INTEREST RATE DERIVATIVES AND RISK EXPOSURE EVIDENCE FROM

INTEREST RATE DERIVATIVES AND RISK EXPOSURE: EVIDENCE FROM THE LIFE INSURANCE INDUSTRY Authors: Hui Hsuan Liu Yung Ming Shiu

Outline INTRODUCTION LITERATURE & HYPOTHESIS ＊ Motivation ＊ Contribution ＊ Purpose ＊ Effects of Risk on Derivatives Usage ＊ Effects of Derivatives Usage on Risk METHODOLOGY ＊ Corresponding Models ＊ Variables Summary EMPIRICAL RESULTS CONCLUSIONS ＊ Data Selection

Motivation-1 √ Bodnar et al. (1998) indicates the 76% use derivatives to hedge interest rate risk in the US firms. √ Bodnar and Gebhardt (1998) and De Ceuster et al. (2000) indicates US firms tend to hedge in order to reduce cash flow volatility. √ Life insurance industry belongs to the long-term insurance industry; they must to consider the external environment factors (ex: inflation rate). If the market rate showed a very slight variation, the interest rate risk increased. Interest rate risk arises from mismatches in the rate sensitivity of the insurer’s inflows and outflows. An increase in interest rates causes the market value of the insurers’ assets to fall. M 1: Corporate interest rate risk hedging in the United States is relatively important, especially for interest rate-sensitive firms, such as life insurers.

Motivation-2 √ Firms can use different ways to manage theirs’ interest rate risk, one technique is to match the rate sensitivities of their assets and liabilities as closely as possible (on-balance-sheet technique); the other is to use derivatives (off-balance-sheet technique). √ Most life insurers use financial derivatives either as part of a risk management strategy or means of income generation. √ As shown in Figure 1, the survey indicates that US life insurers manage their risk exposure by undertaking hedging with large derivatives positions, and thus this sample is suitable for this study. M 2: An important question that life insurance firms concern the role by derivatives played in the exposure to interest rate risk.

The survey shows the participation rate and the notional value of the extent of derivatives usage, which is related to the interest rate contracts undertaken by US life insurers between 2001 and 2006. FIGURE 1: The Participation Rate and Extent of Interest Rate Derivatives Usage by Life Insurance Companies

Motivation-3 √ prior researches have documented the reverse causality from derivative use to risk exposure (Reicher and Shyu, 2003; Bondnar and Marston, 1996; Sinkey and Carter, 2000; Gunther and Siems, 1995), further Hirtle (1997) finds no significant relationship between the extent of derivatives usage and interest rate risk exposure. The topic has not been well examined and empirical evidence varies. M 3: We argue that a firm’s derivative use and risk exposure decisions are simultaneously determined.

Motivation-4 √ Prior research related to the management of capital market risk only discussed for financial and non-financial firms (Ferreira Carneiro and Sherris, 2008; Purnanandam, 2007; Bali, Hume and Martell, 2007; Daniel and Steven, 2005; Hentschel and Kothari, 2001; Cummins, Phillips and Smith, 2001; Sinkey Jr. and Carter, 2000; Guay, 1999; Hirtle, 1997; Hentschel and Kothari, 2001; Tufano, 1996). √Derivatives usage in the financial industry, especially in the insurance industry, the research literature is very limited. √Only in the US (Colquitt and Hoyt, 1997 and Cummins, Phillips and Smith, 2001), the Australian (Ceuster, Flanagan, Hodgson and Tahir, 2003) and the UK (Philip and Mike, 1999) is evidence available that documents derivative hedging practices in the insurance industry. M 4: In order to extend earlier works on the use of derivatives and risk exposure, this work focuses on the US life insurance industry.

Motivation-5 √Prior studies just to find the determinants of firms' hedging and have concentrated on one specific year (Colquitt and Hoyt, 1997 and Philip and Mike, 1999). M 5: We further motivate our work by extending these researches from the statutory reports of US life insurers during the period from 2001 to 2006.

