Article
August 19, 1996: Derivatives Engineering and Technology
Hartford Rolls Out Principia for Front-to-Back Derivatives Support
ITT Hartford Group, the US-based life and property/casualty insurer, has deployed Principia Partners' Principia Analytics System at its Simsbury, Connecticut corporate headquarters. The group's portfolio managers, analysts, traders, risk managers and back office staff are all using Principia to support the derivatives trading activities of Hartford's four main operating units and their respective portfolios.
Hartford initially went live with Principia last October. Vendor support staff and Hartford technologists are now working to further integrate Principia within the insurance group's overall systems environment. This work includes linking the system to a layer of corporate-wide Oracle databases.
Project team members are currently focusing on developing methods for incorporating Principia's data within the group's other investment management systems, such as those used for corporate-wide asset/liability management, risk analysis, regulatory reporting, derivatives documentation and general ledger account postings.
Hartford runs the Principia system on a Sun Microsystems platform. Portfolio managers are outfitted with Sun Sparcstation desktop machines, while most other company staff access Principia via Microsoft Windows 95based PCs running X-terminal emulation software.
Data from Principia's underlying Informix relational database is transmitted over a platform-independent corporate local area network to end-users and to Hartford's Oracle data repository. The Oracle system runs on Hewlett-Packard hardware and supports the insurance group's suite of reporting, transaction processing and accounting systems.
Representative Trades
Hartford began its systems search process early last year, says Joseph Smoolca, the group's director of investment systems. "We wanted to be fair to everyone, so we went through our derivatives books and pulled out 10 to 15 representative trades and asked the vendors to process them," he says. In addition to considering Principia, the project team assessed a short-list comprising Sungard Capital Markets, Renaissance Software and Infinity Financial Technology, he adds.
Hartford was keen to license a system that had the quantitative strength and flexibility to validate prices quoted by banks and security dealers on a wide range of customized derivatives, says Smoolca, many of which were illiquid and highly exotic.
"We found that very few systems had the full array of functionality we were looking for. They were typically either very strong in the front or in the back office. Some weren't very good at either because they were trying to do everything," he adds.
William Meany, the investment manager responsible for Hartford's floating rate securities portfolio, says Principia demonstrated the ability to value, analyze and process a wide range of structured derivatives instruments, including interest rate swaps with Libor caps and knock-in/knock-out features embedded within them.
Breadth and Depth
"A lot of the other companies couldn't do that," he says. "It was breadth and depth that really differentiated the Principia system from the others." However, Smoolca and Meany caution that Hartford conducted its search some 18 months ago, thus many of its findings may not be accurate today.
As examples of the sophisticated and integrated analytic functionality that Hartford was looking for in a third-party software system, Meany cites valuing and managing secondary market purchases of structured notes and the issuance of debt products with embedded option features in them.
"Our portfolio managers and traders are analyzing transactions and shopping around, asking two or three counterparties to price a particular security or derivative instrument," says Meany. "Whether it's a simple interest rate swap, a cap or floor, or a complicated futures hedge that they're looking to put on, they need to be able to make an informed base and ensure that we're being compensated properly for the risks we assume," he adds.
Smoolca says the Hartford project team found Principia to be somewhat more expensive than its competitors, though he stresses that it was difficult to compare the different offerings, given the variety of pricing schemes and functionality involved.
While systems such as Principia are priced on an all-in cost basis, others, such as Renaissance Software's Opus, are priced by module. "I think when all is said and done, there's really not much difference in price among the systems that were short-listed," says Smoolca.
Ex-Repnat Team
Access to Principia staff for consulting purposes has also been important to Hartford. Principia was designed and built by a team of 11 veteran derivatives traders and technologists who had formerly worked as original members of New York-based Republic National Bank's derivatives group.
Principia's development actually stretches back to earlier work members of this group had begun at Mercadian Capital, however. The now defunct Mercadian was a derivatives trading boutique whose creditworthiness was guaranteed by the New England Mutual Life Insurance Company.
