Looking for hidden options

Finding hidden options is an enjoyable and sometimes profitable pastime for connoisseurs of finance. For example, the holders of convertible bonds can extract option value by taking short positions in the issuer's stock. The homeowner's option to pre-pay a fixed rate mortgage when interest rates fall can affect the value of mortgage-backed securities, giving rise to arbitrage opportunities.

For life and savings companies, the hunt for hidden options is less of a pastime and more of a survival skill with the approach of Solvency II and growing consumer transparency pressures. There can be myriad options present: minimum guarantees, policyholder surrender and lapse options, investment strategy options and bonus options. These options interact with each other in potentially complex ways. But hunting the options down can be vital if business and regulatory risks are to be properly identified and controlled.

It's become fashionable to cut away some of the complexity by explicitly identifying options in advance and selling them to new policyholders in a transparent way, such as in variable annuity products. Typically, investors in a unit-linked savings product can pay an annual fee to obtain minimum benefits in the event of death or income withdrawal.

Normally, the customer's choice of underlying fund investments is treated as a separate decision from the purchase of a variable annuity guarantee. But there's no reason why policyholders should see things in that way. As finance aficionados know, the holder of an option, given the choice of asset underlying the option, will choose the most volatile asset possible, in order to maximise the value of their holding.

There is some evidence that speculative investors, including hedge funds, in the United States have followed such a strategy. Are the new wave of European variable annuity providers prepared for such policyholder behaviour?

Some interesting hidden options can be found buried within the capital structure of pension schemes and their sponsors. In many countries (the Netherlands is an important exception), the once explicit option of sponsors to reduce benefits has been eliminated and scheme members are now treated as creditors of the company. But that only replaces an explicit option with a hidden one: the right of management and shareholders with limited liability, to walk away from an insolvent company.

Again, finance theory says that this option value is best maximised by use of volatile assets, whether in the form of a risky business strategy or heavy investment in equities by a corporate pension fund. The job of pension regulators has been to reduce this option value by imposing a potential legal liability on corporate management, by improving pension scheme seniority over other creditors, or reducing benefits as a last resort.

For an example of an option going the other way, consider the case of local government pension schemes. Here, the scheme has a guarantee by its government sponsor - and hence taxpayers - to make up any shortfalls. Unsurprisingly, local government schemes make full use of this option in their asset allocation strategy.

In the world of insurance and pensions, 'hunt the option' is likely to remain an interesting game for some time to come.