and its uses.
0-20, 20-35, 35-50, 50-65, 65-80, 80-100???
In a recent study, 90% of banks are looking into risk management practices while only 42% expect to make any changes. Where does that leave the 48% who are looking into it, but not making any changes? I can tell you: boardroom and executive education.
How many times have we heard of executives who panic when a trader exceeds their VAR on the downside once a quarter? Or, more frightening yet all too common in the heady days of 2005-07, the executives who ignore repeated VAR threshhold violations because they occur to the upside? Everybody complains how useless VAR is, and, believe me, I am no huge fan of VAR; but most of the negatives of VAR stem from a lack of understanding of its limitations and its uses.
Friday, March 13, 2009
Who controls asset allocation?
This one is classic - it is called dollar cost averaging. Now I am motivated to find a reason why dollar cost averaging is not necessarily the best strategy. Hmmm - let's say they fixed their "allocation problem" back at the end of '08 - where would they be now? Enough said.
Intelligent asset allocation means not reallocating because the market has forced you to (one asset's poor performance forces money out of other assets and back into that one in order to keep allocations level). Rather, it means shifting asset allocation because the economy / market has told you to do so (ie. it is the right thing to do).
The truth is, there is so much job/career risk driving these decisions that I am not sure intellect even enters the picture.
Intelligent asset allocation means not reallocating because the market has forced you to (one asset's poor performance forces money out of other assets and back into that one in order to keep allocations level). Rather, it means shifting asset allocation because the economy / market has told you to do so (ie. it is the right thing to do).
The truth is, there is so much job/career risk driving these decisions that I am not sure intellect even enters the picture.
Thursday, March 12, 2009
Mo' Manulife
I promised that I would share more of my thoughts about Manulife so here they are:
It is one thing, in my opinion to approach life contingencies with an actuarial mindset: historically mortality has been at this level then project changes when new info on life expectancy or new diseases emerge. It is a completely different animal to use history as a projection on the future of capital markets. Shame on you, Manulife.
- "we assumed more risk than our competitors" - that is fine, but I hope you can justify why
- "There were more features in these products—I think they probably weren't charged adequate fees for the optionality embedded in them" - are you kidding me? You created a product and are finding out that you did not charge sufficiently? Is that why we find #3:
- "they were somewhat difficult to hedge, although we've had very limited hedging, virtually none in that period" - what you mean is that you did not hedge...at all.
It is one thing, in my opinion to approach life contingencies with an actuarial mindset: historically mortality has been at this level then project changes when new info on life expectancy or new diseases emerge. It is a completely different animal to use history as a projection on the future of capital markets. Shame on you, Manulife.
Equity Rally
These kind of bounces can be characterized in only one way - a bear market rally - because the market never rallies like this in bull markets. What we have seen is a classic short squeeze. I am looking to buy the April 625 puts to change the 725-675 1x2 into a butterfly; it makes it easier to sleep at night.
Wednesday, March 11, 2009
Implied Volatility in Equities
While I do acknowledge that implied volatility in equity markets has come down quite a bit since the heady days of November, compared to any other point in history it remains at elevated levels. Perhaps one reason for this phenomenon is that insurers are getting an ugly wake-up call with respect to the risks they have been carrying on their books. Note the comments by Peter Rubenovitch, CFO of Manulife, which make it unlikely for volatility to ratchet down.
For the investor/trader who has risk capital to play with, one can create excellent breakeven strategies on the downside using 1x2 put strategies. For example, I looked at the following 3 structures (note that with yesterday's rally it has moved away from these levels slightly):
Note also that while breakeven trades may appear very attractive there is huge mark-to-market (MTM) risk, and one must be prepared to deal with those consequences.
Finally, I intend to post further comments to Peter Rubenovitch's statement but I am still shell-shocked by the idea that an insurer would conciously retain the risk on such volatile exposure.
For the investor/trader who has risk capital to play with, one can create excellent breakeven strategies on the downside using 1x2 put strategies. For example, I looked at the following 3 structures (note that with yesterday's rally it has moved away from these levels slightly):
- Buy the April 725-675 1x2 put spread for a credit of 13 - this creates a breakeven of 612 by mid-April
- Buy the June 675-600 1x2 put spread for a credit of 5, which has a mid-June b/e of 520
- Buy the December 550-460 1x2 put spread for even with a breakeven of 370
Note also that while breakeven trades may appear very attractive there is huge mark-to-market (MTM) risk, and one must be prepared to deal with those consequences.
