Italy’s insurers turn to derivatives

Italian insurance companies are facing new regulations requiring them to monitor the balance of their assets and liabilities on a constant basis. Industry analysts believe this will lead to more insurance companies using options for asset/liability management (ALM) – good news for derivatives dealers. 

The Rome-based industry regulator, the Istituto per la vigilanza sulle assicurazioni private e di interesse collettivo (ISVAP), hopes to safeguard the stability of the insurance system by guaranteeing that insurers are able to deliver the returns they promised policyholders. 

ISVAP’s ALM project head, Fausto Parente, says this regulatory initiative originated last year amid concerns about insurers’ exposure to interest rate risk. 

Many of Italy’s 245 insurance companies are newcomers to financial derivatives. Their investment approach, like that of many other insurers across continental Europe, has traditionally been very low risk, with the vast bulk of the assets held in domestic government bonds. 

Since the introduction of the euro, however, the environment has changed. Until 1997, interest rates in Italy stood at over 10%, while a typical life insurance contract offered a guaranteed annual minimum return of 4%. Delivering on the promises was not difficult. Today, expected returns on bond holdings have fallen to 5%, while minimum guaranteed returns on new life policies are down to 2–3%. It’s the volatility of equity returns that makes the delivery of promises difficult. 

Laura Pace, a derivatives sales professional at Caboto, Gruppo Intesa’s Milan investment banking arm, says only a handful of Italian insurers use derivatives, primarily for plain vanilla tools, which are mostly currency swaps rather than structured products.

By law, Italian life insurers’ foreign currency exposure is capped at 5% of total assets, and firms must hedge any exposure exceeding this limit. Typically, insurers use plain currency-by-currency derivatives, mainly forward contracts, and roll over the entire hedge every four or six months. 

However, even Rome-based INA Generali, acknowledged as the most sophisticated derivatives user among Italian insurers, has only used plain vanilla derivatives to replicate the insurer’s life insurance policy portfolio. (INA merged with Generali last February, creating Italy’s largest insurance group. The company says its derivatives strategy is under review.) 

“Our policy at INA was based on plain derivatives, because to use more exotic derivatives you need a specific need and an understanding of the pricing of these instruments,” says Claudio Giraldi, chief executive officer of Capital Management Advisors (CMA) in Rome, and formerly head of capital markets and ALM at INA. Giraldi established CMA, as part of Arthur Andersen, in September to provide
specialised asset management advisory services. 

The former INA, for example, almost fully hedged its currency exposure. This was a function of regulatory constraints, but also of its belief that there was not much money to be made in foreign-exchange markets, says Giraldi. 

Looking ahead, Italy’s insurers will probably use currency derivatives even more intensively, as their business activities become increasingly international and firms raise their foreign investments further to boost returns and diversify risks.

The other major use of derivatives by the insurers is to hedge specific products. Toro Assicurazioni, one of Italy’s larger insurance companies and part of the Fiat Group, for example, protects structured products such as index-linked policies from exposure by hedging with options on single stocks or stock indexes, says Stefano Borre, head of treasury at the insurer in Turin. It also buys floors to protect the minimum guaranteed returns on individual life insurance contracts, which can vary from 4% for older policies to 2.5% for the most recent ones. 

Fideuram Vita, the life insurance arm of Banca Fideuram, typically purchases structured bonds to hedge obligations arising from index-linked policies, according to Gianluca La Calce, head of portfolio management at Fideuram Capital in Milan. Fideuram Capital, the asset management arm of Banca Fideuram, runs group and third-party assets.