Risks Faced by Writers of Investment Guarantees

Daren Lockwood and Matt Cheung

Life insurers commonly provide policyholders with investment guarantees – for example, as a feature of variable annuity (VA) products. These investment guarantees are widely recognised as embedded options, both in accounting treatments and in the approaches generally used by issuers to manufacture the guarantees. In particular, issuers tend to make use of liquid hedge instruments available in the capital markets to fund the guarantees and manage their risk exposures.

These embedded options differ in character from liquid options traded in the capital markets in a number of key respects. For instance, they are often exotic in nature, with significant customisation by the issuer. They also often have higher maturities than the options available in the liquid options market. The underlying for guarantees can be a complex basket of investments with significant basis risk compared to the closest mix of liquid hedge instruments. In addition, although risks associated with policyholder utilisation of the options can sometimes be transferred – for example, through reinsurance deals or mergers and acquisitions (M&A) transactions – information about policyholder behaviour is more limited