Dynamic Hedging Working Party

28 May 2014

Contents 1. Setting the scene

2. Interest rate hedging in traditional annuities and pension funds

3. Equity risk hedging in with profits and variable annuities

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Setting the Scene

28 May 2014

Reducing risk capital

What to hedge?

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Minimizing P&L volatility

Stable free assets

Often what works for one will work for all, but there may be conflicts, especially if metrics don’t represent a true economic view. Example: hedging of Peak 1 free assets.

Solvency

Balance sheet The tail

Extent of dynamic hedging

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Dim

ensi

ons

Hedging for dummies

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Why hedge dynamically?

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Nature of liabilities

Complex

Convex

Dynamic

Tactical profit

Benefits and setbacks of dynamic hedging

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Source: www.pensionsage.com Source: www.risk.net

Other aspects of dynamic hedging

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Source: www.independentaudit.com Source: www.insurancetimes.co.uk

Challenging the norm Equity risk hedging in with profits and variable annuities

28 May 2014

Delta and Gamma

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Delta hedging With Profits:

- Policyholder Fund

- Estate (owned X% by Policyholders)

Variable Annuities:

- Policyholder Fund

- Insurer’s account

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Delta hedging – using futures

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Futures offset changes in Cost of Guarantees arising from the ∆

Delta hedging – futures equivalence

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Delta hedging – replicating portfolio

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Delta hedging – notional shorting

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With Profits

Variable Annuities

Now common practice

Equivalent is short selling

stocks

Delta and Gamma

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Potential Issues: Futures Shorting

Basis Risk

Material?

Near-zero

Trading Cheap & Nimble

Costly &

Cumbersome

Potential Solutions:

Bit of both

A Gamma hedge using options

When to use Options

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Whether to Hedge Gamma

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Options allow:

Reduced capital requirements Peace of mind Source: RBS / Bloomberg

What Variable Annuities With Profits

Current practices

Hedge equity delta and interest rate rho Close to half hedge equity gamma

Variety depending on guarantees / strength of the Fund

Objectives of the hedge

Instruments used for hedging

What Variable Annuities With Profits

Current practices

Hedge equity delta and interest rate rho Close to half hedge equity gamma

Variety depending on guarantees / strength of the Fund

Objectives of the hedge

Pay guarantee claims Minimise amount and volatility of capital requirements Competitive guarantee pricing

Pay guarantee claims Minimise amount and volatility of capital requirements Work with other risk reduction levers

Instruments used for hedging

Variable annuities vs With Profits

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What Variable Annuities With Profits

Current practices

Hedge equity delta and interest rate rho Close to half hedge equity gamma

Variety depending on guarantees / strength of the Fund

Objectives of the hedge

Pay guarantee claims Minimise amount and volatility of capital requirements Competitive guarantee pricing

Pay guarantee claims Minimise amount and volatility of capital requirements Work with other risk reduction levers

Instruments used for hedging

Derivatives Derivatives + Notional Shorting

What Variable Annuities With Profits

Hedging process

Active Daily valuation Real time monitoring Weekly hedge reporting

Pragmatic ¼ or ½ yearly review of liabilities Active under extreme conditions

Variable annuities vs With Profits

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What Variable Annuities With Profits

Hedging process

Active Daily valuation Real time monitoring Weekly hedge reporting

Pragmatic ¼ or ½ yearly review of liabilities Active under extreme conditions

Governance Detailed hedge strategy mandates

Varies from prescriptive with clear delegation to judgmental

Capital Requirements – Vega breakeven

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Challenging the norm Inflation and interest risk hedging in traditional annuities and pension funds

28 May 2014

What Traditional Annuities Pension Funds

Current practices

Hedge interest rate, inflation and FX exposure Not credit risk

Partial hedging of interest rate and inflation exposure

Objectives of the hedge

Instruments used for hedging

What Traditional Annuities Pension Funds

Current practices

Hedge interest rate, inflation and FX exposure Not credit risk

Partial hedging of interest rate and inflation exposure

Objectives of the hedge

Minimize capital Inflation matching mandatory

Reduce and stabilise shortfall between assets and liabilities Target nominal/real/inflation hedge ratios by term

Instruments used for hedging

Traditional annuities vs Pension Funds

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What Traditional Annuities Pension Funds

Current practices

Hedge interest rate, inflation and FX exposure Not credit risk

Partial hedging of interest rate and inflation exposure

Objectives of the hedge

Minimize capital Inflation matching mandatory

Reduce and stabilise shortfall between assets and liabilities Target nominal/real/inflation hedge ratios by term

Instruments used for hedging

Bonds Derivatives: interest rate and inflation swaps

Bonds Derivatives: interest rates/inflation swaps, swaptions, TRS/Repo.

