Annuity Hedging: Impact on the Equity Derivatives Market

Sponsored by and Annuity Hedging: Impact on the Equity Derivatives Market Presenter(s): Philippe Combescot

Annuity Hedging Impact on the Equity Derivatives market Philippe COMBESCOT, Managing Director Global Equity & Commodity Derivatives 10 th Annual Equity Based Insurance Guarantee Conference (Chicago) Session 1A: 17 November 2014 (1045 1215 hours)

Annuity Sales over time Over the last 10 years annuity sales and the split between fixed and variable have been roughly stable. But significant change within each category : VA separate account went from 55% to 81% of Variable Annuities sales Indexed Annuities went from 16% to 60% of total Fixed Annuity sales Annuity Sales per quarter over the last 10 years 80 70 60 50 $ Billions 40 30 Variable Fixed 20 10 Source: LIMRA. 0 2003 1Q 2004 1Q 2005 1Q 2006 1Q 2007 1Q 2008 1Q 2009 1Q 2010 1Q 2011 1Q 2012 1Q 2013 1Q 2014 1Q 2

Insurance companies use of derivatives Derivative hedging per risk type Insurance companies use derivatives to hedge : FX 18% Equity 22% Rates 56% Interest rate risk : 56% of the total derivatives notional. 75% is through swaps, the rest through Caps and Floors Equity risk : 22% of derivatives notional. 80% of equity risk hedging is done through options. The rest through futures and Total Return Swaps. Foreign Exchange risk : 18% of derivatives notional Source: Schedule DB, NAIC Equity option type Equity option position : 400 billion notional 18% 16% 31% Call Put Collar Calls : 31% of total notional. Average maturity is 1.5 years. Mainly used to hedge Fixed Indexed Annuity crediting. Puts : 35% of total notional. Average maturity is 5 years. Underlying is mainly S&P 500. Used to hedge Variable Annuities GLBs Other 35% Source: Schedule DB 3

Variable Annuity guaranteed living benefits Q2 2014 GLB election rate Guaranteed living benefits still popular. Source: LIMRA VA Assets with GLB elected Assets in bln 900 800 700 600 500 400 300 200 100 Others GMIB GLWB GLB Available 88% GLB Elected 76% Out of $27 billions variable annuity sales over Q2 2014 guaranteed living benefits were elected for $18.5 billions. When GLBs are available election rate has been declining since 2012 from 90% to currently 75%. GLWB remains the most popular type of benefits representing 82% followed by GMIB for 13%. VA assets with GLBs growing steadily VA assets with GLWB assets elected represents 62%. GLWB assets increased 2.5 times since the end of 2009 vs 1.75 increase in the S&P 500. Very little increase for other types of GLB. 0 Source: LIMRA. Q4 2008 Q4 2009 Q4 2010 Q4 2011 Q4 2012 Q4 2013 Q2 2014 4

InsCo equity derivatives option position Total current exposure through S&P 500 puts in $ mln < 1.5y 1.5y - 5y > 5y Notional 75,041 17,250 19,629 Delta (6,058) (2,165) (3,417) Vega 72 60 147 Avg strike 75% 65% 64% Source: Schedule DB Largest position relative to the overall equity derivatives market is created by S&P 500 puts, specifically on the long term. Largest vega position. Large forward position Total gamma exposure : $ 600 mlns S&P 500 vega bought per quarter for maturities > 5y 25 21.4 22.4 175% 165% Vega Traded in $mm 20 15 10 5 0 155% 145% 12.8 13.5 135% 125% 115% 6.0 6.1 105% 5.1 3.9 95% 2.9 1.7 0.8 85% 75% 2011Q4* 2012Q2* 2012Q4* 2013Q2 2013Q4 2014Q2 Performance Since 30 Sep 2011 The amount of long term S&P 500 vega bought by insurance companies has significantly decreased since the end of 2012. This is inline with the rise of the Equity market and long term interest rates. Source: Schedule DB Vega traded (mlns) SPX perf (RHS) 10Y Rates perf(rhs) 5

