Index-Based Insurance Risk Management Solutions

Transcription

1 Index-Based Insurance Risk Management Solutions A PRESENTATION FOR CBOE RISK MANAGEMENT CONFERENCE J. Alan Grissom March, 2014 For Financial Professionals. Not for Public Distribution. PROPRIETARY. Permission to reprint or distribute any content from this presentation requires the written approval of S&P Dow Jones Indices.

2 AGENDA INTRODUCTION INDEX SOLUTION: VIX-LINKED FEE INDEX SOLUTION: VOLATILITY MANAGED FUNDS VEGA-HEDGING BENEFITS CONCLUSIONS 2

3 AGENDA 01 INTRODUCTION

4 INSURANCE CARRIERS HAVE A HEDGING CHALLENGE U.S. insurers have equity market exposure in living benefit variable annuities of some $500 billion and total equity vega within that of $1.25 billion Phillipe Combescot, head of Americas equity derivatives structuring and strategy at BNP Paribas in New York, revealed the numbers from analysis of disclosures by U.S. insurers. He estimated that only 30-40% of the vega is hedged. Insurers are the largest buyers of long term SPX vol to hedge vega CBOE RMC in Sintra, Portugal,

5 INSURERS METHODS OF DE-RISKING Exit the market Reduced guaranteed benefits Withdrawal rate reduction Bonus rate reduction Age restrictions Investment restrictions Index funds Product Innovation: Protection based fee pricing VIX-linked variable fee for guarantee features Risk management: Embedded features in funds to reduce market risk Volatility-managed funds 5

6 AGENDA INDEX SOLUTION: VIX-LINKED FEE

7 WHY LINK RIDER FEE TO VIX? Alignment of fee revenues with hedging costs to produce a more stable cash flow for the Carriers. Analogous to ARM (Adjustable Rate Mortgage), the Policyholders could benefit from lower fees during stable market environments; Tying VA fees to VIX is a risk-sharing mechanism that benefits both carriers and policyholders; Two research papers* jointly commissioned by CBOE and S&P DJI. *1. VIX for Variable Annuities is available at 2. VIX for Variable Annuities, part II is available at 7

8 VIX-LINKED RIDER FEE STRUCTURE Fee Mechanics: o Rider Fee = Base Rate + Multiplier (VIX VIX Base); o Adjusts quarterly subject to periodic caps and floors o Rider fee is subject to a life time cap and floor. A hypothetical example: Base rate = 70 bps; Multiplier = 5; VIX Base = 20. Maximum 100bps quarterly change (plus or minus); life time cap = 220 bps; life time floor = 60bps In this example, o Rider fee = 60 bps when VIX = 16; Rider fee = 120bps when VIX = 30. o Cap/floor on fee kicks in when VIX is above 50 or below 18. The initial fee rate (1.10% of the Income Base for Single Life option; 1.35% for the Joint Life option) is guaranteed for one year. After the first year, the fee rate will change based on a predetermined, nondiscretionary formula tied to the change in the Volatility Index ( VIX ), an index of market volatility reported by the Chicago Board Options Exchange. With Protection Based Pricing, the fee rate can decrease in stable markets when the protection guarantee is generally not used and can increase in volatile markets when the guarantee may be critical in helping to protect your income. Source: SunAmerica Income Builder Brochure. 8

9 AGENDA INDEX SOLUTION: VOLATILITY MANAGED FUNDS

10 Volatility Managed Funds The Trend: Variable annuity writers are showing interest in new investment options that actively hedge assets at the subaccount level. The Significance: These protected portfolios reduce the risk of large account-value declines while still providing upside potential. The Payoff: Insurers will have better control over their balance sheets and more satisfied customers. Variable Annuity Carriers Offering Vol-Managed Funds Nationwide Prudential AXA Equitable New York Life Ohio National Forethought Jefferson National Kansas City Life Minnesota Life National Security Benefits Ameritas American Funds Ken Mungan, risk management practice leader at actuarial firm Milliman, has said that hedge savings for an insurer using a volatility-managed fund could be as much as 0.96% -Soleares Research 10