Traditional annuities vs Pension Funds

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What Traditional Annuities Pension Funds

Hedging process

Duration or cash-flow matching Fairly static

Trigger based: Yield/funding level, Averaging in Predominantly passive, some active LDI

Governance

Other

What Traditional Annuities Pension Funds

Hedging process

Duration or cash-flow matching Fairly static

Trigger based: Yield/funding level, Averaging in Predominantly passive, some active LDI

Governance Established mandates Initial negotiations can be lengthy

Other

What Traditional Annuities Pension Funds

Hedging process

Duration or cash-flow matching Fairly static

Trigger based: Yield/funding level, Averaging in Predominantly passive, some active LDI

Governance Established mandates Initial negotiations can be lengthy

Other Regulation Matching adjustment

Third party fund managers

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Initial observations

Annuities Pensions

Cumulative outperformance of active LDI vs. liability benchmark

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Source: Insight Investment

Performance attributing factors

Out

perfo

rman

ce v

s.

Liab

ility

benc

hmar

k

Hedging real yields: Gilts or Swaps?

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3.57%

3.35%

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

Jan-2006 May-2007 Sep-2008 Feb-2010 Jun-2011 Nov-2012 Mar-2014

Rea

l yie

ld (%

)

ILG 25Y real yield 25Y real rate swap Source: Bank of England, RBS

Inflation options: 30 year LPI[0,5]

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3.0%3.1%3.2%3.3%3.4%3.5%3.6%3.7%3.8%3.9%4.0%

Oct-09

Feb-10

Jul-10 Dec-10

May-11

Sep-11

Feb-12

Jul-12 Dec-12

May-13

Sep-13

Feb-14

30 y

r RP

I sw

ap ra

tes

-15-10-505101520253035

LPI[0

,5] s

prea

d bp

s

30yr RPI 30yr LPI[0,5] spread

Inflation options: 30 year LPI[0,5]

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-15-10

-505

101520253035

3.1% 3.2% 3.3% 3.4% 3.5% 3.6% 3.7% 3.8% 3.9%

30 yr RPI

30 y

r LP

I[0,5

] spr

ead

bps

Oct 2011 to Dec 2012 Jan 2013 (CPAC) to dateOct 2009 to Mar 2010 Apr 2010 to Sept 2011

Market distortion – Implied vols 30 yr RPI

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0.2%0.3%0.4%0.5%0.6%0.7%0.8%0.9%1.0%1.1%

0.0% 1.0% 2.0% 3.0% 4.0% 5.0%

Strike (Cap/Floor)

Impl

ied

norm

vol

Aug-10Dec-12Mar-14

Capital implications – April 2014

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RPI swap

Market cost of LPI[0,5]

‘Real world’ cost of LPI[0,5]

Inflation stress

‘Real world’ cost of LPI[0,5]

under stress

Capital requirement

10Y 3.29%

20Y 3.61%

30Y 3.67%

50Y 3.67%

Cheaper to hedge

-3 bps

-2 bps

4 bps

9 bps

-3 bps

-6 bps

-8 bps

-6 bps

-97bps

-84bps -66bps

-66bps

6 bps

10 bps 11 bps

11 bps

3 bps

4 bps 3 bps

5 bps

Source: RBS ALM Emily Penn, Robin Thompson

Capital implications – Dec 2012

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RPI Market cost of LPI[0,5]

‘Real world’ cost of LPI[0,5]

Inflation stress

‘Real world’ cost of LPI[0,5]

under stress

Capital requirement

10Y 2.69%

20Y 2.96%

30Y 3.14%

50Y 3.21%

Cheaper not to hedge

-97bps

-84bps

-66bps

-66bps

17 bps

24 bps

29 bps

33 bps

3 bps

0 bps

-2 bps

-1 bps

7 bps

5 bps

7 bps

7 bps

10 bps

6 bps

5 bps

6 bps Source: RBS ALM Emily Penn, Robin Thompson

Conclusions

28 May 2014

Conclusions

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Challenging the norm

Tendencies and biases

Economic capital

Risk preferences

Capabilities

28 May 2014 36

Expressions of individual views by members of the Institute and Faculty of Actuaries and its staff are encouraged.

The views expressed in this presentation are those of the presenters.

Questions Comments