Impact on S&P500 long term volatility Long term S&P 500 volatility has decreased significantly since 2012 as well. S&P500 volatility still has a steep term structure that appeared mid 2005. S&P 500 implied volatility over the last 10 years 60% 50% 40% 1y 5y in 5y 30% 20% 10% 0% Nov-03 Nov-04 Nov-05 Nov-06 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12 Nov-13 Nov-14 Source: BNP Paribas. Past performance is not indicative of future performance 6

Comparison on implied volatility term structure Current implied volatility term structure Implied volatility 30% 25% 20% 15% 10% Source: BNP Paribas S&P 500 EuroStoxx50 Nikkei 0 2 4 6 8 10 Maturity in years 5y in 5y minus 1y implied volatility spread Implied volatility term structure significantly different across the main indices : S&P 500 term structure is very steep compared to EuroStoxx50 and Nikkei. EuroStoxx50 term structure is close to flat and below S&P 500 beyond 5 years. Most long term structured products on EuroStoxx50 are sellers of volatility. On average Nikkei implied volatility is higher and close to flat. It exhibits a slight dimple around the 5y maturity, the standard maturity of Uridashis. 15% 10% 5% 0% -5% S&P 500 EuroStoxx50 The difference between S&P 500 and EuroStoxx50 term structure increased after the 2008 financial crises : Increased long term put buying from InsCo on S&P 500. Since 2008, given the level of interest rates, long term structured products on EuroStoxx50 are volatility sellers to generate attractive coupon. -10% Nov-03 Nov-05 Nov-07 Nov-09 Nov-11 Nov-13 Source: BNP Paribas. 7

End users of long term volatility across regions US market : Variable annuities living benefits GLxB policy holder is buying an exotic put from the insurance company. Very long effective maturity Insurance company hedging driven economic & regulatory Europe and Japan : Structured notes Retail clients 100% Capital Protection Standard structure : Zero coupon + buy a call option Private banking clients Conditional capital protection : 65% to 85% barrier Standard structure : Reverse convertible : Zero coupon + sell a put option Auto callable is a very popular variation ( Uridashi in Japan) Investing in Notes could result in trading losses. please refer to the risk disclaimer on page 14 for more details. 8

Auto-callable structured notes Auto-Callables are the most popular long term structure sold to end investors in Europe and Asia over the last few years. On Observation Dates (typically yearly), if the Index is above its Initial Level, a high coupon is paid and the structure ends early. If at maturity, the Index has not dropped below a predefined level and the structure has not been terminated early the investor gets his principal back However, if the Index dropped below the predefined level at one point before maturity the investor ends up long the index rather than cash. Typical scenarios for auto-callable structures Synthetically the note buyer is selling a strip of puts spread across maturities weighted by the probability of early redemption at that date. 100 Cancelled with coupon Long the index at maturity To hedge the seller (IB) has to Sell long term volatility Barrier Buy long term forwards Observation 1 Observation 2 Observation 3 Observation 4 (Maturity) Investing in Notes could result in trading losses. please refer to the risk disclaimer on page 14 Source : BNP Paribas. Graphical illustration is included for illustrative purposes only 9

European structured product market Number of issuance per capital protection type SPs issuance by Capital Protection From 2007 to 2009, higher level of protection of initial capital invested due to the increase in risk aversion Since then, with a sustainable low rates environment, higher proportion of structures with invested capital at risk (pre Lehman proportion) Source: BNP Paribas Source: BNP Paribas Number of issuance per maturity SPs issuance by Maturity Higher proportion of longer maturity issuances from 2009 and 2011 to compensate the low rate / risk aversion (high level of capital protection) environment Resilient number of short maturity issuances since 2009 Source: BNP Paribas 10

