Transcript Document

Variable Annuity Industry
Challenges and Opportunities
Canadian Institute of Actuaries - 2009 General Meeting
PD-7 Hedging VA/Seg Fund Products
November 19, 2009
Financial Risk Management
Milliman, Inc.
Agenda
 Valuation Methodology
 Risk Management Strategies
 Impact of Financial Crisis
 VA Hedging Programs
 Innovations in Product Design
 Future Outlook
2
Valuation Methodology - US GAAP
 US GAAP Methodology
– Valuation methodology varies based on the type of guarantee
– Non-life contingent guarantees (GMWB, GMAB, partial GLWB)
•
Risk-neutral valuation under FAS 133/157
•
Sensitive to changes in equity markets, interest rates and implied volatility
– Life contingent guarantees (GMDB, GMIB, partial GLWB)
•
Real-world with smoothing (SOP 03-01)
•
Partial sensitivity to changes in equity markets
– Base product revenues and expenses are earned as operating income
(net of DAC amortization)
 Impact on hedge strategy
– FAS133/157 : Encourages delta-rho-vega hedging
– SOP03-01 : Encourages partial delta hedging
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Valuation Methodology - STAT Capital
 Statutory Capital (RBC C3 Phase II)
– All guarantees are treated equivalently
– Incorporates base product revenue and expenses
– Projection on a real-world basis
– Hedge credit for company’s specific hedge program
– Standard scenario impacts may dominate in certain scenarios
 Impact on hedge strategy
– Encourage delta hedging
– Mean reversion embedded in scenarios discourages rho hedging (in
current market environment)
– Historical calibration discourages vega hedging
– Incorporation of hedge credit makes capital sensitivity neutral to vega and
rho hedging
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Valuation Methodology - STAT Reserve
 Statutory reserving (VACARVM AG-43) counterpart to RBC C-3 Phase II
– Like C-3 Phase II, AG 43 represents a step closer to a principles-based
approach
 Adopted by the NAIC in Sept 2008
 Replaces AG 34 (GMDB) and AG 39 (GLB) reserving methodologies as
of 12/31/2009
– (A slight variation of) AG 33 still used to calculate the Basic Adjusted Reserve
component for the Standard Scenario
– If AG 43 produces higher reserves than was the case under prior statutory
guidelines, a grade in period of (not to exceed) 3 years may be requested
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AG-43 vs. C-3 Phase 2
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AG-43 vs. C-3 Phase 2
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AG-43 vs. C-3 Phase 2
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AG43 needs to be managed
differently from C3P2
 Captive off-shore reinsurance and hedging had been
effective and popular tools in managing C3P2
–
Better yet, use the captive off-shore reinsurance company as the
hedging operation center
 The two approaches may face challenges in AG43
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–
Reinsurer needs to show assets backing reinsurance credit for ceding
company
–
Hedging credit may not reduce AG43 amount much
Impact of AG43 Implementation
for Year End 2009
 There is no simple “rule-of-thumb” for the impact of AG43 for year-end 2009
 Too many factors affecting the results between CTE(70) and standard
scenario amounts and between AG43 and current reserve held
 Examples of factors affecting CTE(70) vs. SSA
- Base product fees
- Base product surrender charge schedule
- Actual guarantee charges
- Policy duration
- Moneyness
- Policyholder behavior assumptions
 Examples of factors affecting AG43 vs. current reserves
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–
Cash flow testing methodology
–
Year end actual capital market conditions
–
Policy duration
Risk Management Strategies
GMWB Hedging Strategy By Type

Stay Naked
–

Semi-Static
–

Buy and hold using a portfolio of options
Need to manufacture the risk management
internally
Static
–