Purpose n examine the effects of interest rate risk exposure on derivative use and the reverse causality from derivative use to risk exposure using a data set on the U. S. life insurers from 2001 through 2006 n examine whether firm’s derivative use and risk exposure decisions can simultaneously determined

Research Contribution-1 √ Three prior studies that focus on non-financial firms and closely connect to this paper. We further research it completely. Country characteristics of governance discuss whether firms use derivatives to reduce risk Guay (1999) financial firms: life insurance Faff and Nguyen (2003) explore the motivation of financial derivatives usage Property-liability insurers by both the participation and the extent model Country characteristics of risk governance to extend the interest rate exposure to related to the and both participation extent model find that there isand littlethe relationship between a firm’s Bali, Hume, Property-liability insurers use risk exposures and the level of derivatives Martell (2007) Country characteristics ofexposure governance derivative usage and risk are simultaneously determined

Research Contribution-2 √ Use the Heckman two-stage sample selection model to test for the self-selection bias. √ We eliminate the potential endogeneity bias of the time-invariant and rarely changing variables. refer Plumper and Troeger (2007) to use the fixed effect vector decomposition (FEVD) technique to eliminate the potential endogeneity bias and to check the robustness of the hypotheses.

Literature & Hypothesis Effects of Risk on Derivatives Usage-1 (1) risk reduction can be achieved with derivatives √ Smith and Stulz (1985) show that hedging the interest rate risk can increase firm value by lowering the bankruptcy transaction cost. √Froot et al. (1994) argue that firms should hedge in order to avoid the cost of external financing when they experience low internal cash-flow.

Literature & Hypothesis Effects of Risk on Derivatives Usage-2 (2) Derivative users have an advantage in the risk-shifting process √Hoyt (1989) points out that derivatives usage would be more appropriate for life insurance firms than general insurers. √Tufano (1996) supports the hypothesis that the gold mining industry can use derivatives to reduce risks. √Purnanandam (2007) indicates that derivatives usage can minimize the risk of external shocks on a firm's operating policies. √Singh (2009) provides a significant negative relation between the use of interest rate derivatives and interest rate risk exposure.

Literature & Hypothesis Effects of Risk on Derivatives Usage-3 (3) hedging with derivatives can limit the degree of interest rate risk exposure that a firm has √Brewer et al. (2007) note that interest rate risk exposure is an important factor that influences the value of a life insurer, as the equity of such firms is sensitive to long-term interest rates. √Daniel and Steven (2005) find that they tend to actively use interest rate derivatives to offset this when firms have larger interest rate risk exposure. √Hirtle (1997) finds that an increase in the use of interest rate derivatives corresponds to greater interest rate risk exposure for a sample of US banks.

Literature & Hypothesis Effects of Risk on Derivatives Usage Overall, we affirm that life insurers will use derivatives for hedging purposes if they face significant interest rate risk exposure. The interest rate risk exposure can affect the both the propensity to undertake such a strategy and the extent of interest rate derivatives usage. In order to examine the issues raised above in more detail, we construct the following hypothesis: H 1: Life insurers with a higher interest rate risk exposure still have a greater propensity to hedging using interest rate derivatives.

Literature & Hypothesis Effects of Derivatives Usage on Risk-1 (1) a number of prior studies take the opposite view on the relation between derivatives usage and risk exposure √Reichert and Shyu (2003) also find that the options usage increases the interest rate risk exposure of banks. √Bodnar and Marston (1996) examine the effects of using derivatives on the volatility of firms' returns, and find that the use of derivatives increases risk exposure. √Sinkey and Carter (2000) and Gunther and Siems (1995) both find that increased use of derivatives by banks tends to result in higher levels of interest rate risk exposure.

Literature & Hypothesis Effects of Derivatives Usage on Risk-2 (2) prior studies have found that firms’ risk exposure to variations in interest rates is not directly related to their derivatives positions √Stulz (2003) points out that carrying out risk management activities (such as hedging by using derivatives) does not increase firm value. √ Hentschel and Kothari (2001) find that the use of derivatives by firms does not measurably increase or decrease the volatility of their returns. √Angbazo (1997) and Simons (1995) find no significant relationship between derivatives usage and the interest rate risk exposure. √Koski and Pontiff (1999) shows that there is no statistical difference in the risk measured and return performance between derivatives users and nonusers in the mutual fund industry. √Hirtle (1997) finds that there is no significant relationship between the extent of derivatives activities and interest rate risk exposure.