Implied dividend and financing rate Current implied dividend term structure 145% 135% 125% 115% 105% 95% 85% 75% Source: BNP Paribas. Past performance is not indicative of future performance 7 year implied financing cost 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 1.2 S&P 500 EuroStoxx50 Difference between S&P500 and EuroStoxx50 implied dividend term structure reflects the flow of end users On S&P500, IBs have to sell delta (TR) and buy back the dividends to hedge the puts they sold to InsCo. Inversely on EuroStoxx IBs have to buy delta (TR) and sell back the dividends to hedge the puts they bought through structured notes. 7y TRS spread above Ibor3m in % pts 1.0 0.8 0.6 0.4 0.2 0.0-0.2-0.4 S&P 500 EuroStoxx50-0.6 Nov-11 May-12 Nov-12 May-13 Nov-13 May-14 Source: BNP Paribas. Past performance is not indicative of future performance Difference between S&P500 and EuroStoxx50 on long term implied financing rate reflects the flow end users. On EuroStoxx50 IBs have to carry the long delta position on their balance sheet. Recent change in regulation has made that more expensive. On S&P 500, InsCo synthetically provide a flow of long term index performance. 11

Fixed Annuity Sales over time Over the last 10 years fixed annuity sales have been roughly stable. But Indexed Annuities went from 16% to 60% of total Fixed Annuity sales Fixed Annuity Sales per quarter over the last 10 years 35 30 25 Indexed MVA Fixed Book Value $ Billions 20 15 10 5 0 2003 1Q 2004 1Q 2005 1Q 2006 1Q 2007 1Q 2008 1Q 2009 1Q 2010 1Q 2011 1Q 2012 1Q 2013 1Q 2014 1Q Source: LIMRA. 12

Indexed Annuity Market Overview Indexed annuities now firmly established as the second largest annuity segment (beyond variable annuity, 3x FA market) Sizeable issuance growth of 7.8% annual rate since 2007 Coming changes which could increase the FIA size: Low interest rates are driving a search for yield and players with alternatives strategies are becoming prominent Baby boomers nearing retirement are nearing peak age for IA sale Sales from 2004-05 (peak year before introduction of IA income rider) are about to exit the surrender charge period US Indexed Annuity Issuance ($Bn) Top 10 2Q2014 YTD Issuance Volumes ($Bn) 50 45 40 35 30 25 20 Allianz Life 6,605 Security Benefit Life 2,352 American Equity 1,913 GAFRI 1,560 Athene USA 1,185 Midland National Life 899 ING 854 EquiTrust 816 Symetra Financial 735 Fidelity & Guaranty Life 696 Top 10 2Q2014 Issuers Market Share 15 10 5 0 Source : BNP Paribas. Winks * 13

Indexed & Indexed Universal Life market trends 2014 thus far one the most active year for new products with 22 new indexed annuities introduced to the market by 6 carriers in Q2 alone S&P 500 still the most common crediting allocation (51%) but down from 66% in Q2 2013. Hybrid Indices are now 2 nd at 31%. Gradual increase toward hybrids exemplify market interest for innovative strategies delivering uncapped crediting. As of Q2 2014, 21 carriers offering indices beyond S&P 500 for indexed annuity and 27 carriers for Indexed Universal Life. Annual point-to-point crediting represents 50% of sales. Monthly point-to-point distant 2 nd at 16% Majority of surrender periods at 10y ( 59%). But 7y surrender period sales increased to 16% from 5% in 2013. 14

Indexed Annuity Most Popular Underlying Increased competition encourages providers to look for differentiation Security Benefit was the 1 st to place FIA linked to custom indices Custom Indices International Indices Euro Stoxx 50 Allianz, American General, ING FTSE 100 Allianz 3% 5% 21% Security Benefit Life: Allianz Annuity linked Trader VIC Index Transparent Value Blended Index Morgan Stanley Dynamic Allocation Hang Seng Aviva, Sagicor, Midland National ishares MSCI HK Index Fund Phoenix Life Nikkei 225 - American General, National Western MSCI EAFE Ameritas Life 72% From 4Q 2013 to 2Q 2014 Athene Barclays US Dynamic Balance S&P Risk Control Shiller Barclays CAPE Index ForeThought Barclays ARMOUR II Gross USD 7% ER Fidelity & Guaranty Life Non S&P Domestic DJIA- Allianz, American Equity, Athene, Midland, Phoenix Life Russell 2000 Allianz, Ameritas, Midland, Sagicor S&P Midcap 400 Midland Nasdaq 100 Allianz, Midland, Phoenix Life, Americo Financial 0.46% 35% 6% 58% Symetra DJ US Real Estate Risk Control 10% S&P Average Daily Risk Control 5% American Equity S&P Dividend Aristocrats 5% Risk Control S&P 500 is still the dominant index with around 60% of the market shares in the EIAs sold in the US + Source: BNP Paribas, Wink S&P 500 US Domestic ex-s&p500 International Custom indices 15

