variable annuity industry challenges and opportunities canadian institute of actuaries - 2009...
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Variable Annuity IndustryChallenges and Opportunities
Canadian Institute of Actuaries - 2009 General MeetingPD-7 Hedging VA/Seg Fund Products
November 19, 2009
Financial Risk ManagementMilliman, Inc.
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Agenda
Valuation Methodology
Risk Management Strategies
Impact of Financial Crisis
VA Hedging Programs
Innovations in Product Design
Future Outlook
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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
– Reinsurer needs to show assets backing reinsurance credit for ceding company
– Hedging credit may not reduce AG43 amount much
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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
– Cash flow testing methodology
– Year end actual capital market conditions
– Policy duration
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Risk Management Strategies
Stay Naked
– Assume enough capital pays for claims
Semi-Static
– Buy and hold using a portfolio of options
Dynamic
– Need to manufacture the risk management internally
Static
– Exotic derivative to manage capital market risk
Reinsurance
– Mitigate capital market and actuarial risks
GMWB Hedging Strategy By Type
No Hedge5%
Static15%
NA20%
Dynamic60%
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
• Full cashflow matching structures
– Minimal adoption
• 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 *
*Source: Milliman 2009 GLB survey
Living Benefit Type Market Share
GLWB 60%
GMWB 15%
GMIB 15%
GMAB 10%
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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 Objectivessource: Milliman survey
Economical 37.5%
US GAAP 25%
IFRS 6.25%
Combination 25%
Statutory cash value 6.25%
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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 Strategiessource: Milliman survery
Dynamic 62.5%Static 6.25%
VAR 6.25%
Combination 25%
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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, VA-CARVM etc.)
– Defining a more transparent and easy to calculate target
• Defining as package of options
• Directly hedging guarantee benefits not included in core strategy
• Using a deductible approach on guarantee benefits
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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
Risks: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
Contracts: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
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
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Innovations in Product Design
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April 18, 2023
Milliman Hedge Cost Index The overall cost of hedging has increased substantially
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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
B. Summary by number of changes
# of Changes (from the above 4 categories) # of Products # of Companies
1 90 15
2 31 15
3 4 3
Total 125 33
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
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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”
• Reduced bonus rates, typically 1-2% reduction
• Reduced length of bonus period or age restrictions
– Asset Allocation• Removal of most aggressive asset allocation model
• Use of more index funds
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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
Stocks
Bonds
Guarantee Fee
Funds
Insurer Balance Sheet
■Guarantee Liability■Hedge Assets■P&L Volatility
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Sustainable VA Business Model
Stocks
Bonds&
Hedges
ReducedGuarantee Fee
Funds Insurer Balance Sheet
■Reduced & Stabilized Guarantee Liability
■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
• Increases in implied volatility
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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
• Reduces cost of VA hedging programs via elimination of OTC risk margin
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Comparison of Asset Allocation Models
Comparison of Asset Allocation Models
From July, 1999 to May, 2009
Performance MeasureConstant Equity %
Target Volatility
Cumulative return 3.1% 19.3%
Realized volatility 12.3% 11.8%
Average equity allocation 60.0% 74.9%
Standard deviation of monthly volatility 6.3% 3.0%
Average allocation by fund
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%
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Monthly Realized Volatility
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
Jul 1
999
Jan
2000
Jul 2
000
Jan
2001
Jul 2
001
Jan
2002
Jul 2
002
Jan
2003
Jul 2
003
Jan
2004
Jul 2
004
Jan
2005
Jul 2
005
Jan
2006
Jul 2
006
Jan
2007
Jul 2
007
Jan
2008
Jul 2
008
Jan
2009
Constant Equity %
Target VolatilityVol-of-Vol Reduced by 52%
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Move Hedges into Customer AccountA 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
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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
Milliman, IncFinancial Risk Management71 S. Wacker Drive, 31st Floor Chicago, IL 60606Ph: +1 312.726.0677Fx: +1 312 499.5700www.milliman.com