Put options power up variable annuities

Variable annuities are a popular long-term investment vehicle and a common component of retirement schemes. In the US alone, about $100 billion of variable annuities are sold every year, making up about half the total annuities market.

But there is no standard way for insurance companies to hedge the risk of variable annuity contracts.

Two industry practitioners have put forward a new hedging method using protective put options. They estimate that the technique can improve risk-adjusted profits for insurers’ variable annuity portfolios by 60%.

The improvement comes from two sources: more efficient use of options as a hedging tool, and a reduction in the capital charges for insurers.

The approach is based on the assumption that a variable annuity can technically be seen as an option on the future value of the premiums. “The liabilities can be modelled as long-dated options and we use short-dated put options to hedge them. And we are framing how to calculate that hedge and optimise capital requirements,” explains Vivek Shah, who oversees investment and hedging solutions at Prudential plc in London. Shah co-authored the research with Benoit Vaucher, director of research at Edhec Business School.

Hedging variable annuities is important because of the nature of the product. The contracts often come with various types of guarantee, making the management of the liabilities more complex for providers. Since variable annuities are affected by market risk, volatility and other factors, the provider must use hedging to ensure the policy delivers the guaranteed income at maturity.

Moreover, insurers need to hold regulatory capital to protect their portfolios in case of sudden drawdowns or a stressed environment. As regulators in Asia, Europe and the US are moving towards the use of risk-based capital metrics, hedging can help reduce the charges by reducing the exposure of the insurers’ portfolios.

Despite the key role of hedging in the performance of these products, the topic is not widely explored in financial theory and literature. The effect of hedging on capital charges is often neglected in the industry, too. “It’s feasible that even among the big institutions this issue hasn’t been properly addressed,” says Shah.

Hedging variable annuities with put options is not simple. The insurer’s liabilities typically have maturities of 20–30 years, while the put options have much shorter maturities, 10 years at best, and are possibly illiquid. The two cannot directly match.

There needs to be greater dialogue between investment banks and insurance firms on how derivative hedging solutions can address insurance firms’ long-dated liabilities and regulatory capital requirements

Vivek Shah, Prudential

Shah and Vaucher’s proposed strategy relies on optimising the P&L of the variable annuity portfolio and its hedges to take into account risk-based capital charges, in addition to market factors and specific elements such as management fees. They do so by rolling positions on put options and rebalancing with a set frequency. To determine the quantity of put options needed, the authors use a backward-recursive method that computes the value of the optimal hedging portfolio for each possible value of the underlying.

Their study shows that the strategy significantly improves risk-adjusted profits for the insurer, in simulations run with a realistic parameterisation and fat-tailed distributions.

The technique doesn’t just exist on paper; it’s also in real-world use, Shah reveals. “In production at Prudential’s US subsidiary, Jackson National Life, a more sophisticated version of this approach is implemented and constantly updated and improved,” he says.

The motivation behind the initial project comes from what Shah perceives as a lack of fully satisfactory support from banks on hedging issues that are specific to the insurance sector.

Banks offer derivative products to insurers looking to hedge their long-term liabilities, but don’t go far in advising on the optimal strategies for their clients, Shah says. Banks also don’t take into account the interconnectedness between hedging strategy and capital charges. Shah, who has a banking background and knows well the other side of the fence, decided to proactively suggest a possible solution. “Essentially what we’re trying to do here is to find the optimal hedging strategy that can be offered to insurance firms to help them manage their longer-dated liabilities” he says.

“There needs to be greater dialogue between investment banks’ structuring and trading teams and insurance firms on how derivative hedging solutions can address insurance firms’ long-dated liabilities and regulatory capital requirements; both in the interest rate and equity dimensions,” he adds.