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Innovation in Insurance Hedging March 2018
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Innovation in Insurance Hedging
March 2018
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Chatham FinancialChatham Financial is a global leader in financial risk management specializing in derivatives execution, advisory, accounting, valuations and debt solutions
Clients around the world use
Chatham for end-to-end risk
management solutions
Global offices spanning
the Americas, Europe
and Asia-Pacific
6
2,000 500Advisors, hedge accountants,
traders, quants, technology
engineers and regulatory
practitioners
on Numerix’s technical team
Annual transaction notional
volume
$500B
Years in business building
the deepest trading and
risk technology expertise
27Hedge accounting and risk
management clients using SAAS
ChathamDirect platform and
outsourced operational solutions
500+
3
NumerixNumerix is the award-winning industry leader in risk management and quantitative analytics for capital market participants
Clients around the world use
Numerix to power their
capital markets businesses
Global offices spanning
the Americas, EMEA
and Asia-Pacific
24
700 200Quants, PhDs, developers and
implementation experts
on Numerix’s technical team
Of the world’s most innovative
technology companies call
themselves a Numerix Partner
90
Years in business building
the deepest trading and
risk technology expertise
21Industry awards spanning
excellence in technology
innovation and leadership
100+
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Today’s Agenda
Annuity – Market Landscape
FIA – Introduction
FIA – Static Hedging
FIA – Dynamic Hedging
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Overview – Market Landscape
▪ Fixed Annuities continue the growth for new sales
▪ Fixed Index Annuities (FIA), amongst other Fixed Annuities, are gaining market share given up by Variable Annuities
▪ Higher issuance of FIAs adds additional market exposure to insurers
▪ Insurance companies issuing FIAs want to hedge efficiently and effectively
0
50
100
150
200
250
300
0
20
40
60
80
100
120
140
160
180
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Annuity Sales Estimates
Total Fixed Annuity Variable Annuity
Industry Market Share by Annuity Product Type
*Source LIMRA Secure Retirement Institute
*Source Insured Retirement Institute: 2017 Review and 2018 Outlook
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Today’s Agenda
Annuity – Market Landscape
FIA – Introduction
FIA – Static Hedging
FIA – Dynamic Hedging
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FIA - Introduction
What is a Fixed Index Annuity?
▪ Unlike a traditional fixed rate annuity, the interest credit is replaced with the up-side performance of an equity index
▪ Most popular crediting options resemble a payout of a “call-like” option
What are the benefits of a Fixed Index Annuity?
▪ Unique product design allows retail consumers to gain additional leverage than they could get otherwise
▪ More portfolio diversification options for consumers
▪ Standard insurance benefits apply (Tax-deferral, living benefits etc.)
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FIA – Behind the Curtain
What does an insurance company do?
▪ Unlike a traditional fixed rate annuity, the interest credit is replaced with the up-side performance of an equity index
▪ The premium is invested into a diversified Fixed-Income portfolio consisting of Corporates, Treasuries and Securitized products (e.g. MBS)
▪ On a standard fixed-rate annuity the policyholder is credited the yield generated by this portfolio less a spread
▪ The index annuity swaps this credit for an equity option
▪ The insurance company will then hedge the written equity option via over the counter derivatives (Static) or using a combination of equity futures and exchange traded vanilla options (Dynamic)
▪ Most popular crediting strategies will offer an embedded call style payoff structure with a fixed term of 1 year
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FIA – Behind the Curtain
▪ A good proxy for the crediting rate (B), is a moving average of the 10yr swap rate (R)▪ 𝐵𝑡 = 𝑤𝐵𝑡−1 + 𝑤𝑅𝑡
▪ A good proxy for option costs on a FIA is a 1 year 5% call spread on the S&P 500 index
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Date
Option Budget vs Option Cost
Sum of Option Budget Sum of Option Cost (105/100)
After
persistent
low yields,
recent
runup in
interest
rates will
reflect
positively
on FIAs
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FIA – Behind the Curtain
Crediting Method Payoff Comment
Uncapped Point-to-Point (PtP)
max(𝑆𝑇𝑆0
− 1,0)Consumer receives full upside of the underlying index.
Capped Point-to-Point (CPtP)
min(cap,max𝑆𝑇𝑆0
− 1,0 )Consumer receives capped upside of the underlying index.
Capped Monthly Averaging Point-to-Point (CMA)
min(cap,maxσ𝑆𝑖𝑛
𝑆0− 1,0 )
Averaging structures are less volatile and typically offer higher cap rates than non-averaging.
