The Milliman Guarantee Index™ is the first of its kind, offering a tool that gives variable annuity (VA) guarantee writers a reference point for valuation and risk management of these long-term liabilities.

The Milliman Guarantee Index represents an important development in this market for insurance companies, investment banks, hedge funds, and others who participate in the VA marketplace as issuers or investors.

The Milliman Hedge Cost Index is an expected cost of hedging indicator that is published each month as a part of the Milliman Guarantee Index report. The Hedge Cost Index can help users better understand the impact of changes in volatility levels and interest rate assumptions on the cost of hedging VA guarantees for a hypothetical lifetime GMWB block. TThe product design and actuarial assumptions used for the hypothetical lifetime GMWB block are described in the white paper Index Methodology (To obtain a copy, contact Ram Kelkar).

The need for the Index

Life insurers subject to U.S. GAAP accounting are currently valuing VA guarantees using methodologies that do not reflect the illiquidity of the guarantees.

VA writers commonly use data from the over-the-counter (OTC) options market for volatility parameters when valuing guarantees. However, VA guarantees have no cash value, and therefore life insurers are not exposed to the risk of forced liquidation. The OTC market is dominated by hedge funds and investment banks that are exposed to forced liquidation, which can trigger cycles of volatile option price movements.

Moreover, VA guarantees are commonly 20- to 30-year options, whereas the OTC options market is generally a 1- to 5-year market at most. Given that the liquidity characteristics of VA guarantees do not match those in the OTC options market, and given that there is no activity in the OTC options market in the 20- to 30-year maturity range, life insurers must look elsewhere to meet the requirements of FAS 157, which contains guidelines applicable to VA guarantee valuation.

Milliman's methodology for VA guarantee valuation is aligned with the guidance in the FASB position papers FAS 157-3 and FAS 157-4, and the Practice Note on FAS 157 and FAS 159 issued by the American Academy of Actuaries.

The Practice Note on FAS 157 and FAS 159 from the Academy of Actuaries issued in February 2009 states that "One approach is to use actual historical long-term volatilities to estimate the projected long-term volatilities for the fair value calculations. If the average historical volatility is used, there may be a need for a separate risk margin since the observed average historical volatility would not include any risk margin."

FAS 157-3, issued in October 2008, notes that "In determining fair value for a financial asset, the use of a reporting entity's own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable where relevant observable inputs are not available…Regardless of the valuation technique used, an entity must include appropriate risk adjustments that market participants would make for nonperformance and liquidity risks."

FAS 157-4, issued in April 2009, adds that "… determining the price at which willing market participants would transact at the measurement date under current market conditions…depends on the facts and circumstances and requires the use of significant judgment." It adds that "…regardless of the valuation technique(s) used, the reporting entity shall include appropriate risk adjustments."

How the Index is calculated

To construct the monthly Guarantee Index, Milliman reflects market data in an analytical process that produces a 1- to 30-year term structure of volatility and a correlation matrix for various market indices. The index provides volatility parameters for VA guarantee valuation on a monthly basis, incorporating a risk adjustment that reflects the uncertainty in the ultimate cost of funding VA guarantee claims.

Disclaimer: The information contained on this Web page is provided for general informational use only and should not be construed as accounting advice. Subscribers to the Milliman Guarantee Index and users of the Hedge Cost Index should consult their own financial, accounting and other advisors to the extent they consider necessary, and make all decisions solely based upon their own judgement and advice from their advisors.