Finally, I intend to post further comments to Peter Rubenovitch's statement but I am still shell-shocked by the idea that an insurer would conciously retain the risk on such volatile exposure.
Monday, March 9, 2009
Fixed Income Volatility
When thinking about fixed income volatility, one must recognize that the curve must be parsed in order to assess ultimate risk. The front end is highly dependent on the overnight target rate set by central banks, the back end is a commodity driven by multiple factors, such as fear, inflation expectations, regulatory regime (ie. UK pension LDI), carry considerations and investor preference. The belly of the curve is pulled by the front & back end considerations with varying degrees of strength.
So when I read a research report that tells me that the Fed has effectively sold puts on the back end by introducing the concept of quantitative easing into their player's manual, I am forced to look back at my post Macro Thoughts It is precisely at times like these, where the breadth of opinion is bifurcated and few sit in the precious middle, that makes for volatile times. Indeed, US 10y bonds found some yield resistance at 3%, and it appears bonds could break by 50bps either way in a very short period of time. Not a great time to be short fixed income volatility in the back end of the curve.
See chart here
So when I read a research report that tells me that the Fed has effectively sold puts on the back end by introducing the concept of quantitative easing into their player's manual, I am forced to look back at my post Macro Thoughts It is precisely at times like these, where the breadth of opinion is bifurcated and few sit in the precious middle, that makes for volatile times. Indeed, US 10y bonds found some yield resistance at 3%, and it appears bonds could break by 50bps either way in a very short period of time. Not a great time to be short fixed income volatility in the back end of the curve.
See chart here
Thursday, March 5, 2009
The Pendulum
"Stocks are screaming cheap" We have been hearing this mantra ever since the ink on Warren Buffett's contract with Goldman Sachs dried. Wake up people - Buffett bought call options on Goldman but he also gets paid 10% per year. Granted the notes are most certainly well offside but given the poor outcome of letting Lehman fail, I say it is unlikely that Goldman is put down to rest. The point being, given the timing Buffett got a sweet deal.
As for the rest of us, we need to recognize that every cycle resembles a pendulum. The further it gets stretched in one direction, the greater the swing to the other side when the music stops. So too in this monetary cycle. The pendulum swung much too far toward easy money and it is already pretty ugly as we are in the overcompensatory phase of that excess. How far does the pendulum swing in the other direction? We won't know for another year or two. But as a mentor of mine used to say: "those with a penchant for picking bottoms end up with smelly fingers".
As for the rest of us, we need to recognize that every cycle resembles a pendulum. The further it gets stretched in one direction, the greater the swing to the other side when the music stops. So too in this monetary cycle. The pendulum swung much too far toward easy money and it is already pretty ugly as we are in the overcompensatory phase of that excess. How far does the pendulum swing in the other direction? We won't know for another year or two. But as a mentor of mine used to say: "those with a penchant for picking bottoms end up with smelly fingers".
Wednesday, March 4, 2009
The New Mark-to-Market
Much ink has been spilled of late in Canada on the performance of the public pension plans, since OMERS and the Caisse have released their results with HOOPP and Teachers' coming up. While I read a great deal about the fact that Caisse may have overestimated their performance, much of the discussion centred around ABCP. Wherefore art the questions on real estate, private equity and other illiquid assets? How are these valuations being set?
I recently spoke with a partner at a private equity firm who told me that he wrote down their portfolio by 15% in 2008. When asked how he got to that number, he licked his index finger and stuck it in the air to indicate that the entire process is very subjective. Needless to say, the last thing we need are valuations which are determined by those people whose bonuses are dependent on said valuations.
Hence the recent discussions by FASB
https://www.fis.dowjones.com/WebBlogs.aspx?aid=DJFVW00020090219e52k000jj&ProductIDFromApplication=&r=wsjblog&s=djflbo
and
http://blogs.wsj.com/privateequity/2009/02/19/fasb-vs-pe-industry-round-two/
anybody know what the CICA is doing on this front?
I recently spoke with a partner at a private equity firm who told me that he wrote down their portfolio by 15% in 2008. When asked how he got to that number, he licked his index finger and stuck it in the air to indicate that the entire process is very subjective. Needless to say, the last thing we need are valuations which are determined by those people whose bonuses are dependent on said valuations.
Hence the recent discussions by FASB
https://www.fis.dowjones.com/WebBlogs.aspx?aid=DJFVW00020090219e52k000jj&ProductIDFromApplication=&r=wsjblog&s=djflbo
and
http://blogs.wsj.com/privateequity/2009/02/19/fasb-vs-pe-industry-round-two/
anybody know what the CICA is doing on this front?