Literature & Hypothesis Effects of Derivatives Usage on Risk-3 √In sum, a review of the literature shows that whether or not interest rate derivatives can be used to hedge against interest rate risk is still inconclusive. √The related arguments are quite different from established theories of corporate risk. √We thus speculate that even if life insurers use more derivatives to hedge, they can not completely remove the risks they face, and thus we present the following hypothesis: H 2: Life insurers have a greater propensity to hedging using interest rate derivatives, they still with a higher interest rate risk exposure.

Methodologies (1) two-equation simultaneous equations model 2 SLS method represents a dummy variable (interest rate derivative user= 1; nonuser= 0) to represent the participation decision on interest rate derivative use or a continuous variable to represent the extent decision by life insurer i in year t. √ √ denotes the interest rate risk exposure of life insurer i in year t. √CV 1 and CV 2 are two different sets of control variables

Methodologies (2) model of measure the interest rate exposure √ where is the common stock return of life insurer i in year t; a constant, is the percentage change in the 6 -month Libor rate in month t; is the monthly returns on the CRSP equal-weighted index for month t, and is the error term. √ represents the interest rate risk exposure measured as a percentage change in the rate of return on the life insurer’s common stock due to a 1% change in interest rates. The six-month Libor rate is used in the model because it is the benchmark used for most floating rate debt. √ represents the rate of return on the CRSP equal-weighted market index for NYSE, AMEX, and NASDAQ firms.

Data Collection-1 √ We mainly use the CRSP, COMPUST and Edgar database to retrieve the data to calculate the proxies for variables used in this research. √ Through the Edgar, we hand-collect the data of firms’ derivative activities from notes to the firms’ financial statements. If an insurer indicates that no hedge exists within the interest-rate contract, and then the contract is not included the measurement of hedging by the firm, the insurer is classified as a "non-hedger. “

Data Collection-2 √ Of 45 these insurers, 41 disclose detailed derivatives information in their 10 -K filings and annual reports for the period 2001 to 2006. √ The sample is comprised of 41 life insurers from 2001 to 2006, with a total of 244 firm-years observations, 133 of which reported the relevant information about using interest rate derivatives, and 111 did not.

Variables Summary Variable Definition Panel A: Endogenous variables Interest rate derivative participation Participation decision: 1 for interest rate derivative users, 0 otherwise Interest rate derivative usage Ratio of the year-end notional volume of interest rate derivatives by total assets Interest rate risk exposure Ratio of the return on the life insurer’s common stock due to a 1% change in interest rates Panel B: Control variables Leverage Ratio of the book value of total liabilities to the market value of equity Convertible bonds Dummy variable = 1 if the life insurer use convertible bonds, 0 otherwise Affiliation Dummy variable = 1 if the life insurer affiliates to a financial group, 0 otherwise Cash flow Ratio of the cash flow per share scaled by total assets Firm size Natural logarithm of total assets Floating rate debt Ratio of the floating rate debt to total long-term debt Interest coverage ratio Ratio of the operation income before depreciation to the interest expense Quick ratio Ratio of quick assets to current liabilities Underinvestment costs Ratio of the book value of equity capital to the market value of equity capital Asset-Liability management Dummy variable = 1 if the life insurer uses the balance-sheet to the interest rate risk management, 0 otherwise

EMPIRICAL RESULTSUnivariate Analysis-1

EMPIRICAL RESULTS Univariate Analysis-2

EMPIRICAL RESULTSMultivariate Analysis-1

EMPIRICAL RESULTSMultivariate Analysis-2

CONCLUSIONS-1 Consistent with our expectation, we find that life insurers with higher interest rate exposure are motivated to participate in the interest rate derivative market and use more interest rate derivatives. √ The derivative usage and risk exposure decisions are simultaneously determined. √ The rationale is that insurers can maximize firm value by reducing financial distress costs and thus insolvency probabilities through derivative hedging (Cummins, Phillips, and Smith, 2001). √

CONCLUSIONS-2 We also document the insurers that participate in the interest rate derivative market and use more interest rate reverse causality from interest rate derivative use to risk exposure. We find that derivatives would have higher interest rate risk exposure. √ possibly because the use of interest rate derivatives allow the insurer to increase their interest rate risk exposure but maintaining a certain level of solvency. √ According to the Hoyt (1989), life insurers have long-term insurance contracts which are sensitive to interest rate fluctuations then general insurers. We infer that life insurers use derivatives for hedge is thus directly related to interest rate risk exposure. Taken together, our evidence suggests that interest rate risk exposure positively affect interest rate derivative use, and vice versa.

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