# Variable annuities face more hedging challenges in Asia

## Variable returns

The Asian variable annuities (VA) market is far from homogenous – and has proven to be a tough market to crack. At one end of the spectrum lies Japan, which is second only to the US globally, in terms of size. The rest of Asia’s VA market lies more at the other end of the scale, and is patchy. Several isolated deals have been done in jurisdictions such as Hong Kong and Australia during the past five years, but they have had limited success. The only significant exception is Korea, which has seen rapid growth from next to nothing in the last few years, but is still far from being a fully developed market.

Insurance companies, however, view this shortfall as an opportunity. They point to Asian fundamentals to explain their high expectations. In 2010, Asia has about 465 million people above the age of 60. Even leaving out China and India, this figure is still high, at an estimated 155 million people, compared with the US, where the number is around 67 million. Meanwhile, the amount of variable annuities currently sold is low, with estimations for the biggest market in Asia ex-Japan, Korea, standing at about $19 billion, compared with$160 billion in Japan and \$1.1 trillion in the US.

The financial crisis took its toll on some of the early forays into VAs. “The experience has not been good for all,” says George Coppens, director for asset and liability management structuring at Credit Suisse in Hong Kong, who notes that a number of insurers that sold VAs stopped writing new business at this time. “Companies in the US suffered and Japan is closed for business at the moment.”

In 2007, HSBC and Manulife launched deals in Hong Kong. HSBC later withdrew its product, while Manulife paused sales. HSBC’s product, Life Invest Protection Plan, was in the guaranteed minimum death benefit (GMDB)/guaranteed minimum accumulation benefit (GMAB) format (see box, page 20) and had guarantees after 10 years. Manulife’s product, Secure Income Plus, was in the format of guaranteed minimum withdrawal benefit (GMWB) and whole life, a type of insurance policy. In Australia in 2007, Axa and ING launched the first products into that market, with what bankers describe as “limited success”.

According to banks, the market volatility witnessed during the crisis resulted in insurers being far more wary of taking on market risk generally, and this is in part driving business for banks, both for pricing and extra hedging. Amit Agarwal, managing director for rates structuring, Asia Pacific, at Barclays Capital in Hong Kong, believes concerns about market risk are second only to the absence of reinsurers in driving hedging activity – while the third-biggest influence is regulatory. “Because they are ultimately writing put options based on the performance of the portfolio, they have turned out to be very expensive,” he adds, noting high volatility pushes up put prices. During the crisis, the Vix index, the volatility index measuring implied volatility of Standard & Poor’s 500 index options, often referred to as the ‘fear gauge’, moved from 20 percentage points in August 2008 to 80 percentage points in October of the same year.

Bankers note that in Asia, insurers typically kept their market risk unhedged pre-crisis, but that this stance is softening. “What we are seeing in Asia ex-Japan is that most insurance companies are very concerned about anything that requires them to take risk,” says Gregory Yu, head of equity and fund derivatives structuring for Asia Pacific at JP Morgan in Hong Kong. “In the past, insurance companies, especially the international ones, were very willing to develop their own products and take on their own risk, and hedge it on their own – so they become the true designer of the products. But what we have seen since the financial crisis, for VA, are insurers asking people to take on the risk for them.”

Agarwal adds that now, “especially for the multinational firms, you must have a plan in terms of how you are going to manage the risk before you can launch the product”. He says there are correlation risks between the market and the actuarial part of a VA deal, and the correlation risks within the market risk itself, which could be driven by interest rates, plus equities, which can be mitigated to some extent.

The hedging process for these deals is extremely secretive, however, with banks declining to give details on exactly how the correlation between market and actuarial risk is hedged. Agarwal says banks will increasingly structure features such as volatility controls into the products from the outset. A further trend for new products is for the banks to help the insurers structure the new products so that the actuarial risk is minimised, even if it remains with the insurer.

“In general, what we observe in Asia is that whether insurers hedge or not depends a lot on their internal risk management practices,” says Ken Su, a consultant at Barrie and Hibbert in Hong Kong. However, Su adds that local insurers might be more interested in hedging through their statutory balance sheets. He says a number of local insurers without European or North American parents do not have sufficient internal expertise in terms of how they hedge. And some local insurers also do not calculate economic capital, so they are not incentivised for quantifying risk on a fully market-consistent basis. Hence there is a severe lack of incentive for them to build these hedging programmes.