NA
20%
No Hedge
5%
Dynamic
–

Assume enough capital pays for claims
Exotic derivative to manage capital market
risk
Static
15%
Dynamic
60%
Reinsurance
–
Mitigate capital market and actuarial risks
Source: Moody’s
Survey
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Risk Management Strategies - Trends
 Industry trend towards dynamic hedging
– Effective in mitigating risk
– Uses vanilla, liquid instruments resulting low transaction costs
– Hedge positions are continuously updated to reflect policyholder
experience
– Minimal transaction costs incurred from adjusting hedge positions to
prospective changes in assumptions
– Becoming industry standard practice with best practices evolving
– Regulators and rating agencies recognizing dynamic hedging as risk
mitigating techniques
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Risk Management Strategies - Trends
 Static hedging
– Increased product innovation
•
Basket lookback options
•
Levered equity options with higher payouts in low interest rate environments
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Full cashflow matching structures
– Minimal adoption
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High transaction costs
•
Doesn’t protect against policyholder behavior risk
•
Companies that transitioned away from static customized hedges : Importance
to follow on industry standard practices
 Reinsurance availability?
 As the volume of guarantees increase, a combination of strategies will
be employed
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Impact of Financial Crisis
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US VA Market Overview
 About $1.3 trillion asset under management as of year end 2008
 96% offer living benefit guarantees *
 Distribution of living benefits are roughly *
Living Benefit Type
Market Share
GLWB
60%
GMWB
15%
GMIB
15%
GMAB
10%
*Source: Milliman 2009 GLB survey
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The Recent Financial Crisis has been Severe
 Failure of well known financial institutions
– Lehman Brothers, Merrill Lynch, Bear Stern
– Credit risk is brought to the fore
 Worldwide decline in equity market
 Rapid reduction of interest rates
 Increased volatility
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Impact of Financial Crisis
 Insurance industry was materially impacted by recent market events
 Primary drivers were asset impairments and Variable Annuities
– Variable annuity guarantees were highlighted
 Key drivers of losses related to VA’s
– DAC unlocking on base product
– Basis risk on actively managed funds
– Exposure from un-hedged guarantees
 Hedging of in-force guarantees was fairly effective
– Milliman survey results showed approximately 94% effective between
Sept 2008 to March 2009
 Costs of issuing new guarantees have increased substantially
– Costs are typically higher than rider charges
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Insurance Industry View on VAs
 Variable Annuities and guarantees continue to be a vital part of the
insurance industry
– Pure protection business is still important, but asset accumulation &
income products dominate sales
– VA guarantees differentiate life insurance companies from mutual fund
companies and banks
– Guarantees still provide customers with a good value proposition
– Global opportunities
 Creating a sustainable VA business model requires
– 1. Product Design innovation
– 2. Re-evaluation of hedge objectives
– 3. Improvements to hedge program and operations
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VA Hedging Programs
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Hedge Program Objectives
 Hedge programs could have conflicting objectives
 Selection of hedge program objectives reflects management risk
preference and appetite
 Trade-offs of objectives are often needed
 Fair value protection has historically been most common
 Capital protection and macro-hedging gain popularity recently
Distrubtion of Hedge Objectives
source: Millim an survey
Statutory cash
value 6.25%
Combination
25%
Economical
37.5%
IFRS 6.25%
US GAAP 25%
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Hedge Strategies
 Almost all use a dynamic hedging strategy
 More sophisticated companies opportunistically use a combination of
strategies
 Almost all companies incorporate a delta hedging strategy.
 Some also layer on rho and vega hedging strategies
 69% of respondents do not hedge all exposures
Distribution of Hedge Strategies
source: Millim an survery
Combination 25%
VAR 6.25%
Static 6.25%
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Dynamic 62.5%
Hedge Objectives
