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Variable Annuities
1.
© EduPristine – www.edupristine.com Variable Annuities Risk Management Challenges
2.
© EduPristine | (Confidential) Topics • Introduction to Equity Based Insurance Guarantees • Managing the risks –
Traditional Approaches – Recent Approaches • Risk Management Challenges • Equity Based Insurance Guarantees in Indian context
3.
© EduPristine | (Confidential) Introduction to Equity Based Insurance Guarantees – Death Benefits • Guaranteed amount in case of policyholder’s death during the term of a contract –
Living Benefits (GMAB, GMWB and GMIB) • GMAB: Guaranteed sum at the maturity of the contract • GMIB: Guaranteed floor of income at the end of holding period • GMWB: Guaranteed return of premium over time – Index Annuities • Participation in equity market with a floor and a cap – Variable Universal Life • Universal life with flexibility to participate in equity market
4.
© EduPristine | (Confidential) Some Illustrations ** Charts are
taken from Morningstar Report Titled Living Benefits
5.
© EduPristine | (Confidential) Insurer Perspective Each policy in VA with guaranteed benefit rider becomes a short put option with different – Strike (Guarantee Amount) – Underlying (Fund Value which depends upon investment allocation) –
Maturity (Contingent upon living) Insurance Policy + Capital Market Security
6.
© EduPristine | (Confidential) Managing Risk • Mortality and Lapse – Determines the maturity of the option written by insurer –
Policyholder behavior is a key factor • Depends upon age, sex, economic background and various other factors • Modeling is more art than science • Some insurers use predictive modeling for this
7.
© EduPristine | (Confidential) Managing Risk • Guarantees – Some insurers decided to not hedge guarantees •
Almost all of them are out of VA business now – Reinsurance • Not many reinsurer in the market after financial crisis – Dynamic hedging • Replicate the payoff using available exchange traded and over the counter derivative • Primarily three greek strategy – delta, vega, rho
8.
© EduPristine | (Confidential) Typical Dynamic Hedging Program • Replicates liability and rebalances hedge portfolio based on market movements Greek Instruments Used Delta
Equity futures, Total Return Swaps, Vanilla Options Rho IR futures, IR Swaps Vega Vanilla Options, Variance Swaps End of Day Market Data Stochastic Scenario Generator (RN) Liability Model Asset Models Trading Floor (Rebalancing) Database/Reporting Engine Rebalancing based on Greeks coverage P&L Report, Attribution Actuarial Assumptions
9.
© EduPristine | (Confidential) Challenges With Dynamic Hedging • Unmitigated Risks – Greeks other than Delta, Vega, Rho –
Higher order greeks • Pricing – Inadequate hedge cost assumption • Basis Risk – Difference between hedge indices and fund performance
10.
© EduPristine | (Confidential) Challenges With Dynamic Hedging • Liquidity – Bid‐Ask widens in stress markets •
Counterparty risk – Credit risk in OTC contracts • Systemic failure • Controls and Execution “Perfect Storm” in during financial crisis
11.
© EduPristine | (Confidential) And then there is Accounting… • Wide difference in accounting standards related to valuation of hedge instruments and liability • You need to figure out what you are trying to hedge –
Stat Earnings? – GAAP Earnings? – Economics? • Unfortunately you can pick only one
12.
© EduPristine | (Confidential) Some knee jerk reactions… • Increased price of guarantees – Higher premium for writing the option •
Reduced benefits – Lower strike of the put option • Restrict equity allocation – Lowering the notional
13.
© EduPristine | (Confidential) Recent Developments… • Indexing premium on Volatility – Reduces the risk of undercharging hedge cost •
Volatility Managed Funds – Dynamic allocation based on volatility of the index – Overlaying derivatives in the fund
14.
© EduPristine | (Confidential) Volatility Managed Funds • Allocation between equity and bond changes to target a constant volatility (subject to cap) – Reduces Vega exposure significantly –
Generally there is higher alpha • Does not impact Delta or Rho – So you still need a dynamic hedging program • This is steadily gaining popularity
15.
© EduPristine | (Confidential) Equity Linked Insurance Market in India • There is obviously a market for these products – It is set to expand as some early “Gen‐X” approaches retirement in next 5‐7 years •
First generation ULIP has disappeared from market post 2010 • Highest NAV guaranteed ULIP became largest selling ULIP since Sep 2010 – CPPI Strategy – Not aligned to stock index – Can get cash locked
16.
© EduPristine | (Confidential) Equity Linked Insurance Market in India • To expand further innovation are required – Managed volatility fund can be a potential candidate •
Development of derivative markets – To be able to dynamically hedge market risk • Regulatory approvals for derivative usage
17.
© EduPristine | (Confidential) Key Points… • VA Guarantees are complex – Can be viewed as exotic derivative contracts –
Needs dynamic hedging for risk management • Issues with dynamic hedging – Accounting issues – Basis, Liquidity and Counterparty – Unaccounted risks • Recent Developments in US market – Managed volatility funds – Volatility indexed fees • Indian market – High potential – Needs further development in derivative markets – Managed volatility fund can be a good option
18.
© EduPristine | (Confidential) QUESTIONS?
19.
© EduPristine – www.edupristine.com Thank You ! Visit Us On: http://www.edupristine.com/ca Contacts Us: help@edupristine.com
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