Executive summary
This is an update of investment market movements over the last five years and of economic conditions as at June 2010 for the UK economy.
Equity markets fell with the FTSE-100 decreasing from 5413 at the end of December 2009 to 4917 at end of June 2010. Equity implied volatilities at June 2010 have increased after a dip between June 2009 and December 2009, but have not yet reached the levels observed at the end of 2008.
The Bank of England base rate remains at 0.5% and this has kept short term gilt yields low with an upward sloping yield curve. At medium durations, the yield curve has decreased with yields nearing 4.5% between terms 12 and 25 years compared to 5% at December 2009. At long durations, the yields have remained constant compared to December 2009. Swap yields are higher than gilts at the short end, but still below gilt yields at the long end. The crossover point for the swap and gilt curve is now 10 years, similar to that observed at December 2009.
The value of maturity guarantees on with profit funds will have risen slightly due to lower asset share values and higher asset share volatility. GAO costs will most likely have decreased due to lower asset share values and lower swaption volatilities
1. Market analysis
1. Equity Markets
1.1.1 Equity Market Prices
The FTSE-100 has decreased by almost 10% while the Datastream UK Total Return Index1 has decreased by 6% in the 6 months from December 2009 to June 2010, meaning the index is still far below the highs reached in the middle of 2007.
1.1.2 Equity volatility
The benchmark option that many insurers use is the implied volatility of a 10 Year FTSE-100 Capital Index forward at-the-money option. The equity implied volatility at June 2010 has risen by around 2% compared to December 2009 and remains above the rates prior to 2008. The quotes from investment banks for the benchmark option were within a tight range. The implied volatility over the past five years is shown in chart 2
1.2 Bond markets
1.2.1 Yield curve movements
Over the last six months, the UK gilt yield curve has decreased significantly for terms up to 10 years. The yields at mid terms have fallen by up to 57 basis points (that is, 0.57%) while long term yields are almost unchanged from December 2009. As at June 2010, the yield curve starts at a very low 0.5%, however, rises to 4.5% for mid and long terms. The yield curves below are constructed with government bonds only and do not consider rates for very short investments.
Chart 3 illustrates the yield curve movements over the last three years.
Following the worst point of the credit crunch in the autumn of 2008, the spreads on swaps relative to gilts narrowed for all terms. Furthermore, the spreads are still negative for longer terms with crossover term of 10 years. This effect is described in more detail in our note "Swap spreads – Why have they become negative"2 dated December 2008
1.2.2 Bond price movements
The decrease in yields for short and mid terms over the last six months has caused gilt prices to rise. For example, the value of a gilt with 15 years to maturity and a 5% coupon has risen by 5.7% over the last six months. Taking into account the coupons received, this gilt's total return would have been approximately 8.2% over the last six months. The return on longer gilts would have been lower, reflecting the greater stability in the long end of the curve.
1.2.3 Swaption implied volatility
Sterling swaption implied volatilities decreased from December 2009 to June 2010 except for short option and swap terms. Our benchmark 15 year into 20 year at-the-money swaption implied volatility has decreased by around 2% measured in absolute terms.
The following chart shows changes in the benchmark 15-year into 20-year swaption implied volatility over the past four years. From this chart it can be seen that after the recent 4% fall, the benchmark volatility has returned to levels regarded as normal prior to the credit crunch.
1.2.4 Bond volatility
The swaption volatility has implications for the prospective volatility of bond prices. Using some approximate calculations we found that the volatility of the 10 year ZCB Constant Maturity Bond Index has decreased by 0.9% in absolute terms over the last six months as shown in chart 6.
Using some approximate calculations we found that the volatility of the 10 year ZCB Constant Maturity Bond Index has decreased by 0.9% in absolute terms over the last six months
2.1 Maturity guarantees
2.1.1 Returns
For a UK with-profits fund with a 60% Equity Backing Ratio (EBR), and the remainder invested in a 5% 15-year gilt, the last six months saw a negative return of 0.5%. This decrease in asset share is mainly due the fall in equity but limited by the increase in bond prices.
2.1.2 Asset share implied volatility
Asset share implied volatility depends on many factors. We give a simplified example to show how market values have moved using the equity and bond volatilities cited above.
Assuming zero correlation between medium-term bonds and equities, the volatility of an asset share with a 60% EBR has slightly increased over the last 6 months. The increase of 1.2% in absolute terms and can be attributed to the rise in equity volatilities.
The calculations above used the 10 year ZCB Constant Maturity Bond Index volatility described earlier in this Report
2.1.3 Maturity guarantee value
Where maturity guarantees are currently out of the money, the small decrease in asset share values is likely to have moved them towards the guaranteed level, increasing the cost of those guarantees.
The change in value of a 10-year put option on an asset share that was at-the-money spot on 31 December 2004 can be calculated approximately. This example gives an indication of how the changes in asset share volatility and asset values could affect a maturity guarantee.
The strike value for the put option in these calculations is £100. (We have assumed that the strike price remains constant in the single premium maturity guarantee calculations below. In practice the strike price would probably have risen in line with reversionary bonus awards.) The asset share is assumed to be £100 at 31 December 2004 and, ignoring premiums and charges, would have grown to £133 by 30 June 2010.
In our example, the small decrease in asset share values and the increase in asset share volatilities have increased the value of the guarantee from December 2009.
2.2 GAO contracts
With most GAO contracts held by UK Life insurers heavily in the money, the yield curve is a key factor in determining the amount of reserves required for GAO liabilities. If no change had been observed in the yield curve, we would expect GAO costs to decrease, due to the lower swaption volatility. However, some of this decrease has been offset by the rise in long-term forward rate As a first example, we have calculated the price of an at-the-money 15-year into 20-year swaption contract over the past three years. The swaption price is based on £100 nominal.
Our simple example shows a small decrease in the swaption price over the last six months to the end of June 2010 mainly due to the decreased swaption volatility
For many offices whose GAO contracts are well in the money, a more meaningful comparison may be the change in the price of a forward swap contract. We have calculated the value of a forward swap contract (15-year forward, 20 years duration) with a fixed 8% strike rate. The swap price is based on £100 nominal.
The value of the swap has decreased by approximately 6% over the last six months. This is due to the shape of the yield curve with forward rates increasing for longer terms as opposed to December 2009. Chart 10 shows changes in the value of the forward swap over the past four years
As a final example we try to take account of the effect of Asset Share growth on GAO values. In the graph below we have combined the growth in the Asset Share with the change in value of a forward swap to estimate the increase in value of a GAO.
The GAO value in this example has decreased by around 6% over the last six months and is now similar to values seen in 2007 and 2008. This fall again is due to the change in the yield curve shape as well as the lower asset share return. Chart 11 shows the value of this contract over this period.
Footnotes
1 The Datastream UK Total return index tends to be more representative of insurers' exposure as it is derived in a similar way to the FTSE-100 but includes the reinvestment of dividends
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.