2012 09 infoline guaranteed life bonds
TRANSCRIPT
Risk Management for Guaranteed Life Bonds
Presented byServaas Houben (Prudential)Neil Dissanayake (Milliman)
1
Agenda
Current regulatory and capital framework
Guaranteed life bonds product details and product example
Market risk management
Case study
September 19th 20122
Agenda
Current regulatory and capital framework
Guaranteed life bonds product details and product example
Market risk management
Case study
September 19th 20123
EMIR & Central Clearing Mandatory clearing of all qualifying OTC derivatives at a CCP
• CCP = Central Counterparty Risk mitigation standards for non-centrally cleared derivatives Exemptions:
• Small non-financial firms, below defined thresholds• Pension schemes (for 3-years temporarily)• Foreign exchange (?) (may depend on MIFID2 classification)
Reporting of all derivative transactions to trade repositories CCPs to be regulated on a consistent basis across EU members CCPs subject to capital requirements and transparency
2012 2013
EMIR primarylegislation in-force
EP adopts EMIR
ESMA to submittechnical standards
Expected Go live date for 1st eligible classes of
instruments (including swaps)
September 19th 20124
EMIR Implications• Costs for end user?
– implementation– margining– CCP costs– reporting
• Will we see reduced…– hedging?– liquidity?– price differentiation?– counterparty risk?
• OIS-curve discounting– Net Receive Fixed
• gain from existing positions
The move to a cleared interest rate swap market has started already.
Source: LCH Clearnet
September 19th 2012 5
Risk Free CurvesSnapshot of market and Solvency II curves
Risk Management Hedging uses assets quoted on OISPricing (Guarantees) Funding for hedging based on OISProvisioning Solvency II based on LIBOR & UFR
– One-off surplus (based on current market environment)– Hedging efficiency and provisioning risk due to LIBOR-OIS basis
EUR 24 August 2012
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
1 11 21 31Term (Years)
EUR / 24 August 2012 / Spot / Annual
Market LIBORMarket OISSolvency II Risk Free
Source: Bloomberg / Milliman
September 19th 2012 6
Solvency II-OIS SpreadAnalysis of daily data points
Term 1-year 20-year 30-year
0.5% percentile 34 bps 17 bps 61 bps
Median 56 bps 22 bps 72 bps
99.5% percentile 95 bps 29 bps 93 bps
EUR from 2 Jan 2012
0.00%
0.20%
0.40%
0.60%
0.80%
1.00%
1.20%
1.40%
1.60%
1 11 21 31Term (Years) Source: Bloomberg /
MillimanSeptember 19th 2012 7
Capital & Risk ManagementSolvency II • Significant difference between market and Solvency II for discounting long-
term fixed cash-flows• Currently Surplus.
– But… this depends on UFR relative to prevailing market conditions• SCR Capital Charge for this basis and risk of reversal?
Risk Management• Added complexity and potential inefficiency in current hedge strategies.• Are there solutions?
– LIBOR-vs-OIS basis hedge-able via swap– Active markets currently for EUR (liquid to c20 years) plus GBP and USD
• Full Solvency II-OIS more challenging
September 19th 2012 8
Regulatory and Capital Framework
Regulations
• Solvency I:• Reserve 4% of unit funds• Focus risk measurement• Different regimes in Europe
• Solvency II:• Standard formula:
• Instantaneous stresses • Rebalancing during stress not
allowed • Favours static hedges
• Internal model:• Uncertainty exact regulations• Use test
Capital
• Value at Risk:• Instantaneous shock• Risk reduction due re-balancing
limited• Benefit from hedged assets in-force
• Conditional Tail Expectation:• Tail Value at Risk: average of VaR• Considers entire lifetime of policy• Risk reduction due to future trading
more effective (in theory)• High computationally intensive• Model approximations may limit the
effectiveness allowed for in practice
September 19th 2012 9
Agenda
Current regulatory and capital framework
Guaranteed life bonds product details and product example
Market risk management
Case study
September 19th 201210
Product Details
• Profit sharing mechanisms
• Roll-up rates• Ratchet
• Guaranteed annuity options
• UL + guarantee• WP guarantee
• Flexibility investment mix
• Profit sharing• Hedging
implications
• Guarantee• Withdrawal
benefits• Death benefits• Tax benefits
Life insurance
Investment exposure
OptionalityExamples
11
Examples Dutch Products Features Bonuses non discretionary:
Formula based
Bonuses based on contractual agreements
Board responsible for setting realistic contract rates at start date
Valuation challenges:
Bonuses path dependent
Computer computation power required
No ring fencing arrangements as in UK
Immediate annuities Lump sum at t = 0, payments over time
Most competitive product (cross selling bank products)
Company profit sharing
Annuity guaranteed payment as under immediate annuities, plus
Company profit sharing when return exceeds annuity guarantee
Excess interest, company profit
Max return (Company profit sharing, government bond return x year period)
Interest rate discount When company return is expected to be higher than guaranteed return, policyholder discount given at start of the policy.
