Are Options Right for Your Organization?

With the Great Recession in the rear-view mirror, many organizations are using—or considering the use of—options. According to The 2014 Insurance Investment Benchmark Survey, approximately one in ten insurers (12%) are currently invested in options, while another eight percent are considering options for their portfolios.

Options are often thought of as risky, complex investments. The use of credit default swaps (a binary option) by Lehman Brothers and Bear Sterns are famous examples of options mismanagement, and the news’ headlines associated with those companies’ collapses did little to quell concerns surrounding these securities.

Yet options are a part of everyday life. Individual health insurance, for example, is an “option” purchased by a person who assumes that the cost of his or her health care will rise. The up-front insurance premium, which can be likened to the cost of purchasing a call option, ensures that the person buying the insurance will pay only a known amount or rate for health services, regardless of fluctuations in the market cost of health services. The insurance company, or the option seller in this case, assumes the potentially unlimited risk that the insurance buyer could be unhealthy and have large medical bills. But insurance companies expect that if they sell policies to a large number of people, most of them will not have high medical expenses, and on average this “option” will earn a profit.

Options can be structured in a dizzying number of ways, often featuring complicated terms and conditions, and the accounting treatment can be difficult, especially when the underlying assets are obscure and data sources are limited. Options investments can be risky when mismanaged, but combining the right options strategy with an advanced investment accounting and reporting solution—which simplifies the processing and accounting of complex assets—can greatly assist investors in the mitigation of risk, and in the generation of yield.

Accounting Implications

As derivative securities, an option’s value is based on the performance of an underlying asset or basket of assets such as equities, indexes, commodities, and currencies. The right option strategy in the right hands has the potential to help significantly mitigate risk as well as generate income.

Insurance investment professionals have two ways of accounting for options: hedge accounting and fair value accounting. The qualitative nature of hedge accounting requires a greater degree of manual intervention by the individual or firm preparing the financial statements, making it difficult to automate. Conversely, fair value accounting for options behaves much like traditional accounting for equities; it is quite simple from a reporting standpoint and easier to automate. When fair value accounting is used, changes in the fair value of the option during the holding period will flow through unrealized valuation gain or loss in statutory accounting, which ultimately affects surplus. The default treatment for both GAAP and IFRS accounting standards requires that changes in fair value during the holding period flow through net income.

Investors evaluating options for their portfolio need to consider their own tolerance for loss, as well as how much of their portfolio they are willing to tie up if selling a covered call. It is also important to consider what mechanisms are in place when evaluating outstanding positions:

• Are daily reports available to evaluate the effectiveness of a strategy and manage the portfolio?
• Is there constant communication with the investment manager to ensure written options are covered?
• What is the most appropriate strategy for your portfolio?
• Do you have systems in place to handle the complex accounting?
• Are your internal accounting systems capable of handling different options configurations?