Managing Risks Underlying Variable Annuity Liabilities

Frank Zhang

With so many unknowns and variables, particularly related to future volatility in the capital markets, variable annuity (VA) writers must address the risks – both insurance and capital market risk – to the profitability of products. VA guarantees, especially, should be treated as derivatives for the pricing calculation. Unlike traditional insurance liabilities, which are leveraged to the market to a lesser degree and are traditionally managed by pooling risk, derivatives must be managed differently. In fact, the capital market risks associated with derivatives cannot always be diversified away. Insurers will need to determine and manage the trade-offs between earnings volatility and capital optimisation, as well as those between marked-to-market profitability (based on forward-looking implied or expected volatility) and trading profitability (based on realised volatility). VA writers are increasingly improving their VA risk management sophistication, combining pricing with hedging, combining hedging for the earnings with hedging to cover the tails of the distribution of economic/capital risk, and incorporating scenario stress testing into capital management within an advanced risk