Investors’ demand for protection against market-related losses has increased significantly. The recent bear market has changed customer psychology. Variable Annuity (VA) policyholders no longer swing for the fences in making VA product choices. Instead, there has been a shift to more stable asset allocations and increased selection of guarantees.
For insurers ready to capitalize on this shift, this is excellent news. For years, guarantees on variable annuities were viewed as ancillary “bells and whistles” that attracted little customer attention. Due to the bear market experience, guarantees have become primary selling points for these products. Life insurers can improve their market position by meeting customer needs for guarantees.
However, offering death, annuitization, withdrawal, and account balance guarantees necessitates a disciplined risk management program. Guarantees magnify an insurer’s exposure to market fluctuations, and they can cause extreme financial stress during a market decline. To protect solvency and profitability, VA writers are implementing programs to hedge these guarantees.
Of the top VA writers in the United States, approximately 75% are currently hedging or in the process of implementing a hedging program. This shift in insurer practices was motivated by several factors. First, the economic risk of VA guarantees is too significant to leave unhedged. Second, changes to GAAP accounting and statutory capital rules provide significant financial management incentives. Finally, rating agencies and market analysts do not want insurers to accept significant exposure to stock market fluctuations. In our work with rating agencies, we have noted many positive comments on insurers’ hedging programs.
Implementing a hedging program is far from simple. Essentially, hedging will become a new core activity of the life insurance company. This is a complex activity requiring enhancements to the firms’ organizational structure, technology platform, and financial management process. Hedging is not a one-time, ad hoc activity; it is a permanent, ongoing process with potential for continuous improvement.
The good news is that hedging can also provide a competitive advantage. Insurers with hedging capability have the opportunity to use capital more efficiently, stabilize income, and improve ratings and market perception. However, the greatest opportunity lies in integrating hedging with product development and marketing strategy. Insurers have the opportunity to develop products that truly resonate with customers’ desires.
Potential purchasers of variable annuities have a range of products available to them. According to the Investment Company Institute, US$6.4 trillion was invested in mutual funds at end of 2002. This is eight times the size of the variable annuity market. By capitalizing on investors’ demand for financial protection products, insurers have an excellent opportunity to grow the VA market.
Once a hedging program is implemented, a VA writer is able to develop guarantees that were previously not possible. For example, there has been substantial interest in the introduction of guaranteed minimum withdrawal benefits (GMWBs). GMWBs allow policyholders to withdraw funds over an extended period of time. This rider does not require annuitization, and it guarantees that the total withdrawals will equal or exceed the original premium deposit. Several insurers have linked GMWB development with the introduction of a hedging program.
In the GMWB example, this rider is considered a derivative with respect to the GAAP accounting rule, FAS 133. Therefore, the value of the GMWB liability on an insurer’s balance sheet will fluctuate with market movements. A hedging program can help offset these fluctuations.
The hedging strategies for VA guarantees in use today were developed to suit the specific needs of life insurers. VA guarantees are long-term, illiquid benefits. Typically, there is no direct analog in the financial markets. For example, it is impossible to purchase a GMDB or a GMWB on the Chicago Mercantile Exchange. In its current form, the over-the-counter derivatives market is limited in its ability to offer hedges for VA guarantees. The typical Wall Street investment bank offers hedges with maturities ranging up to five years. Claim payments on VA guarantees can extend over a 20- to 30-year horizon.
Also, over-the-counter derivatives have a fair value that can be realized for cash. Guaranteed minimum death benefits can only produce a claim at the time of death. While bear markets can lead to investor anger and frustration, investors generally do not want to file an early claim for death benefits. Similarly, other VA guarantees are illiquid riders with no cash value.
When establishing hedging programs, insurers are seeking to take maximum advantage of the long-term illiquid nature of VA guarantees. One example of this is the use of dynamic hedging strategies to manage the risk of these riders. Typically, this involves establishing a portfolio of hedge assets and adjusting the size of this portfolio to offset the VA guarantee risk. Hedge assets include futures, options, and swaps. The choice of hedge assets varies with the financial goals of the insurer, and the most common hedge assets are futures and option contracts on the S&P 500, Russell 2000, and the NASDAQ 100. A typical insurance company may trade once per week to balance the hedge portfolio to the guarantee liability.
Successful dynamic hedging requires a disciplined approach to financial management. One can think of a hedge profit center that is responsible for payment of VA guarantee claims. The hedge profit center collects premium, earns interest, pays claims, and receives gains and losses on hedge instruments. The hedge profit center should produce periodic profit and loss statements, as would be expected by any strategic business unit. In addition, there should be a detailed gains-by-source analysis that evaluates performance of the hedging program.
No hedging program will produce perfect results. However, an insurer should have clear expectations for the results of the hedging program, and it should track actual versus expected performance. In our experience with hedging programs, this process provides a great deal of insight into the VA business, and results have been generally positive.
Given the level of interest that we have seen in hedging programs, we think it is safe to say that hedging has arrived in the life insurance industry, and it is here to stay. In addition, it is exciting to see companies combine hedging with their marketing strategy. The combination is powerful, and enhanced guarantees resonate with a strong desire by the investing public for flexible products that provide reasonable protection against severe stock market declines.
Ken Mungan, FSA, MAAA is in charge of the Financial Risk Management Practice in the Chicago office of Milliman. His practice develops and supports MG-Hedge™, Milliman’s solution for comprehensive analysis, implementation, and execution of VA hedging strategies.