In early 2016 the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2016 – 01 (ASU 2016 – 01), changing how financial institutions account for unrealized capital gains and losses on their equity investments.

The update eliminated the “available-for-sale” classification typically used to measure the value of equity holdings, requiring instead that equity holdings be measured at fair value and that any changes to fair value go through net income. With the aging bull market in stocks becoming more unpredictable, many insurers that hold equity investments are seeking to replace or supplement their portfolios with a less volatile strategy without sacrificing equity-like returns.

In this paper we explore how the introduction of an equity index put-writing strategy to a strategic asset allocation has the potential to add value to a typical non-life insurance portfolio. Subsequently, we explore how such a strategy has the potential to reduce an insurer’s net investment income (NII) volatility—a potential concern following the implementation of ASU 2016 – 01.

A Few Key Takeaways:

  • ASU 2016 – 01 could cause an insurer’s NII volatility to double, depending on its holdings.
  • A strategic allocation to an equity index put-writing strategy could reduce NII volatility under the new accounting rules by 32% in our model.
  • An equity index put-writing strategy may help reduce surplus volatility while keeping NII and AM Best’s capital adequacy ratio (BCAR) constant.

We find that an equity index put-writing strategy offers attractive risk-adjusted return potential and complements the other assets typically held in non-life insurance portfolios.

A collateralized put-writing strategy—represented in this paper by the CBOE S&P 500 PutWrite Index (the “PutWrite Index”)—consists of a short position in a 30-day at-the-money equity index put option and an investment in short-term U.S. Treasuries with a value equal to the put option’s notional value. Writing a put option has the effect of converting future equity capital appreciation and dividend/buyback return potential into upfront cash flows collected through premiums. Utilizing an insurance-like mechanism in which premiums are collected to help mitigate offset losses that may result from equity decreases, an equity index put-writing strategy can generate a more consolidated return profile compared to public equity investments.

Figure 1. Collateralized Put Writing has the Potential to Offer Better Risk-Adjusted Return

Index Annual Return vs. Risk, June 1986 through December 2018

Source: Bloomberg LP, CBOE. Index data is gross of fees. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment.

As illustrated in Figure 1, the PutWrite Index produced equity-like returns with less volatility than the specified equity indices from June 1986 to December 2018, resulting in a better risk-adjusted return profile. These results are driven by the design of the PutWrite Index. Figure 2 illustrates how a put-writing strategy generally behaves in three different markets; as you can see, while it may underperform its reference index in strong up markets, a put-writing strategy generally keeps pace in a moderate bull market and does comparatively better in flat markets and down markets.

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