12
Present value fixed and floating bond
• Fixed bond: fixed coupon payments and principal payment at maturity. Present value function of current interest rates (0% profit sharing).
• Floating bond: variable payments depending on interest rate. Present value constant (100% profit sharing).
• Profit sharing is within these extremes.
Present value of 10 year annual coupon 4% bond
60708090
100110120130140150
0% 2% 4% 6% 8%
FixedFloating75% Profit sharing25% Profit sharing
Pres
ent v
alue
liab
ilitie
s
Yield
September 19th 2012 13
GLB as combination of fixed bond+callor floating bond+put
• Interest call option with strike value 4%:– Payout option when yield above
4% guarantee– Payout option (yield) = Max(100 –
value fixed bond (yield), 0)• Interest put option with strike
value of 4%:– Payout when yield below 4%
guarantee – Payout option (yield) = Value fixed (yield) – value floating
Present value of 10 year annual coupon 4% bond
0
20
40
60
80
100
120
140
0% 2% 4% 6% 8%
FixedCallBond + call
Pres
ent v
alue
liab
ilitie
s
Yield
September 19th 2012
0
20
40
60
80
100
120
140
0% 2% 4% 6% 8%
FloatingPutFloating + put
14
Company profit sharing – overall payoff
• Example:– Time horizon 10 years– Payment of 100 at time 0– Guarantee 4%– Profit to policyholder 40% above
guarantee– No life insurance, or (other)
operational risks• Fixed bond + call:
– bond (4% guarantee) – call (profit sharing for return
above 4% guarantee)• Floating bond + put:
– Stock (x% profit sharing)– Put (guarantee of 4% return)
Pres
ent v
alue
liab
ilitie
s
Yield
September 19th 2012
60
70
80
90
100
110
120
130
140
150
160
0% 2% 4% 6% 8%
AboveguaranteeBelowguarantee
60
70
80
90
100
110
120
130
140
150
160
0% 2% 4% 6% 8%
Bond
Call
60
70
80
90
100
110
120
130
140
150
160
0% 2% 4% 6% 8%
Stock
Put
15
Hedging ProcessOption value
• Monte Carlo• Replication
portfolios• Differential
equations
Other risks
• Lapse• Operational• Counterparty• Basis • Liquidity
Hedging
• Measurement variables• Capital requirement• P&L volatility• Reserves
• Hedging approach• No hedging• Additional reserves• Hedging solutions
September 19th 2012 16
Agenda
Current regulatory and capital framework
Guaranteed life bonds product details and product example
Market risk management
Case study
September 19th 201217
Market Risk Management(using hedging techniques)
September 19th 2012
Delta (& Gamma)(Risk from
underlying fund value)
Rho(Risk from interest
rates)
Vega(Risk from realised
and assumed volatility)
Effectiveness of Hedging
18
Hedge Mapping
September 19th 2012
Underlying Assets(e.g. managed
fund; unit-linked funds)
Guaranteed Life Bond
(LIABILITY)
Liquid Risk Factors
(e.g. FTSE index, GBP rates)
Capital Market Instruments
(ASSETS)
19
Basis Risk
ReplicatingOptionality
Optionality
Delta HedgingDelta Hedging• Hedge instruments: Futures, forwards, total return swaps, ETFs,
delta 1, short-selling stocks, reverse repo + sale• Re-balancing creates convexity to match liability ( gamma risk)• Expected cost from ‘buying-high / selling-low’ funded by hedge
premiums• Key is balancing the trade-off between:
– Liquidity / spread– Roll cost– Threshold– Rebalancing freq.– Hedge Basis
September 19th 2012
-€ 216,000
-€ 212,000
-€ 208,000
-€ 204,000
-€ 200,000
Liability 1% Delta Equity Index20
Source: Bloomberg / Milliman
Rho HedgingRho Hedging• Hedge instruments: OTC interest rate swaps, cleared
interest rate swaps, swaptions• Similarly re-balancing creates convexity ( gamma risk)• Key issues:
– Term structure risk vs liquidity / spread– Roll vs unwind– Valuation issues
• CVA-pricing• OIS vs LIBOR
September 19th 2012
-€ 650,000
-€ 600,000
