Managing Interest Rate Risk: A Case of IFFCO Tokio General Insurance Company
FICCO Tokio General Insurance was incorporated on December 4th 2000. It was established as a joint venture between the Indian Farmers Fertilizer Co-operative (IFFCO) and its associates and Tokio Marine and Nichido Fire Group, Japan.
Like other insurance companies, the role of IFFCO Tokio was absorption of non-life risks. The major issue which IFFCO Tokio was facing, same as with other insurers, was managing the liability payments which at times can be highly variable due to completely unknown business risks as well as contractual nature of obligations. Being a non-life insurance company, the investment policy of IFFCO Tokio could not be the same as any other life insurance company.
Apart from this, the key issues like long tail in claims reporting, processing and payments as well as an underwriting cycle could not allow a long duration of liabilities.
The key objective in front of the company was managing risks efficiently and so as to deliver maximum profit to the shareholders. The major composition of portfolio of general insurance companies and hence of IFFCO Tokio was to be comprised of Central Government and State Government securities. Although these kinds of securities did not bear any default or credit risk, they were exposed to interest rate risk and reinvestment risk. The major issue in such securities was an inverse relationship between the interest rate risk and reinvestment risk. When interest rates increase, bond prices decrease giving better reinvestment return. But in case of decrease in interest rates, bond price increase leading to a capital gain and also increased reinvestment risk.
Given that the insurance companies have large amount of corpus fund which increases daily and which should be invested with top priority, a small change in the interest rates can impact their profit either positively and negatively. A number of factors can lead to interest rate risk and hence affect the portfolio of insurance companies. The portfolio of investment assets of IFFCO Tokio GIC stood worth INR4368 crore and the benchmark yield was 9.16% for the FY 2014-15 which further increased to 9.31% for the FY 2015-16....................
Background
In June 2014, the Insurance Regulatory and Development Authority (IRDA) had allowed insurers to invest in interest rate derivatives for hedging against interest rate risks in their transactions. Such derivatives helped life insurance companies a lot to hedge the interest rate risk, because their liabilities were long term in nature. Any change in interest rate could impact their future value of investments...........
IRDA Guidelines on Investment Portfolio for General Insurance Companies and IFFCO Tokio’s Portfolio
As per IRDA regulations (Appendix I), all the general insurance companies shall invest and at all times keep invested its investment assets in Central Government securities, (not less than 20%) State Government securities and other approved securities.............
Investment Portfolio of IFFCO Tokio GIC
Total amount of investment by IFFCO Tokio was worth INR4,831 crore as on March 31st 2016. Total investment in Bond market including Central Government securities & State Government securities was INR1,515.58 crores, i.e. 32% of the total investments (Exhibit III). Minimum amount required by IRDA was 30% of total investment to be invested in Central Government securities & State Government securities. IFFCO Tokio had invested more in corporate bonds which gave more return as compared to the government bonds............
Interest Rate Swaps – Its use for IFFCO Tokio GIC
Total investment of IFFCO Tokio in fixed rate bonds was INR1515.58 crore and the average yield from these bonds was expected to be lower than the average investment yield of 9.31% because GOI bonds always had lower yield compare to any other bonds and the yield was 8.20%. The returns from bonds were fixed. As a result, when interest rate increased, it affected opportunity cost of holding the investment with less interest rates because market interest could become more than the interest IFFCO Tokio got from the fixed rate bonds............
Structure of 1-year Interest Rate Swaps and their use for swapping interest rates
Considering a decline in short term rates, in order to offset the interest rate risk underlying the portfolio of short term instruments paying floating rate of interest, IFFCO Tokio decided to use 1-year IRS.........
Assumptions:
• The swap would be structured as a 1-year fixed interest rate swap, paying floating rate of interest and receiving fixed rate of Interest. Payments were to be made daily.
• Last quote on April 11th 2016 of 6.54% was to be taken to calculate IRS for receiving the interest payments which would be constant throughout the year.
• ............
Structure of 3-5 year Interest Rate Swap and its use for swapping interest rates
The second kind of swaps used by IFFCO Tokio was a 3 year and a 5-year swap. This was used to hedge long term fixed rate bonds. Long term rates were expected to increase hence, this was constructed as a payer swap involving..........
Assumptions:
• The swap was a 5-year fixed interest rate swap. Last quote on April 10th 2016 of 6.54% was taken to calculate fixed rate of IRS for paying the interest payments which would be constant for next 5 years.
• ............
Interest rate Swap to hedge a portfolio of 5-year 8.27% G-Sec 2020 for rising opportunity cost of holding the bond
Whenever a fund has been lying idle, it incurs an opportunity cost. So if funds are not utilized, companies lose interest payments, thereby decreasing their profitability drastically particularly for insurance companies. Insurance companies have current accounts with their banks which do not yield any return because it is a current account............
Swap to Hedge Bond Portfolio
IFFCO Tokio decided to use the following hedge to protect against interest rate risk of 8.27% G-Sec 2020
• Notional Principal in the swap was INR10 crore.
• This swap creation assumed that INR10 crore was invested in 5 Years residual maturity, benchmark security 8.27% GS 2020 with yield of 7.7541 %
• ..........
Assignment questions
I. What is the difference between liabilities’ and assets’ portfolios of life and non-life insurance companies?
II. What is the significance of underwriting cycle in case of non-life insurance companies?
III. What are the factors affecting interest rate risk?
IV. ...........
Exhibits
Exhibit I: Interest Rate Risk and How IRS Helps
Exhibit II: Yield Movement of 10-year Benchmark Central Government Securities (FY 2016-2017)
Exhibit III: Total Portfolio
Exhibit IV: Bond Portfolio
Exhibit V: Investments based on Residual Maturity