11 VOLATILITY-MANAGED FUNDS: RAPID GROWTH $ $ $ $84.12 $ $ $59.22 $ Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 Source: Soleares Research Portfolios LLC in Operation Initial Registrations Assets Under Management in $B 11

12 THREE VOLATILITY-MANAGED INDICES Three cases of vol-managed funds, as represented as the following indices: 1. S&P 500 Risk Control with target vol 15%* and Exponential-Weighted Moving Average (EWMA) historical vol as control variable; 2. S&P 500 Risk Control with target vol 15% and VIX implied vol as control variable; 3. S&P 500 Dynamic VEQTOR (allocate between S&P 500 and VIX) * The target vol 15% was chosen to be consistent with the historical vol of the VEQTOR index 12

13 Risk Control Methodology Original Base Index Risk Control Overlay Process Resultant Risk Control Index Volatility Increases Sub Index Weight Decreases Index Cash Weight Increases Base Index Target Risk Control Level Risk Control Index Volatility Decreases Sub Index Weight Increases Index Cash Weight Decreases Source: S&P Dow Jones Indices 13

14 S&P 500 DYNAMIC VEQTOR Dynamic Allocation between Equity (S&P 500), VIX (Short term Futures) and Cash, with a stop loss at 2% over 5 days. Target Volatility Allocation Implied Volatility No Implied Volatility Implied Volatility Realized Volatility (RVt-1 ) Downtrend Trend Uptrend Less than 10% 2.50% 2.50% 10.00% 10% RVt-1 < 20% 2.50% 10.00% 15.00% 20% RVt-1 < 35% 10.00% 15.00% 25.00% 35% RVt-1 45% 15.00% 25.00% 40.00% More than 45% 25.00% 40.00% 40.00% Implied Volatility Trend is decided by the moving averages (MA) of VIX: If 5d MA is above 20d MA, +1 for uptrend signal; If 5d MA is below 20d MA, -1 for downtrend signal; The signal has to maintain for 10 consecutive trading days to count as a trend, otherwise it counts as no trend. Source: S&P Dow Jones Indices. Charts and Graphs are provided for illustration purpose. 14

15 AGENDA VEGA-HEDGING BENEFITS 05 15

16 SIMULATION DETAILS Working with Numerix, the equity vega term structures for a range of GLWB products are simulated, with varying fee and fund strategies: 2 different fee strategies: fixed and VIX-indexed; 4 different fund strategies: static, target vol based on realized (EWMA) vol, target vol based on VIX, and VEQTOR Specifications: GLWB Base case: Fees: 1.2% Static: 60% equity/40 bond Equity: S&P 500 Bond: 5y zero-coupon Deterministic rates Rider Specification: Withdrawal rate based on age at withdrawal: 4%/5%/6% vs ages 65/75 Annual ratchet; 5% simple annual rollup during deferral period up to 10Y Fixed rider fee: 0.7% Actuarial Assumptions: 8 different ages and withdrawal cohorts Mortality is A2000 Base lapse based on 7Y surrender charge period One-sided dynamic lapse function of the policy s moneyness, measured as the ratio of Account Value to Guarantee Value Equity model: Kou Jump-diffusion model calibrated by historical S&P 500 dynamics. * S&P Dow Jones Indices and Numerix are working on a joint white paper to provide the details of this study. 16

17 GLWB VEGA PROFILE: FIXED FEE 0.020% 0.000% % % % % % % 20+Y 20Y 19Y 18Y 17Y 16Y 15Y 14Y 13Y 12Y 11Y 10Y 9Y 8Y 7Y 6Y 5Y 4Y 3Y 2Y 1Y Stat RC: EWMA RC: VIX VEQTOR Source: Information based on a currently unpublished whitepaper from S&P Dow Jones Indices and Numerix. All data and Chart is hypothetical and provided for illustrative purposes only. 17

18 GLWB VEGA PROFILE: VIX-LINKED FLOATING FEE 0.020% 0.010% 0.000% % % % % % % 20+Y 20Y 19Y 18Y 17Y 16Y 15Y 14Y 13Y 12Y 11Y 10Y 9Y 8Y 7Y 6Y 5Y 4Y 3Y 2Y 1Y Stat RC: EWMA RC: VIX VEQTOR Source: Information based on a currently unpublished whitepaper from S&P Dow Jones Indices and Numerix. All data and Chart is hypothetical and provided for illustrative purposes only. 18

