Measuring Hedge Effectiveness

Peter Phillips

Insurance companies hold assets and liabilities that are sensitive to market movements, the passage of the time and, in some cases, policyholder behaviour. Almost all life insurance products are subject to interest rate changes. Whole life insurance products, where the majority of the benefit payments are towards the end of the policy, also have very long durations, giving rise to interest rate sensitivity. A small shift in the interest curve could have a large impact on the reserve and capital requirements of such products. Annuity products that pay a certain amount over the lifetime of the policy also face such interest rate risks. In addition, these products are also subject to other capital market risks, such as equity returns. Equity returns influence the investment income earned from the premiums paid by policyholders. Furthermore, variable annuities (VAs) often come with riders that guarantee a minimum benefit to be paid or withdrawn over time. These benefits behave in a similar way as financial derivatives, which respond sensitively to many risk factors in a complex way.

Hedging strategies have long been employed by insurance companies to manage such product exposures to