Principia Partners introduced its Principia Analytics System at the high-end of the derivatives systems marketplace around 15 months ago. In addition to the Hartford contract, the vendor successfully landed a contract to implement its system among a group of eight US Federal Home Loan banks earlier this year (DE&T, March 8). This involved the new vendor winning out over its larger and more established competitors, including Summit Systems, Sungard, Renaissance and Infinity.
Theresa Adams, Principia's marketing manager, describes the system as a "complete front-to-back office solution" for derivatives trading and risk management. "It provides a complete set of tools for traders, sales and marketing staff, risk managers, credit officers, operations and accounting staff," she claims.
By choosing Principia, Hartford has effectively outsourced its derivatives pricing function, says Smoolca. Principia is also able to meet the group investment division's derivatives market data requirements, another factor that differentiated the vendor from its competitors, he adds.
In addition to reselling market data from the likes of Reuters, Dow Jones Telerate and the various derivatives exchanges, Principia also produces its own set of value added derivatives market data, including volatility and correlation statistics.
Hartford downloads this information on a daily basis via dial-up phone lines and modems. "We don't have the infrastructure and people to perform tasks such as capturing prices and rates and making sure they're clean and normalized," says Smoolca.
"What we've been doing over the last year is really taking a lot of information out of Principia, profit/loss-type information, cashflow data, and porting that to our Oracle repository in order to link our derivatives portfolios with our underlying asset portfolios," he adds. "We need to bring this information together to provide a uniform view for accounting, compliance, portfolio management, risk management, decision support and reporting."
This integration work includes linking the Principia system to Hartford's Maximus asset management and portfolio accounting system. Maximus serves as the system of record for the group's fixed income and equity securities portfolios. It sold by Malvern, Pennsylvania-based Premier Solutions.
Accessing Principia data and linking it to internally developed and off-the-shelf software packages was the one area the project team found the system wanting, according to Smoolca: "They have all this front-office information in Principia, it just wasn't encapsulated into existing off-the shelf software. I know Principia are looking at developing a general ledger systems interface, and we'd love that."
"We've already got certain aspects of such a link in place today. They're also talking about putting in electronic confirmation capabilities that would enable us to incorporate Principia data into our own reporting environment, and that's a strategic development for us," he adds. "All the pieces are starting to come together, the data is there, the algorithms are there, now it's just a question of how to best access that information and tailor and use it within our environment and organization."
The ITT Hartford Group comprises four main operating units: Hartford Life Insurance Company; Hartford Underwriters Insurance; Hartford Fire Insurance and Hartford Accident and Indemnity.
Hartford Life is the most active user of derivatives within the group. As of year-end 1995, the life insurer had $13 billion of outstanding OTC and exchange-traded derivatives on its books, according to Derivatives Sales Alert, a weekly trade publication.
In addition to managing a majority of the group's asset portfolios, Hartford's investment division is also responsible for controlling the insurance group's overall liabilities, including a range of insurance-related investment products such as index-linked annuity contracts. The investment division also takes care of the group's overall balance sheet management and is responsible for monitoring and managing the credit risks of its investment portfolios.
Hedging Risks Out
Hartford's investment policy is to fully hedge out undesirable market and credit exposures from its investment portfolios on a cashflow and duration basis through the use of derivatives and other hedging instruments, says Meany.
The insurer's derivatives usage is centralized to the extent that all its derivatives transactions flow through to a specialist derivatives trader for execution, he adds. The single largest portion of these are allocated to the insurer's so-called Separate Account category.
Hartford's in-house portfolio managers employ derivatives on a microhedging basis to insulate the group's portfolios from adverse changes in market rates, such as foreign exchange rate risk, while investment division front office staff use them on a macro-level to manage the insurance group's overall balance sheet-related risks.
Executing Strategies
In doing so, the group's portfolio managers, analysts and traders work together to design, evaluate and execute hedging strategies that make use of by now relatively familiar derivative instruments such as Libor-based single and multi-currency fixed-for-floating interest rate swaps and caps/floors.
They also use a range of more esoteric and customized derivatives including constant maturity treasury (CMT) and constant maturity spread (CMS) indexed swaps and swaptions. These are used to hedge prepayment risks inherent in the group's mortgage-backed securities holdings and to translate CMT and CMS-linked debt offerings into a Libor basis.
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