 Historically hedge objectives focused on managing quarterly GAAP
earnings volatility
– Fully hedge equity, interest rate and volatility risk of GMAB, GMWBs and
a portion of Lifetime GMWB
– Partially hedge equity exposure of GMDB, GMIB and life-contingent
portion of Lifetime GMWB
 There are often conflicts between objectives in US GAAP and
economic fundamentals
 Recent events have brought more focus on statutory balance sheet
– Severe market events have caused companies to shift focus to solvency
– New statutory capital and reserve methodologies are more market
sensitive
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Macro / Capital Protection Hedge
 Solution has been to overlay a Macro / Capital Protection hedge above
core strategy
 Complex problem with many dimensions
 Different ways to approach it:
– Explicitly hedge capital sensitivity
•
Requires revaluation of capital sensitivity and existing hedge program
•
Captures detailed dynamics and non-economic behavior (standard scenario, VACARVM etc.)
– Defining a more transparent and easy to calculate target
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•
Defining as package of options
•
Directly hedging guarantee benefits not included in core strategy
•
Using a deductible approach on guarantee benefits
Hedge Effectiveness Results in Two Studies
 Milliman conducted two studies of hedging program effectiveness during the turbulent
period between September 2008 and March 2009.
 Milliman found the average effectiveness to be 93% during September 2008 and
October 2008
–
S&P decreased 24.5% from 1283 to 969
–
Very rapid movements
–
Realized volatility as high as 60%
 Milliman found the average effectiveness to be 94% between November 2008 and
March 2009
–
S&P decreased 17.6% from 969 to 798
–
Market shown more stabilized decline
 Hedge effectiveness is defined as
(hedge asset payoff) / (liability fair value increase due to hedged risks)
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Bifurcation of Hedging Results
 Bottom line : How much a hedging program has recovered total losses?
– Question 1: How effective is the hedging program in recovering losses it
is designed to cover?
– Question 2: How much loss is not covered by a hedging program?
 Milliman’s studies covered the first question, and not the second one.
 It is critical to distinguish these two questions
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What Has Worked
 Insurance company hedging programs are designed to reduce the
exposures to capital market risks
– Do not take risks to make a profit
 Use simple hedging instruments
– Futures contracts
– Plain vanilla options
– Little counterparty risk
 Be highly transparent
– Open discussion of hedging methodologies
– Reviewed and audited by multiple parties
– Contained operational risks
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What Hasn’t Worked
 Leave critical exposure unhedged
 Follow accounting peculiarities blindly
– US GAAP SOP03-1, Canadian GAAP are not fair valued
– Following non-fair value accounting rules blindly hurt the economic
fundamentals
 Deviate from sound risk management principles
– Under pricing
– Unchecked fund allocation
 Keep hedging practice as a secret
– Leaving blind spots in hedging programs
 Basis risk must be controlled
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Enhancements to Hedging Programs
 Basis risk management
 Expanding hedging program to uncovered risks
 Macro hedging
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Expand Hedge Instrument Universe & Adopt
24 Hour Market Coverage
Contracts:
Risks:
Equity Index Futures
Equity Total Return Swaps
Interest Rate Swaps
Interest Rate Futures
Swaptions
CMS/Libor caps/floors
Volatility Futures
Variance Contracts
OTC Equity Options
Exchange-traded equity options
Hybrid derivatives
Inflation Swaps
Fixed Income Total Return Swaps
Credit-Related Swaps
Currency Forwards
Currency Futures
EQUITY
S&P 500
Russell
NASDAQ
DJ Industrials
Canada S&P TSX
DJ Eurostoxx 50
FTSE
Nikkei
Topix
Hang Seng
Hang Seng China Enterprise
Korea Kospi
Taiwan TWSE
India Nifty
Brazil Bovespa
Emerging Markets
Australia S&P ASX 200
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INTEREST RATES
Canadian Interest Rates
Euro-zone Interest Rates
UK Interest Rates
Swiss Interest Rates
Japan Interest Rates
CURRENCY CROSSES
On Rate Pairs From Above
Innovations in Product Design
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Milliman Hedge Cost Index
 The overall cost of hedging has increased substantially
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July 17, 2015
Latest Trends in VA GLB – Late 2008 To 2009

