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“Progressive History” of Insurance’s Entry in Derivatives Market

Fang submitted 2021-09-07 10:00:28

It has been exactly one year since insurance institutions entered the market of government bond futures.

Although not long, insurance institutions have entered the stock index futures market for 8 years. As a "big man" in the financial market, insurance institutions have higher requirements for income stability and risk management due to the requirements of capital attributes. In the process of using financial derivatives, it has played a role in the rich allocation strategy of derivatives and risk hedging, and it is becoming an increasingly important participant in the derivatives market.

In the past ten years, the income has increased and the effect of the derivatives has appeared. Investors changed their cautious attitude and actively encouraged investment managers to use stock index futures. However, as more and more insurance institutions begin to explore the use of derivatives, calls for further improvement of the derivatives market varieties and rules have gradually increased.

The reporter's interview found that institutions generally feel that: the variety of the derivatives is not abundant, and the red line that pension funds cannot be used for long-position hedging of stock index futures, restricts the space for the investors to operate. Several interviewees told reporters that they hope to increase the variety of stock index futures, such as the science and technology innovation board and the ChiNext stock index futures, and also look forward to increasing the number of hedging underlyings.


Gradually enter the derivatives market and increase returns

Insurance institutions have gone through a process of gradual liberalization when entering the market for derivatives.

In 2010, China's stock index futures were launched, and the Shanghai and Shenzhen 300 stock index futures were officially listed for trading. Two years later, the former China Insurance Regulatory Commission issued the "Regulations on Insurance Funds Participating in Stock Index Futures Trading", marking that insurance funds were officially allowed to participate in stock index futures trading.

And in 2013, the government bond futures trading had been rebooted. Only in 2020 the insurance companies had been allowed into the government bond futures market.

The reporter learned that in only one year, some insurance institutions have begun to use government bond futures for multiple purposes. An asset management company disclosed that it is currently in the process of applying for eligibility. The preparations for the system have been basically completed, and in the future it is ready to actively participate in government bond futures trading.

In contrast, after years of evolution, stock index futures have become an important tool for insurance institutions to enrich their allocation strategies and hedge their risks.

Taking the China Securities 500 Index as an example, the long-term discount range was 10%-12% before, and it is currently 5%-7%. If an insurance institution uses the CSI 500 Index as the benchmark and long-term holding a long position in the CSI 500 stock index futures, the long-term allocation of insurance institutions is more meaningful.

From a bearish perspective, insurance funds mainly use stock index futures for long-term portfolio risk smoothing and expansion strategies for income sources. At present, insurance institutions participate more in A-share new IPO share purchase, and the successful rate of offline IPO share purchase is higher, and the income is relatively certain, but the renewal has requirements on the market value of the other stocks positions. Institutions can use stock index futures to hedge against the risk of market value fluctuations in new open positions. This is equivalent to if the stock positions partly lose money, the futures part will make money, so as to ensure that the overall market value of the holding positions does not lose. And if the hedging strategy is appropriate, and futures may be used to increase the overall profits.

Regarding the effect of using stock index futures for hedging, a certain pension fund began to formally operate and operate hedging strategies in February this year. Judging from the performance of products using hedging strategies, most of the company's products are benchmarked against the CSI 300 Index. From February to July this year, the CSI 300 fell by about 6%. In the same period, the company's hedging strategy return rate was higher than 2%, showing a certain income enhancement effect relative to the underlying index. At present, the funds using such hedging strategies are still increasing steadily.

An asset management company also took a positive attitude towards the application of stock index futures. In 2015, they issued the first quantitative hedging portfolio insurance asset management product in the insurance asset management industry. In 2017, they issued the industry's first quantitative hedging equity pension product. In 2019, they also allocated stock index futures in the occupational annuity.

In the opinion of the relevant person in charge of that fund, the use of derivatives for risk control helps the market to maintain stability. When there is a major decline in the market, he will not directly reduce the stock positions, but to use more derivatives for hedging operations.

The person in charge explained that this situation is due to systemic risks caused by short-term market fluctuations, not because of the fundamental changes in the stock itself. If you sell the stock, you may have to buy it back after the volatility ends. If the position is relatively large, the cost of this process is very high, so in many cases, futures will be used for hedging.


Pension and annuity investment "embrace" derivatives, and short-term assessment pressure is high

Among all types of insurance funds, pensions and annuities have higher requirements for risk control and return stability, hence there’re higher requirements for the use of derivatives in the management process.

Annuity and pension management institutions are also undergoing a "offensive and defensive" change in customer attitudes in the trial phase of the application of derivatives.

According to the relevant person in charge of an asset management fund, the use of stock index futures in the annuity management industry has been relatively active in the past two years, mainly due to the good results obtained from the application of stock index futures in annuity management in the past few years.

Take the industry's first quantitative hedge pension product as an example. Since its establishment, the annualized rate of return has exceeded 8%, the maximum drawdown is around 4%, and the risk taken is relatively limited. Quantitative hedging pension products are biased towards absolute returns. Many trustees are optimistic about these products and hold them for a longer time.

The process of funds using stock index futures tools for annuities is gradually advancing. Annuity customers for certain funds are all entrusted by third parties, and the principal or agent entrusts the annuity assets to a legal person trustee institutions (referred to as the trustees) that meets the national regulations. The trustee is generally a bank or pension insurance institution. The trustee then signs an investment management contract with the investment manager. The asset management company plays the role of an investment manager.