In addition to this increased interest in hedging by international firms, bankers believe insurers are currently readying a new suite of VA deals across Asia. Credit Suisse’s Coppens says the market situation is changing given the underlying client demand, and insurers are now preparing themselves for another foray into the products. Although, at the time of writing, this new wave of VA deals has yet to appear, some bankers tip it to start in the very near future. “There are those that are faster than others, those that have been engaging [with the banks to arrange products] for a long time since the crisis,” says Yu. “We will see products in the later half of this year, though others are still just getting it together.”

Traditionally, investors move towards bond portfolios as they approach retirement. However, with inflation risks rising and market volatility increasing, equity investments with guarantees, which VA provides, is more palatable. Many investors also have the expectation of equity-like returns, given the returns they saw pre-crisis, or because of the amounts that their portfolios were wiped out during the crisis, and the need to recoup some of these losses. Australians, for example, were estimated to have lost on average 30% of their pension portfolio value in the market downturn. In particular, with interest rates low in many Asian jurisdictions, bond portfolios are unattractive.

“We know that the participants in the market are interested in launching VAs, it is just a matter of what type of VA and the most economically optimal VA that they are looking for – from a risk perspective to both the policyholder and the underwriters of this risk,” says Daniel Yap, head of the insurance solutions group at Nomura in Singapore. However, he also notes that at this stage the costs of structuring hedging products, and also the cost of maintaining them are still relatively high in Asia. “[It] will take time to become as normal as a term insurance will be, or whole life insurance,” he says.

Despite the attractions – and the perceived potential benefits of VAs – the products are not easy to handle, and not all insurers are fully behind the idea of taking them to market. A senior actuary at a major European insurer based in Hong Kong says his firm is not offering the products and has no plans to offer them in the territory. “It is probably a new product that has benefits for consumers, but it is difficult in this environment to really put together,” he says.

The actuary adds that his firm is controlling its risks by restricting its product offerings. “There has been a bit of an attitude shift, because we are more conscious of the type of product we put on,” he says. “But I think the investment banks want to make a genuine effort to help us sell.”

However, he did acknowledge a  rising demand for VA products and activity among his peers in some pockets. For these VA deals that are currently being brought to market, however, most banks are only willing to take on the market risk of the trade, not the insurance risk. This kind of hedging is not new – banks have been willing and able to take market risk for a long time through structured products, but typically reinsurers would also work to take on market risk in a bundle with insurance risk. But reinsurers are said to have limited appetite for the risks at present.

If there is a difficulty for the insurers in terms of finding enough banks or reinsurers willing to take on insurance risk, the result is that some of that risk remains on the balance sheets of the insurer. However, while some international participants are focused on their hedging, in certain markets domestic insurers remain less concerned, or are unwilling to pay the price of hedging. “Korean domestic players do not hedge,” says one senior structurer at a European bank in Hong Kong. “There is a perception that local insurance companies do underprice the value of the put option or capital guarantee,” he says. “It kind of squeezes out the multinational insurance companies, which would like to get the entire risk off their balance sheets – it makes it very difficult for the multinationals to enter the Korean market.”

Is there going to be an increasing trend of better risk management for local insurers? “In general, yes, but the speed of change will depend upon a variety of factors – regulatory drivers, awareness of the risk on their balance sheet and how quickly will they want to adopt market standard behaviour,” Barrie and Hibbert’s Su says.

“Although local insurers might be somewhat behind in computation, in some cases local insurers are willing to take a market view, for example, if they think the market is going down they become buyers of put options to hedge out some of their market risk.”

Essentially local insurers are comfortable having the risk on their balance sheets and hedging on an ad hoc basis.

Another connected broad trend is for insurers of all types to re-examine their capital positions post-crisis. “We are seeing a trend of clients addressing their capital programme, hence looking at ways to better manage capital, to reallocate capital, to make their capital work hard,” says Yap, adding that capital tied up in capital-intensive products such as VA is inefficient. “It goes back to the point of post-crisis it’s all about capital efficiency, so what we are seeing is the market or the sector embracing new ways of addressing capital management in the region.”

Yap says the volatility of the VA investment portfolios – the underlying equity funds that are existent for a particular trade – is costly because there is a need for large reserves of capital weighed against the more risky assets. The capital cost is driving insurers to seek hedges for the volatility in the funds – essentially, when insurers hedge it will release regulatory capital.

Yap notes that Nomura is working on trades in both Japan and Korea to hedge outstanding VA deals, where equity volatility is putting pressure on capital. “So what we’ve been working on essentially is: a client has a portfolio, [and they’re] thinking about capital management, how best to manage capital within the local environment, for both products as well as growth for their business in certain jurisdictions such as Japan.”