Volatility target overlay : methodology To create a viable product for a fixed index annuity, new indices usually included a volatility target overlay. A volatility target overlay adjust the exposure to the underlying assets with the aim of achieving a target volatility The volatility control deleverages underlying exposure when volatility is rising and leverages when volatility is falling Exposure not allocated to the underlying assets is allocated to a synthetic overnight cash If realized volatility < Target Increase underlying exposure Set a target level for volatility Observe underlying realized volatility Overall volatility ~ Target volatility If realized volatility > Target Decrease underlying exposure Exposure Source: BNP Paribas, for illustration purposes. 16

Why a Volatility Target overlay? Advantages Drawbacks Efficient Option pricing Stable & predictable option price with little dependency on market conditions No extra premium paid for implicit volatility Correlation between index and its volatility Volatility target overlay can have negative consequences in raging bull markets or in low volatility bearish trends Innovation Expands the underlying assets universe Trading an option is possible even if the underlying index has no or very illiquid volatility market Education IMOs & agents End client Offering benefit Sales differentiation. Extension of the distribution channel. Persistent product offering No cap on the crediting strategy Liquidity Option market is less liquid than S&P 500 s option market 17

Volatility Target Overlay : Specification Underlying S&P 500 Target Volatility 15% Observation Period Rebalancing Frequency 20bd and 60bd Daily Maximum Exposure 200% Tolerance 10% Daily calculation of the annualized Realized Volatility of the Reference Index over the last 20 & 60 business days Daily calculation of the Target Exposure : Target Exposure Target Volatility max( 20bd Volatility, 60bd Volatility) Daily comparison of the Target Exposure to the Current Exposure If the difference is > Tolerance, readjust to Target Exposure If the exposure is < 100%, the remainder of the portfolio is invested in cash If the weight is > 100%, leverage is provided to the Underlying subject to the Maximum Leverage level 24/11/2014 18 For Institutional Investors Only Not For Use With Retail Investors, Not Intended for Further Distribution

Hedging Volatility Target Overlay Risk of simple delta hedging for option on indices with Volatility Target overlay : Volatility of volatility risk Jump risk. Underlying / Fixed income correlation risk Realized volatility of S&P 500 with and without 15% volatility target overlay 50% 45% 40% Exposure (rhs) 60bd rlz vol 60bd rlz vol with overlay 200% 180% 160% Volatility 35% 30% 25% 20% 140% 120% 100% 80% Exposure 15% 10% 60% 40% 5% 20% 0% Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Jan 13 Jan 14 Source: BNP Paribas, for illustration purpose. 0% 19

Risks & considerations related to Notes investments Purchasing the Notes involves a number of risks. Prospective investors should reach a purchase decision only after careful consideration with their financial, legal, accounting, tax and other advisors regarding the suitability of the Notes in light of their particular circumstances. The following highlight some, but not all, of the risk factors in purchasing the Notes. An investment in the notes is subject to the credit risk of the issuer. The actual or perceived creditworthiness of the issuer may affect the market value of the Notes. Certain built-in costs are likely to adversely affect the value of the Notes prior to maturity. The price, if any, at which the issuer will be willing to purchase the Notes from investors in secondary market transactions, if at all, will likely be lower than the original issue price and any sale prior to the maturity date could result in a substantial loss. The tax consequences of the Notes may be uncertain. You should consult your tax adviser regarding the U.S. federal income tax consequences of an investment in the Notes. The investor does not benefit from dividends of any securities comprising the underlying asset. For Auto-Callable Features: The Note may be early redeemed one time at the sole discretion of the Issuer and the investor will receive 100% of the invested principal plus an Early Redemption Premium. No further payments will be made on the Notes. For Knock-in puts: Risk of partial or total principal loss at maturity if the worst performing Index closes below the Knock-Out Barrier on the Final Valuation Date. A knock-out Event, and thus Redemption Amount at maturity, is not determined until the Final Valuation Date. 20

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