Hedging Variable Annuity Guarantees
in the Current Environment
Actuaries’ Club of Hartford/Springfield
May 17, 2012
VA Guarantees – Some Basics
Hypothetical Acct Value TIME HAV Guarantee Base Pay-In Waiting Period Pay-Out Clients elect whichever produces greatest benefitVA Guarantees – Some Basics
GMDB
– Guaranteed Minimum Death Benefit
GMAB
– Guaranteed Minimum Accumulation Benefit
GMIB
– Guaranteed Minimum Income Benefit
GMWB
– Guaranteed Minimum Withdrawal Benefit
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GMxB : Often used as a Common Reference
Examples: • Equity Level • Interest Rate Level • Equity/Rate Volatility • F/X Level/ Volatility • Correlations Examples: • Policyholder Behavior • Mortality Improvement • Operational Failure • Transaction Costs • Counterparty Exp. • Accounting ￚ Ex: Currency Translation
VA Guarantees Hedging – Risk Sources
Risks we can hedge in the Cap markets
(and choose to)
Risks we can hedge in the Cap markets
(and choose not to) Risks we can’t hedge in
the Cap Markets
VA Riders – Value Drivers of Hedgeable Risk
Interest Rate Volatility
Equity Price Volatility
Interest Rate Level
Equity Price Level
Value of GMxB Rider
(Put Option)
VA Hedging: Examples of Products Used
Product Covered Risk Covered Cost
Equity Futures • Equity • Negligible Upfront, Embedded carry cost, Quarter roll cost
Treasury Futures • Interest Rate • Negligible Upfront, Embedded carry cost, Quarter roll cost
Interest Rate Swaps
Total Rate of Return Swaps • Interest Rate & Equity
• Bid/ask per tenor and type
• Carry emerges over time
Equity / Interest Rate Options
• Equity & Interest Rate, Equity
& IR Volatility • High upfront or over time
Interest Rate / Equity Variance Swaps
• Equity&
IR Volatility
• No upfront
• Carry emerges over time
Hybrids Capital Market Reinsurance
• Combination of market risks
“Recent” Market Trend -- Equity and Interest Rate
S&P 500 0 800 1600 2400 1 /0 6 5 /0 6 9 /0 6 1 /0 7 5 /0 7 9 /0 7 1 /0 8 5 /0 8 9 /0 8 1 /0 9 US Swap 10 Year 0.0% 2.0% 4.0% 6.0% 8.0% 1 /0 6 5 /0 6 9 /0 6 1 /0 7 5 /0 7 9 /0 7 1 /0 8 5 /0 8 9 /0 8 1 /0 9“Recent” Market Trend – Volatility and Correlation
S&P vs. USDJPY Monthly Return Correlation
-0.5 -0.3 -0.1 0.1 0.3 0.5 0.7 0.9 1/06 5/06 9/06 1/07 5/07 9/07 1/08 5/08 9/08 1/09
3yr 5yr 10yr
S&P Implied 10 Year Volatility
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 1 /0 6 5 /0 6 9 /0 6 1 /0 7 5 /0 7 9 /0 7 1 /0 8 5 /0 8 9 /0 8 1 /0 9
“Recent” Market Trend – Correlation
Volatility
10 Year Horizon Monthly Return -0.1 0.2 0.3 0.4 0.5 0.6 0.7 1/03 1/04 1/05 1/06 1/07 1/08 1/09 Date C o rr e la ti o n F a ct o r 10 Year Horizon Monthly Return (0.2) (0.1) -0.1 1/03 1/04 1/05 1/06 1/07 1/08 1/09 Date C o rr e la ti o n F a ct o r“Recent” Market Trend – F/X and Basis Risk
• Japanese Yen Strengthening vs US Dollar
– US Companies with Japanese Yen Exposure
– Yen Liabilities / Dollar Investments
– Will we see ¥/$ at 100 again?
• Basis Risk
– Always present
– Active Fund Management / Tradable Index Mapping
– Significantly Increased During Crisis
“Recent” Trend – Regulators/Rating Agencies
• US and Foreign Regulators
– US Regulators: Solvency Concerns
• Better understanding of business
» Questions on Hedging at any sign of Market Disruption » SocGen Rogue Trader: Jan 2008
» May 2010 Flash Crash
» Early August 2011 Equity Volatility
– Foreign Regulators Very Cautious
• Rating Agencies
“Recent” Trend – Analysts/Investors/Policyholders
• Analysts
– Issuing More Analysis and Reports on VA Writers
– Questions During Earnings Calls
• Investors
– Paulson at Hartford
– Equity Hammered at Any Sign of Trouble
– Perceived or Real
• Policyholders
– Will React with Market and Trust/Distrust a Brand
– Will Lapse policies
VA Hedging: Reactions
• Increase in Guarantee Charges
– Immediate Reaction: Reflect increase in Hedging Costs
• Product Design Changes
– Good Risk Management: First Step
• Some Product Features are Difficult to Mitigate
– Product De-Risking
• “Feature Creep” Disappeared • Restriction on Funds
– Limited Movements/Transfers – Actively Managed Index Fund
– Reduce/Eliminate Foreign Currency Exposure
Reduction in Capital Markets Exposures
VA Hedging: Reactions
• Start/Increase Hedging Coverage
– When to Start? At any Cost?
– Increase Number of Greeks Covered. How About Cross-Greeks?
• Delta + Gamma + Rho + Vega
• Short Dated Gamma Hedging as Vols Came Down from Market Highs
– Refine (Add) Hedging Indices (
Reduce Basis Risk)– Increase Universe of Hedge Assets Used
• Hedge Against Capital Increases
– Disconnect Between Accounting Bases
• Highlighted at Distribution Tails • Macro Hedge Programs
• Put-Spread Collars Around Year End
– Need to Monetize Positions with Certain Market Conditions/Liquidity Concerns • Usage has Reduced Since 2008
VA Hedging: Reactions
• Tightening Hedging Guidelines
– Tighter Required Rebalancing Range
– More Frequent Access to Capital Markets
• Transaction Costs?
– Maybe more Flexibility Needed
• Requires Increase in Tolerance with High Volatility Markets
• Active Trader Instead of Program Trades Move with Market Dislocations
• Counterparty Diversification
• Reduce Credit Risk Exposure
VA Hedging: Reactions
• Use of Basket Hedges
– Long Term or Rolling Short Term
– Target Overall Tail Risk
• Or Specific Risk: Manager Basis Risk, Credit Risk in U/lying Funds
– Structure with Broker/Dealer
• Costly/Time Consuming
• Traditional Reinsurers Still Out
• Abandon the Market
• Place Business in Runoff
– Still Need to Manage/Hedge Closed Block • Put Business up for Sale