Monthly sum caps (MSP) max(0,min 𝑐𝑎𝑝,
𝑆𝑖𝑆𝑖−1
− 1 )Offers greater upside return in a steadily increasing market.
How does interest get credited?
▪ Here is a list of the most popular crediting strategies that are used in the market:
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FIA – Behind the Curtain
How do insurers hedge interest credits on FIAs?
▪ As shown on the previous slide, the crediting methodologies are specifically chosen to complement an existing derivative structure available to purchase
▪ Insurers can purchase the derivative outright (Static) or decide to manufacture it inhouse by dynamically rebalancing the exposure (Dynamic)
Crediting Method Hedge
Uncapped Point-to-Point
Call Option
Capped Point-to-PointCall Spread
Capped Averaging Point-to-Point
Capped Asianing Option
Monthly sum caps Cliquet
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Today’s Agenda
Annuity – Market Landscape
FIA – Introduction
FIA – Static Hedging
FIA – Dynamic Hedging
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FIA – Hedge Strategy Overview
Static Strategy Recap
▪ Insurance companies will issue policies with predetermined strike/index dates that determine when the policy “buys” into the market
▪ Depending on the perceived rate of persistence of the underlying cohort, the Insurer will make a determination how of the exposure needs to be hedged
▪ The insurer will then purchase the relevant hedge derivatives to offset their exposure profile
▪ The profit/loss of a static strategy is largely determined by: 1. The mismatch between actual and expected policy holder behavior 2. The grouping assumptions used to define the cohort of policies
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FIA – Static Strategy PnL
Illustrative Example
▪ The insurer receives $1,000,000 in premium and offers a 5% capped return on the SP500
▪ Due to various decrements, the insurer expects only $970,000 of the initial premium will remain inforce to receive an interest credit
▪ To hedge the exposure to rising SP500 levels, the insurer will purchase a 1 year Call Spread with a 5% cap on the SP500 with a $970,000 notional value
Eq Scenario \Actual Decrement
AD 0% AD 2% AD 5% AD 7% AD 10%
EQ Dn 20% 424 424 424 424 424
EQ Dn 10% 424 424 424 424 424
EQ Up 0% 424 424 424 424 424
EQ Up 1% 224 524 724 924 1,224
EQ Up 2% 24 624 1,024 1,424 2,024
EQ Up 5% (576) 924 1,924 2,924 4,424
EQ Up 10% (576) 924 1,924 2,924 4,424
EQ Up 20% (576) 924 1,924 2,924 4,424
The company can be underhedged in
the event that the total decrement rate
is lower than expected
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Today’s Agenda
Annuity – Market Landscape
FIA – Introduction
FIA – Static Hedging
FIA – Dynamic Hedging
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What could be different with dynamic hedging?
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FIA – Hedge Strategy Overview
Dynamic Strategy Recap
▪ Insurance companies will issue policies with predetermined strike/index dates that determine when the policy “buys” into the market
▪ The insurer will then calculate the market sensitivity of all policies issued to determine the total sensitivity of the portfolio to various market risk factors
▪ For example, the general market risk profile of a collection of PtP, CPtPs, CMAs and MSPs has the following characteristics:
(4,500,000)
(4,000,000)
(3,500,000)
(3,000,000)
(2,500,000)
(2,000,000)
(1,500,000)
(1,000,000)
(500,000)
-
EQ Dn20%
EQ Dn10%
EQ Dn5%
EQ Dn2%
EQ Dn1%
EQ Up0%
EQ Up1%
EQ Up2%
EQ Up5%
EQ Up10%
EQ Up20%
PV
PV
(180,000)
(160,000)
(140,000)
(120,000)
(100,000)
(80,000)
(60,000)
(40,000)
(20,000)
-
EQ Dn20%
EQ Dn10%
EQ Dn5%
EQ Dn2%
EQ Dn1%
EQ Up0%
EQ Up1%
EQ Up2%
EQ Up5%
EQ Up10%
EQ Up20%
Eq Delta
Eq Delta
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FIA – Hedge Strategy Overview
Dynamic Strategy Recap
▪ After calculating the sensitivity profile of the issued options, the Insurer will try to offset this sensitivity with an equity future contract or another vanilla derivative
▪ The goal of this strategy is to structure an offsetting portfolio that can effectively mitigate impact of market factors on the issued option
▪ Here is an example of same option profile with an equity future overlay:
(180,000)
(160,000)
(140,000)
(120,000)
(100,000)
(80,000)
(60,000)
(40,000)
(20,000)
-
EQ D
n 2
0%
EQ D
n 1
0%
EQ D
n 5
%
EQ D
n 2
%
EQ D
n 1
%
EQ U
p 0
%
EQ U
p 1
%
EQ U
p 2
%
EQ U
p 5
%
EQ U
p 1
0%
EQ U
p 2
0%
Portfolio Delta
-
50,000
100,000
150,000
200,000
250,000
EQ D
n 2
0%
EQ D
n 1
0%
EQ D
n 5
%
EQ D
n 2
%
EQ D
n 1
%
EQ U
p 0
%
EQ U
p 1
%
EQ U
p 2
%
EQ U
p 5
%
EQ U
p 1
0%
EQ U
p 2
0%
Futures Delta
(20,000)
-
20,000
40,000
60,000
80,000
100,000
120,000
140,000
EQ D
n 2
0%
EQ D
n 1
0%
EQ D
n 5
%
EQ D
n 2
%
EQ D
n 1
%
EQ U
p 0
%
EQ U
p 1
%
EQ U
p 2
%
EQ U
p 5
%
EQ U
p 1
0%
EQ U
p 2
0%
Portfolio + Futures Delta
With a Futures overlay, our portfolio
will have a Delta close t 0 for small
changes in the underlying.
