As hedging becomes increasingly popular for variable annuity insurers, they must invest in the necessary tools to make it effective, cautions David Hopewell

Today's insurance industry finds itself in interesting times. Aging populations, increased personal responsibility for financial management, a hyper-competitive marketplace, and increased sensitivity to risk on all sides have led to a wave of innovation that has positioned the industry to serve retirement security needs in a variety of ways.

Consumers want innovative products that offer flexibility and protection.

An example is the latest product in variable annuities (VAs), the Guaranteed Minimum Withdrawal Benefit (GMWB). Combining access to account values with flexibility in asset allocation and a long-term guarantee of performance, these have proved successful in helping companies gather assets. At the same time, they expose the issuers to a complex set of risks. Which policyholders will receive benefits, when will they receive them, and how much will be needed?

Now enter the regulatory community and rating agencies, each asking for companies to take more responsibility for measuring and managing their risks, especially those linked to stock market returns and guarantees.

Companies must reduce their risk or increase their capital, as they strengthen their analytic skills to demonstrate the effectiveness of either approach.

This is a worldwide trend, and the recent variable annuity and capital initiative in the US is probably just the beginning.

Traditionally, direct writers have been able to rely on reinsurance to reduce their exposure to such unknowns, but cover available for VA guarantee writers is both very limited and expensive when it is available at all.

To sell the GMWB, writers must find a way to manage their risks. For most of them, VA guarantee risk management now means hedging.

WHY HEDGING?

Hedging was not common among insurers until a few years ago, and was mostly focused on interest rate risk management. Equity hedging was seen as a losing bet because at best, hedging transforms stock returns into bond returns; buying put options to protect against falling equity markets was even worse, with an expectation of losses over time as the premium paid exceeded the option payoffs.

The bear market of 2001-2002 changed all that. The once in a generation fall in equity indexes reduced company income from management fees, increased their obligations under VA guarantees, and was accompanied by a bear market in credit that impaired other assets. Industry financials were badly hurt during the period, and some notable write-downs were taken. The biggest writers understood clearly that the risk of another downturn could put their earnings, business plans, or even the companies themselves at risk.

Reinsurers took a hit. Some had concentrated exposure to VA guarantees and a fee stream sufficient to pay benefits only in friendlier markets.

Most responded to losses by ceasing new production, although they were obligated by existing treaties to continue accepting the risk for some time thereafter.

Regulators also took note. The National Association of Insurance Commissioners (NAIC) asked the actuarial community to come up with an approach that would help VA guarantee writers determine how much capital they needed to hold to survive that rare event, an average catastrophe. This approach is known as C3 Phase II, and it has broad implications for VA product design, pricing, and risk management.

C3 Phase II makes the statutory balance sheets of insurance companies that write VA guarantees much more sensitive to the rise and fall of equity markets. As equity markets fall, companies require more dollars of capital to maintain their required capital level. Capital is expensive, and most companies with a significant VA guarantee business cannot afford to maintain a capital balance big enough for a falling market; when the markets fall, they must reduce risk or raise capital. Writers might prefer reinsurance as they have in the past, but without it most must hedge.

Hedging is a partial substitute for VA writers without reinsurance. By hedging, VA writers can substantially pre-fund the increased cost of claims from falling equity markets and falling interest rates. They can customise the strategy to support their unique business goals; in fact for the major VA writers risk management for VA guarantees is such a critical part of their business that relying solely on external sources of risk relief (such as reinsurance) is probably unacceptable. Hedging GMWB and other VA guarantees is a large effort calling for specialised skills and IT infrastructure. Companies must allocate the resources to support the high volume of complex calculations required to select appropriate portfolios of derivatives, as well as train back office and risk management personnel, and will usually need to modify their investment accounting and general ledger systems.

STARTING FROM SCRATCH

In the best case, hedging helps companies understand and control what claims will cost them; transforming the equity index level driven, option like claims payoff into a more predictable cost. But even the best hedge strategy is only as good as the other variables in the claims equation: who is paid, and when? To help answer these questions companies will rely on their actuaries and the modelling systems they have in place.

In some cases, they will find that these systems are not up to the task.

Older systems may lack features needed to do the proper analysis. Companies may be saddled with different legacy systems for different blocks of business, or they may find that their actuarial modelling environment and their in-force administration environment do not integrate well and are difficult to control. Finally, companies frequently find that the computing demands of these new approaches are too large for existing platforms, that runtime becomes the constraining factor in their risk modelling, and that simply throwing hardware at the problem doesn't solve it. Many VA writers are finding that rather than just requiring another model, C3 Phase II and the associated issues of hedging and product design will require them to transform their modelling approach with new software platforms, hardware installations, and actuarial modelling processes.

The changes around VA guarantees are happening at the same time that enterprise risk management (ERM) initiatives are starting within VA writers.

The tools and techniques of C3 Phase II will need to integrate into their ERM methodology. This is an incentive for companies to put extra thought into their C3 platform selection with special focus on quality, speed, and flexibility.

Companies face challenges even after they have become effective hedgers.

A strategy that provides relief from economic risk alone may not be enough.

Companies will need tools and processes that allow them to balance risk reduction, capital control and income volatility. Model-based capital combined with realistic simulation of capital markets prices and hedging strategies will become the standard for VA writers. Specialised modelling platforms that can take advantage of advances in computing power - are fast, functional for the products of today and flexible enough for what's next - are required as companies move into the era of derivatives-based risk management and the model-driven balance sheet.

CALL TO ACTION

The principles-driven, model-based balance sheet requirements of C3 Phase II are here to stay. Variable annuities with guarantees are the first product type in the US to be subject to this type of requirement, but won't be the last. Other products with significant long-term financial guarantees will also transition from static reserves and formulaic capital to balance sheet requirements that are more realistic and based on economic simulations. Under this approach capital adjusts far more quickly to current economic conditions than under past approaches, meaning that capital needs will increase at the least convenient time. Both direct writers and reinsurers serving these markets will need to find a way to calculate and fund their risk capital requirements over a wide range of outcomes, perform scenario-based analysis of product design and pricing integrated with simulation of realistic hedging strategies, and develop processes and tools to tie everything together.

Transformed actuarial processes and leading edge technology will offer speed and effective use of resources, along with the flexibility, accuracy, and institutional controls that are requisite for large companies. Companies that want to be in the market of the future need to prepare now.

- David Hopewell is senior actuarial advisor at Ernst & Young's Insurance and Actuarial Advisory Services (IAAS) practice.