19 VEGA-HEDGING BENEFITS: SUMMARY AND CONCLUSIONS GLWB model Fee Fund Claim Leg Vega Fee leg Vega Net vega Vega Duration (years) 1 Fix Stat % % % Fix RC: EWMA % % % Fix RC: VIX % % % Fix VEQTOR % % % Float: VIX Stat % % % Float: VIX RC: EWMA % % % Float: VIX RC: VIX % % 0.151% Float: VIX VEQTOR % % % 3.31 Both VIX-linked fee and Vol-managed funds can help reducing vega of GLWBs RC funds with VIX as the control parameter is the most effective and can even create positive Vega when combined with VIX-linked floating fee. VEQTOR style fund structure is the most effective in shifting the vega term structure to the short term, resulting in the shortest vega duration. Source: Information based on a currently unpublished whitepaper from S&P Dow Jones Indices and Numerix. All data is hypothetical and provided for illustrative purposes only. 19

20 PERFORMANCE DISCLOSURE Some index concepts discussed within this presentation are hypothetical and have not been launched. They are still in the concept phase only. Since there is no live data for these concepts, the performance and data are back-tested based on the concept s methodology. In performing these back-tests, existing indices may have been used as underlying building blocks, and those existing indices may include live or back-tested history. The official history is used when available, however, based on the time period reviewed, back-tested calculations may have also been used. For any of the existing indices, the back-test calculations are based on the same methodology that was in effect when the index was officially launched. Complete index methodology for those existing indices are available at The inception date of the S&P 500 Dynamic VEQTOR Index was May 25, The launch date of S&P 500 Risk Control 15% were September 10, 2009, at the market close. All information presented prior to the index inception date is back-tested. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. Complete index methodology details are available at Past performance is not an indication of future results. Prospective application of the methodology used to construct the S&P Index may not result in performance commensurate with the back-test returns shown. The back-test period does not necessarily correspond to the entire available history of the index. Please refer to the methodology paper for the index, available at or for more details about the index, including the manner in which it is rebalanced, the timing of such rebalancing, criteria for additions and deletions, as well as all index calculations. It is not possible to invest directly in an Index. Another limitation of back-tested hypothetical information is that generally the back-tested calculation is prepared with the benefit of hindsight. Back-tested data reflect the application of the index methodology and selection of index constituents in hindsight. No hypothetical record can completely account for the impact of financial risk in actual trading. For example, there are numerous factors related to the equities (or fixed income, or commodities) markets in general which cannot be, and have not been accounted for in the preparation of the index information set forth, all of which can affect actual performance. VIX is a registered trademark of Chicago Board Options Exchange, Incorporated. The VIX methodology is the property of the Chicago Board Options Exchange ("CBOE"). CBOE has granted Standard & Poor s Financial Services LLC ("S&P"), a license to use the VIX methodology to create the S&P 500 Short Term VIX Futures Index, S&P 500 Mid Term VIX Futures Index and S&P 500 Dynamic VEQTOR Index Series. The index returns shown do not represent the results of actual trading of investor assets. S&P Dow Jones Indices LLC maintains the indices and calculates the index levels and performance shown or discussed, but does not manage actual assets. Index returns do not reflect payment of any sales charges or fees an investor would pay to purchase the securities they represent. The imposition of these fees and charges would cause actual and back-tested performance to be lower than the performance shown. In a simple example, if an index returned 10% on a US $100,000 investment for a 12-month period (or US$ 10,000) and an actual asset-based fee of 1.5% were imposed at the end of the period on the investment plus accrued interest (or US$ 1,650), the net return would be 8.35% (or US$ 8,350) for the year. Over 3 years, an annual 1.5% fee taken at year end with an assumed 10% return per year would result in a cumulative gross return of 33.10%, a total fee of US$ 5,375, and a cumulative net return of 27.2% (or US$ 27,200). 20

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