The department of the relevant person in charge is mainly responsible for annuity management. According to his introduction, the assessment cycle of annuities is shorter than that of other insurance funds. The assessment period for insurance funds generally may be 3 to 5 years, but the longest assessment period for annuities is only one year.

In addition, due to the general public perception that “annuity money cannot be lost”, Annuity investors pay more attention to the absolute returns.

Under this kind of assessment pressure, customers ultimately compare the absolute income levels of the annuity managers in a short period of time. Even if the overall market declines, positive returns needed to be guaranteed, and financial derivatives play an important role. If there is a sharp decline in the market, derivatives can be used to hedge against the downside risk of market.

However, the short-term assessment model also brings challenges to the investment management of the institution. The assessment mode has become a major factor affecting investment operations. Under the model of pursuing absolute returns, many investment managers will inevitably rely more on timing of the trade, chase the hot stocks, and deviate from the originally set investment scope. The current short-term assessment pressure in the annuity industry has caused annuity management institutions to pursue short-term gains, making it difficult to truly make long-term investments, and it also affects the long-term capital attributes of insurance funds.

To solve this problem, we need to work hard on investor education. We can refer to the life cycle or target date management mode of foreign pensions. In foreign countries, the pension management model is generally divided into several different grades according to the life cycle of customers, and different asset allocations are carried out. Among them, for the age group between 25-35 years old, the risk tolerance level is the highest. At this time, pension assets can be allocated with a higher upper limit of equity exposure. Since then, as the age increases, the equity ratio of pension assets will automatically shrink when they are 35-40 years old. By the age of 60 and 65, the equity ratio drops to zero and only a fixed income assets can be allocated.

The assessment cycle under this foreign pension management model is also relatively long-term, and may be a cycle of 5-10 years. Different assessment standards are carried out for the corresponding risk levels of different age groups. In this case, the investment behavior of the pension management institutions can also be more long-term oriented.


The cost of hedging is high, and institutions look forward to the “unwinding” of insurance long hedging limit

At present, China's financial derivatives cover three major stock index futures varieties: one option product and three government bond futures products, forming a basic framework. This is not enough in the view of the institutions.

The current requirements for futures-spot matching imposed some restrictions on institutions. The index constituent stocks of the three listed stock index futures are in the same scope as the constituent stocks of the CSI 800 Index. Under the requirements of futures and spot matching, if investors want to short stock index futures, investors must hold 800 constituent stocks of the China Securities Index, which means that only 800 stocks can actually be hedged.

There are more than 4,000 A-share stocks. With the development of the A-share market, including the implementation of the registration system, the number of targets that need to be hedged has far exceeded the CSI 800 constituent stocks. Institutions wish to have more diversified hedging instruments.

If the CSI 1000 Index is included, then 1,800 stocks can be hedged.

Nowadays, the high cost of using stock index futures to hedge has also become a problem for institutions.

In hedging products, institutions hold long stock spot positions and short stock index futures with the similar market value. The discount on stock index futures is the cost of hedging operations. Taking the CSI 500 as an example, assuming that the stock spot long positions with the CSI 500 index as the tracking benchmark can generate 15% excess returns in a year relative to the benchmark index, the annualized hedging cost of the CSI 500 stock index futures is calculated at 7%. The 15% yield is 8% after subtracting 7% hedging cost. Calculated on the basis of 70% of the position ratio, only 5.6% remains. After deducting management fees, custody fees, etc., the final rate of return is only about 5%, and the cost-effectiveness of the entire product is greatly affected.

The institutions believed that the main reason for this result is that the entire market now has fewer tools for hedging. A large amount of hedging demand is concentrated in the stock index futures market, leading to long-term mismatch of the long and short forces in the stock index futures market.

To put it simply, long hedging is to lock in the future buying price at the current point in time. Assuming that the Shanghai and Shenzhen 300 Index is currently 5000 points, the price of the stock index futures contract is 4800 points, and there is a discount of 200 points. At this time, investors can buy stock index futures at a cheaper price, and expected future futures prices will return to the index spot price. The part of such futures converge to spot is the excess return.

Under the premise of the existence of futures discount to spot, if an institution spends part of its funds for long-term long hedging, it can earn a stable excess return that exceeds the index increase. However, the current regulations have drawn a red line, and pension management agencies cannot carry out long-term long hedging operations. This makes it impossible for institutions to earn excess returns through such operations. To enable the long hedging has become another big expectation of institutions.

China's derivatives market system, rules, and varieties are in the process of continuous improvement and innovation. Looking ahead, with the advancement of financial system reforms and the development of the financial derivatives market, derivatives will play an increasingly important role in the modern financial system.

Jiang Yang, former vice chairman of the China Securities Regulatory Commission, once referred to the derivatives market as the risk management financial market, juxtaposed with traditional indirect finance and direct finance. The three markets have different functions. The indirect financial market focuses on bank financing, the direct financial market focuses on capital market financing, and the risk management financial market focuses on price discovery and risk management. The three markets complement each other and are all different and connected. He proposed that the development of China's derivatives market should be gradually promoted in accordance with the maturity of the market economy, the needs of the real economy, and the depth and breadth of the capital market, so as to make progress while maintaining stability.







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