11 March 2013

Risk.net: OTC reforms present technology challenges for insurers

Wide-ranging changes to the OTC derivatives market are leading insurers to upgrade their collateral management systems, often quite substantially. But the complex requirements and computational power needed are providing a challenge - not just for insurers but also for software vendors.

Profound changes are underway in the over-the-counter (OTC) derivatives market, which will have far-reaching implications for insurers that use swaps and other derivatives products to mitigate their risks. Pricing of even the most standard interest rate products has become much more complex since the financial crisis when the basis between the overnight index swap (OIS) rate and Libor blew out and diverged massively, leading to the need for multi-curve models to price even vanilla swaps.

But that is not all. Quoted derivatives prices now often factor in adjustments for credit risk and funding costs. Meanwhile, the move to central clearing of standardised derivatives means initial and variation margin is now required on most deals. Furthermore, the new central counterparty (CCP) clearing organisations are putting stringent criteria on what they will accept as collateral.

If insurers want to check the derivatives prices dealers are now quoting, they need considerably more sophisticated and powerful technology than they have traditionally had at their disposal. The same goes for the ability to calculate likely initial and variation margin. Meanwhile, the overall increase in the demand for collateral, as well as the more specific and restrictive requirements of credit support annexes (CSAs) to derivatives master agreements that dictate what assets can be posted, require more efficient management of eligible assets than has previously been the case.

Where insurers and their asset managers have bitten the bullet and addressed these issues, they have found the need to upgrade their systems substantially or acquire new ones. In some cases, this has meant turning to specialised OTC derivatives and collateral management systems originally developed for the sell side. This presents a challenge for technology vendors as well - traditional buy-side system vendors have to add capabilities for complex pricing, while sell-side vendors have to adapt their systems for the more limited budgets and IT resources that insurers generally have compared with banks.

The days of insurers entering a swap deal based simply on quoted price when looking to hedge their exposures are fast disappearing, warns Satyam Kancharla, chief strategy officer and senior vice-president of the client solutions group, at New York-based pricing and risk software supplier Numerix.

The best way for an insurer or other buy-side firm to know that it is being offered a fair price - taking collateral, credit-value adjustment and other factors into account - is to be able to replicate the pricing calculation of the counterparty banks, says Mike Walsh, head of solutions distribution and management at London-based Legal & General Investment Management (LGIM). "We recognised early on that we needed sophisticated systems to keep banks fair in terms of pricing and to be at the cutting edge versus our competition", says Walsh.

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