With effective date through mid May09, 33 VA writers filed changes on 125
existing products; 8 VA writers filed 12 new products.

Summary of 2009 VA product changes:
A. Summary by nature of changes
Change Category
# of Products
# of Companies
Sales Discontinued or Restricted
42
18
Fee Increased
62
29
Product Features Scaled Back
44
19
Asset Allocation Changed/Restricted
16
10
Total
125
33
# of Products
# of Companies
1
90
15
2
31
15
3
4
3
125
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B. Summary by number of changes
# of Changes (from the above 4 categories)
Total
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Industry Trends
 Filing requirements provide some flexibility for minor product
changes, major product changes require re-filing
 The more immediate changes are:
– Rider Fees : Increases between 15-30bps on both existing and new
business
– Withdrawal Rates
•
Increased earliest withdrawal age to 65
•
Adjusted age bands, still 5% at age 65
– Reduction in features
•
Removal of “doubler”
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Reduced bonus rates, typically 1-2% reduction
•
Reduced length of bonus period or age restrictions
– Asset Allocation
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•
Removal of most aggressive asset allocation model
•
Use of more index funds
Product Design
 Design changes to date have been incremental
adjustments to current products
 Next generations of designs should consider:
– Guarantees that adapt to capital market conditions
– Including hedges inside separate accounts
– Asset allocation models that target a specific volatility
– Revaluate compensation structure
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Existing VA Business Model
Funds
Stocks
Bonds
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Insurer Balance Sheet
Guarantee Fee
■Guarantee Liability
■Hedge Assets
■P&L Volatility
Sustainable VA Business Model
Funds
Insurer Balance Sheet
Stocks
Bonds
&
Hedges
■Reduced & Stabilized
Guarantee Liability
Reduced
Guarantee Fee
■Reduced P&L Volatility
■ Transfer of Hedge
Breakage & Basis Risk to
Policyholder
■ Reduced Behavior Risk
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Asset Allocation Models – Current Approach
 Asset allocation models are widespread in the VA market
– Typically: Conservative, Moderately Conservative, Moderate, Moderately
Aggressive, Aggressive
– Each model targets a specific equity allocation (ie 20, 40, 60, 80, 100%)
– Current models do not consider VA hedging programs
– Quarterly model updates lead to GAAP income volatility for VA writers
– This approach exposes VA writer to material P&L volatility
•
37
Increases in implied volatility
Asset Allocation Models – Alternative
 Conservative, Moderately Conservative, Moderate, Moderately
Aggressive, Aggressive models constructed to target a specific risk
level
– Target a constant volatility level for the account value
– Much better integration with VA hedging programs
– Volatility target used directly in GAAP reserve calculation
– Asset allocation process reflected in VA-CARVM & RBC C3P2
calculations
•
Stabilizes statutory reserves and capital
– Eliminates exposure to implied volatility
•
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Reduces cost of VA hedging programs via elimination of OTC risk margin
Comparison of Asset Allocation Models
Comparison of Asset Allocation Models
From July, 1999 to May, 2009
Performance Measure
Constant
Equity %
Target
Volatility
Cumulative return
3.1%
19.3%
Realized volatility
12.3%
11.8%
Average equity allocation
60.0%
74.9%
6.3%
3.0%
Large Cap US Equity Fund
40.0%
50.0%
Technology Opportunity Fund
10.0%
12.5%
International Equity Fund
10.0%
12.5%
Fixed Income Fund
40.0%
25.1%
Standard deviation of monthly volatility
Average allocation by fund
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Monthly Realized Volatility
45%
40%
35%
40
Constant Equity %
Target Volatility
Vol-of-Vol Reduced by 52%
30%
25%
20%
15%
10%
5%
0%
Move Hedges into Customer Account
A Sustainable Manufacturing Process
 Embedded derivative largely disappears from insurer B/S
– Quarterly P&L volatility is dramatically reduced
 Customer owns the hedges
– Hedges are an asset allocation choice, NOT expressed as a fee
– Customer’s account value is supported during market declines
 Basis risk & other hedge noise is absorbed in the customer account
value
– Actively managed funds work well under this approach
 Behavior risk is dramatically reduced
 Process accommodates full spectrum of guarantee designs
 Guarantee fee is reduced & stabilized
41
Future Outlook
Key Risks In the VA Industry
 Sustained decline in equity market
 Increase in interest rates leading to disintermediation
 Irrationally rich benefits for better market share
– High rollup rates
 Policyholder behavior risk
– Lapse assumption not materializing
 Underpriced products requiring large capital causing long term
low ROE
 Hedging programs can only protect risks in the future
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Financial Risk Management
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Floor
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