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My question is about option based portfolio insurance in practice.

Some insurance companies offer products where there is a mutual fund (equity and bonds) and a guarantee attached. This guarantee is usually given by some investment bank.

The bank can either apply a CPPI model or it can apply option based insurance meaning that it acts as if it had sold a put option on the mutual fund. Talking about the option case: what do banks in practice do?

Is it usual to

  • hedge the risk by selling futures?
  • swap the risk somehow?
  • apply strict risk limits for the mutual fund?
  • demand a certain strategy for the fund?
  • anything else?

What is the best practice for options based portfolio insurance?

EDIT: To be more precise about the product: in Austria we have a pensions system financed by the state (by contributions by the labor force). As this will probably not suffice for the future the population is motivated to invest in retirement pension insurance contracts.

These insurance contracts are mainly saving contracts where monthly payments are invested in a mutual fund that holds 30% stocks and 70% bonds. Additional to this there are premiums by the state. Furthermore these insurance contracts need to have guarantees attached such that you get at least all your money invested back after a minimum time of say 10 years.

I assume that this system is applied in other countries as well. So this question is rather general.

final edit: there are insurance companies who sell these products in retail. Then there is the guarantee that can be implemented by an investment bank as option based portfolio insurance. I hope the term "insurance" is clear wherever it appears in my question.

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are you asking about going practice on the bank or insurance side? Thanks –  Matt Wolf Jul 14 at 8:50
    
I am asking about the investment bank that offers the guarantee. I would like to know how this is usually done (the offer) and how this is hedged in the bank's trading room. I have a specific case in mind and I would like to compare what they do to how "it is usually done". Thanks! –  Richard Jul 14 at 8:52

1 Answer 1

It depends on the exact nature of the risk in question as well as the mandate of the options desk at the bank. Generally such products are "created" and hedged at exotic option sell-side desks. There are a myriad of different kinds of risk the bank and hence the insurance company may offer their clients insurance against. It could range from inflation risk, broad directional risk, volatility, correlation, and what have you.

Hence, I do not think there is a one-size-fits-all answer to your question. But as you brought up a mutual fund (equity and bonds) with insurance attached I try to add my thoughts in this area:

A number of scenarios could play out:

  • The desk may want to hedge against directional risk in which case it could either buy put options on broad bond and equity indexes, enter into forward agreements with other banks to custom tailor the hedge, it could source the hedge through internal trades with other desks to offload their exposure and hedge at cheaper cost.

  • Often times, however, it goes the other way around. A large exotic desk may sit on large baskets of cash equity, for example and it may package them and sell a correlation product, oftentimes attached to other products in order to market it as "insurance" or "hedge". To mind come various correlation products that were sold during 2008/2009. Such desk would then approach a retail based bank to distribute said product or they may pitch the product to insurance companies which may buy the products for their own internal hedge or structure an insurance product with the sell-side bank to sell as insurance product to their own clients (and I guess that is what you mentioned).

  • Another possibility is that they simply knit-pick certain risk exposures, some of which they hedge out and others they happily take onto their own books if it suits their view. This may become less common now with reduced proprietary risk taking but nonetheless it is still done.

Edit, to reflect the additional information provided in the question:

Generally, I have not heard about restrictions that are imposed on any mutual fund manager in order to insure against a possible loss of invested capital. However, that does not mean that insurance companies or in general issuers of such principal insured assets would not involve portfolio managers in order to work very closely with banks that structure such assets. Now, it happens, and I hear of banks that structure the whole product, hoping that their in-house asset managers get to manage the invested principal and the product is simply sold to insurance companies or other middle-men who mark up the price and then pass it to their clients. But it can also as well happen that buy side firms only outsource the insurance portion to structuring desks at banks. It depends on the relationships, the amount of principal that is expected to be invested, on the resources of the firm that actually invests the assets which of the two alternative routes is favored. Again, there is no single approach that is always taken but it really depends on above mentioned factors.

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Thanks for the answer. It answers parts of my question. I will edit the question with some more precise info. –  Richard Jul 14 at 11:01
    
I edited my answer. –  Matt Wolf Jul 14 at 13:26

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