He notes that one trade Nomura is working on is a partial risk transfer on an equity index that best matched the funds the insurer offered to the public. Nomura then wrote options on that, but which are subject to a mortality index. Extra protection can be added if mortality increases to a certain trigger level. The transfer is partial, because the insurance company still maintains the basis risk between the bank’s equity index and the underlying, as well as the bank’s mortality index and the actual experience of mortality in the insurer’s domestic population. Yap stresses that each trade is highly dependent on each individual insurer’s circumstances and jurisdiction.

According to some bankers, re-insurance that covered both insurance risk and market risk is waning, which could drive insurers to turn to banks if they have risk concerns. Many reinsurers exited their businesses in the region post-crisis, according to Barclays Capital’s Agarwal. “[They] ended up realising that the risk they were taking was actually worth much more,” he adds.

“Our key message is that especially after the financial crisis,  many reinsurers are no longer willing to take on this risk,” says Agarwal. “A lot of reinsurers are not active [in Asia] anymore. It leaves insurance companies with banks to take on these risks.” As a result, many banks are increasingly building up their teams to fill the gap, seeing this as a potentially lucrative business.

However, the majority of banks are not willing to take on insurance risks because of a lack of expertise, but this is slowly changing too. Some specialised dealers such as Nomura take both, while others, such as Goldman Sachs, have been acquiring their own re-insurance businesses, blurring the distinction between reinsurer and investment bank. Some bankers, including a senior structurer at large US house in Hong Kong – one that is willing to take on only very limited amounts of insurance risk – challenged the ability of banks to take on this risk efficiently. “The question I would ask is, ‘if the insurer has always taken on mortality risk, and has the facility to do it, then why would they believe an investment bank can do it cheaper’? I believe most investment banks would give a similar picture,” he says.

He also acknowledges deals are not just done on costs but says now insurers are more involved with the banks in product creation, they are less able to isolate insurance risk and may not be able to manage it correctly. If the banks fully understood the product’s mechanics, in some cases it might be better from the insurer’s perspective to pass on the insurance risks to them, even though their general insurance risk pricing is likely to be expensive, relative to an insurer.

The ability of banks to take on insurance risk, however, is a function of their willingness to extend their balance sheet strength. And participants note there are few with the balance sheet available. “The problem you have with respect to banks is really regulatory… rather than what sort of risk it is. The issue is regulatory capital for banks,” says one equity structurer at a major European investment bank based in Hong Kong. He adds that whether or not a bank has free capital, often depends on the country of domicile for the bank, and that more relaxed capital requirements allow firms to access this business.

Yap says the decision by insurers about whether or not they turn to a bank for both insurance and market risk is not only dependent on the insurer’s objectives, but also the regulatory requirements the insurers face themselves and their sensitivity to capital efficiency. “That could drive a client to essentially reinsure the whole product off their books, hence releasing the regulatory capital that is on their books,” Yap says.

He adds that conversely, there are some insurers that are quite comfortable with their capital position and willing to use the capital to deliver capital-intensive products such as VA. “Others, on the other hand, post-crisis, are experiencing capital efficiency issues and would now look to reinsure some of these products off their books.”

What are variable annuities?

Variable annuities (VAs) are a combination of an investment product with life insurance benefits. Investors get different exposures for their investment, with the insurance company guaranteeing a minimum payment(s) for a fee. At the end of an accumulation stage, the insurance company guarantees a minimum payment, with the remaining income payments varying on the performance of the underlying portfolio.

It is hard to describe a typical product in the Asian market, because the markets are not homogeneous, and the types of products are broad. However, a typical VA product in Japan might have a 10- to 15-year tenor, with the investor able to invest in various different bonds or equity funds, and more recently China and Bric (Brazil, Russia, India and China) funds.
VAs can be broadly broken down into four kinds. Guaranteed minimum death benefit (GMDB), which guarantees the payment a minimum death benefit to the policyholder‘s beneficiary upon death. Guaranteed minimum accumulation benefit (GMAB), which guarantees a minimum accumulation value for the contract a certain point in time. Guaranteed minimum income benefit (GMIB) guarantees a level of annual income on retirement, during a fixed period or until the policyholder‘s death. And guaranteed minimum withdrawal benefit (GMWB) guarantees that the policyholder can monetise a fixed percentage of their initial investment annually. Some variants guarantee withdrawal until death, and often funds can be periodically reset.