Tuesday, March 3, 2009
Pension Funding
So companies are having a tough time in this environment; the last thing they need is to find that their funding surplus is now a massive deficit. Check this out:
http://www.chicagobusiness.com/cgi-bin/article.pl?articleId=31402
And the double whammy is key - lower interest rates means discounted liabilities have increased while lower stock market means assets have decreased.
Why do companies not understand that with pension funding on their balance sheet, they face this type of risk?
Just one aspect of growing my consulting business.
http://www.chicagobusiness.com/cgi-bin/article.pl?articleId=31402
And the double whammy is key - lower interest rates means discounted liabilities have increased while lower stock market means assets have decreased.
Why do companies not understand that with pension funding on their balance sheet, they face this type of risk?
Just one aspect of growing my consulting business.
Market bounce?
Barry Ritholtz comes up with top notch stuff day after day...here is an interesting chart:
http://www.ritholtz.com/blog/2009/03/sp-500-index-vs-200-day-moving-average/
http://www.ritholtz.com/blog/2009/03/sp-500-index-vs-200-day-moving-average/
Public Pensions - a great debate
The Financial Post has had an interesting debate on public pensions...see here:
http://network.nationalpost.com/np/blogs/fpcomment/archive/2009/03/02/counterpoint-pension-funds-are-workers-best-bet.aspx
and the first part is here:
http://network.nationalpost.com/np/blogs/fpcomment/archive/2009/02/26/terence-corcoran-the-model-that-s-killing-pension-plans.aspx
There are multiple layers of questions surrounding public plans and this touches on 2 of them:
http://network.nationalpost.com/np/blogs/fpcomment/archive/2009/03/02/counterpoint-pension-funds-are-workers-best-bet.aspx
and the first part is here:
http://network.nationalpost.com/np/blogs/fpcomment/archive/2009/02/26/terence-corcoran-the-model-that-s-killing-pension-plans.aspx
There are multiple layers of questions surrounding public plans and this touches on 2 of them:
- benefits - the benefits are too rich, as evidenced by the private sector - when was the last time you found a private sector pension plan with inflation indexing??
- investment management - is the public being well served by the investment management of these funds? let's start with the alternatives: indexed portfolios, non-risky asset investments only - the real issue is that these complaints are only surfacing after a poor year - why were these self-righteous critics not out there complaining when year after year these plans were racking up 7% returns?
Monday, March 2, 2009
Macro thoughts
Deflation vs Inflation - who will win?
Is this really in doubt? I mean, Helicopter Ben comes flying in to the rescue with thousand-dollar bills and it is all over...inflation solves many problems for the US but I have rarely read about the ills that it brings with it. Consider a retiree on a fixed pension, or the poor whose rent will potentially climb faster than their income. It is clear that inflation brings with it social unrest that will shake this continent worse than anything in its history.
Is this really in doubt? I mean, Helicopter Ben comes flying in to the rescue with thousand-dollar bills and it is all over...inflation solves many problems for the US but I have rarely read about the ills that it brings with it. Consider a retiree on a fixed pension, or the poor whose rent will potentially climb faster than their income. It is clear that inflation brings with it social unrest that will shake this continent worse than anything in its history.
Inaugural post
Welcome to my blog - my intent is to post the following:
- various thoughts on risk management in the modern world
- macro thoughts on the world economy
- various trades in the FX and fixed income worlds, which is where I come from and leads into....
who am I?
An actuary by training, I meandered through pension plan consulting and life in the back rooms of an insurance company until a position opened in the investment department. I spent a few years modelling liabilities and designing hedging strategies for those products, when I moved to the "sell-side" and made markets for clients in fixed income options and interest rate swaps. Finally, I joined a pension plan as a portfolio manager in 2007, only to have my tenure there cut short in December 2008 due to current market conditions. I am now an independent risk management consultant with (in my opinion) a unique perspective on the world of money due to my varied work experiences.
- various thoughts on risk management in the modern world
- macro thoughts on the world economy
- various trades in the FX and fixed income worlds, which is where I come from and leads into....
who am I?
An actuary by training, I meandered through pension plan consulting and life in the back rooms of an insurance company until a position opened in the investment department. I spent a few years modelling liabilities and designing hedging strategies for those products, when I moved to the "sell-side" and made markets for clients in fixed income options and interest rate swaps. Finally, I joined a pension plan as a portfolio manager in 2007, only to have my tenure there cut short in December 2008 due to current market conditions. I am now an independent risk management consultant with (in my opinion) a unique perspective on the world of money due to my varied work experiences.
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