Taxonomy of Equity, Interest Rate, Hybrid and Customised Derivatives Used for Risk Management

Taras Klymchuk and Golnar Montazem

We will begin this chapter by examining various risks that life insurance carriers are exposed to in the course of writing market-linked life insurance business, including both retirement and protection products. We will then discuss which considerations are important for the carriers to think through while designing a hedging programme, before describing several hedging programmes commonly used by life insurers (such as dynamic hedging, advanced dynamic hedging and customised hedging), focusing on the derivatives used in each of these programmes and the specific risks hedged with them. We will demonstrate each hedging approach with specific examples illustrating how several common market-linked liability types (eg, US-style index-linked universal life and annuities, UK-style guaranteed annuity options, guaranteed minimum death/living benefits embedded in US/ Japan-style variable annuities) can be hedged. The chapter will conclude with a comparison of these hedging approaches.

TYPES OF RISKS EMBEDDED IN LIFE INSURANCE PRODUCTS

There are three main types of risk in life insurance products:

• • insurance risks (mortality, longevity, morbidity);
• • behavioural