-€ 550,000
Liability 1bp rho (DV01) EUR 30-year swap rate21
Source: Bloomberg / Milliman
Vega HedgingVega Hedging• Risk characteristics:
– Re-balancing strategy cost (buy-high / sell-low) higher than priced for in pricing and provisioning assumptions
– Changes in mark-to-market of liability on balance sheet due to changes in market assumed volatility
• Hedge instruments: ETOs, OTC index options, variance swaps, swaptions
• Key issues:– Long-term risk vs Short-term liquidity– Implied Vol (and broker-dealer premium) vs Realised Vol
(and uncertain gamma risk)– Counterparty risk – Skew (ATM vs ITM or OTM)
September 19th 2012 22
Agenda
Current regulatory and capital framework
Guaranteed life bonds product details and product example
Market risk management
Case study
September 19th 201223
Hedge Effectiveness(Case Study)
September 19th 2012
• Aggregation of actual European performance data
• Analysis Period = 1 June to 1 September 2011
• Mixture of minimum withdrawal, accumulation and death guarantees
• Mixture of single and regular premium business
• Normalised to un-hedged loss of EUR 100 million for the period
24
Hedge EffectivenessLIABILITY ASSETS P&L
Market Risk - HedgedEquity Delta € 27,311,224 € 25,622,682 -€ 1,688,542 94%Bond Delta -€ 5,841,967 -€ 5,925,252 -€ 83,286 101%FX Delta -€ 2,409,184 -€ 2,286,173 € 123,011 95%IR Rho € 71,538,920 € 66,098,359 -€ 5,440,561 92%IR Vega € 3,763,508 € 4,614,651 € 851,143 123%
93%Market Risk - UnhedgedEquity Vega € 697,434 -€ 697,434Cross -€ 615,171 € 878,452 € 1,493,623Theta (net premiums) -€ 2,586,752 € 1,037,040 € 3,623,792TC / Interest -€ 98,343 -€ 856,713 -€ 758,370
Net P&L (exc. Basis Risk) € 91,759,670 € 89,183,045 -€ 2,576,624 97%
Fund Mapping Basis € 8,240,331 -€ 8,240,331
Net Capital Markets P&L € 100,000,000 € 89,183,045 -€ 10,816,955 89%
September 19th 201225
Source: Milliman
Hedge Effectiveness
September 19th 2012
Time Series of WeeklyP&L Impacts
Impacts Graphed:• Equity Delta
• Bond Delta
• FX Delta
• Rho
• IR Vega
• Cross Effects & Theta
Graphs on same scale
Clear Reduction in Volatility
-€ 40,000,000
-€ 30,000,000
-€ 20,000,000
-€ 10,000,000
€ 0
€ 10,000,000
€ 20,000,000
€ 30,000,000
€ 40,000,000
10-Jun 17-Jun 24-Jun 01-Jul 08-Jul 15-Jul 22-Jul 29-Jul 05-Aug 12-Aug 19-Aug 26-Aug 02-Sep
Unhedged P&L (no hedge assets)
Equity Delta Bond Delta FX Delta Interest Rate Rho Interest Rate Vega Theta Cross Effects
-€ 40,000,000
-€ 30,000,000
-€ 20,000,000
-€ 10,000,000
€ 0
€ 10,000,000
€ 20,000,000
€ 30,000,000
€ 40,000,000
10-Jun 17-Jun 24-Jun 01-Jul 08-Jul 15-Jul 22-Jul 29-Jul 05-Aug 12-Aug 19-Aug 26-Aug 02-Sep
Hedged P&L (with hedge assets)
Equity Delta Bond Delta FX Delta Interest Rate Rho Interest Rate Vega Theta Cross Effects
26Source: Milliman
Summary
September 19th 2012
• Broad range of products with embedded long-term guarantees and significant market risk exposure
• Regulatory change via EMIR and Solvency II and uncertainty over implementation of some of these rules is making hedging more challenging
• However, hedging on a dynamic basis is still a powerful method to mitigate market risk for long-term guaranteed life bonds
27
References
S. Loisel, Variable annuities: confronting points of views of insurers and bankers, with an emphasis on surrender risk, March 2011 Central Bank of Ireland, Requirements on Reserving and Risk Governance for Variable Annuities, 2010 ESMA press release on EMIR, http://www.esma.europa.eu/system/files/2012-403_0.pdfContact details:
Servaas [email protected], http://actuaryabroad.wordpress.com/+44 (0)207 548 2774
Neil [email protected]+44 (0)20 7847 1557
September 19th 2012 28