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Hedge Strategy Historic Analysis
Perform a hypothetical forward looking
simulation for a hedge strategy
Talk about engaging in a vol-arb strategy
-2,500,000
-2,000,000
-1,500,000
-1,000,000
-500,000
0
500,000
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Option Portfolio Hedge Portfolio (Delta only)
Dynamic Strategy Recap
▪ To validate a efficiency of a Delta only hedging strategy, a hedge back test was performed.
▪ For a portfolio of 60M in account value issued on 1/1/2015, rebalance the delta using daily rebalancing dates, until all of the options have matured, 1/1/2016. Initial fair value of the option portfolio is 1.5M.
▪ Overall, the hedge portfolio is able offset most of the risk, but hedge breakages are still prevalent:
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Hedge Strategy Evolution
Emerging Trends
▪ As the FIA market gets more saturated, companies will look to modify their approach to hedging.
▪ The popularity of alternative investment strategies offered through FIAs, will continue to strengthen the relationship between Insurers and Investment Banks that offer options on such strategies.
▪ The rise of registered/structured FIAs, also creates new hedging challenges.
Source EBIG 2017: Fixed Index Annuity – Hedging and Risk Management
0 1 2 3 4 5 6 7
Static
Static w/ Dynamic Overlay
Dynamic
Number of Participants
More Dynamic No Change More Static
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Contact Information
Phil WeeberExecutive [email protected]: 484.731.0241
Phil leads Chatham’s Financial Services
Practice, providing insights and
transparency to companies facing front,
middle and back office challenges related
to the financial hedging of annuities and
the general account.
Since joining Chatham in 2003, Phil has
worked across asset classes advising
clients with risk strategy, hedging
implementation and execution.
Previously, he led the Commodity Risk
Practice, advising corporations in various
industries. Phil also headed Chatham’s
structured finance team and led business
development efforts, working with public
and private real estate companies.
Phil holds a MBA from Emory (Goizueta)
University, a Masters in Engineering from
the University of North Carolina, and a BS
in Engineering from the University of
Michigan.
Arsen ArutyunovSenior Pre-Sales Financial [email protected]: 312.466.5709
Arsen is a Senior Pre-Sales Financial Engineer at Numerix and provides actuarial solutions to clients focusing on hedge strategy design and implementation, liability modeling, and risk-neutral valuation with a focus on Fixed Index Annuities and Variable Annuities.
Prior to joining Numerix, Arsen served as an Associate Actuary for Sammons Financial Group working on experience studies and financial planning models for fixed indexed annuities and indexed universal life. Arsen is an Associate of the Society of Actuaries (ASA).
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Why Chatham and Numerix
▪ Our offering provides institutions a much more sophisticated approach to hedging than what has been available on the market, which will drive margin improvement and decrease exposure
▪ Chatham and Numerix have a combined 60+ years of experience serving the needs of a wide variety of institutions who trade and hedge using derivatives
▪ We have highly complimentary corporate cultures and product offerings based on a customer first and innovation centric approach
▪ We believe that there is appetite in the insurance industry for a much more robust hedging service which combines:▪ Chatham’s vast global experience in managing trading, operations, and hedge
accounting▪ Numerix award winning quantitative modelling capabilities
