What Exactly is Variable Annuity Hedging?

I was planning on writing up a summary of some of the variable annuity hedging effectiveness reports, but I received some questions asking to give a little background on what exactly hedging is. Therefore, before I dive into hedge effectiveness, I will dedicate today's blog to describing hedging basics. I will keep this at a high level, but if you are really dying to learn more or have any questions please let me know.

Q: In one sentence or less, what is variable annuity hedging?
A: It is a risk management technique that allows insurance companies to transfer the capital market risk (i.e. stock prices dropping) involved in issuing annuity guarantees to other parties for a fixed cost.

Q: Why do insurers need to hedge?
A: When an insurance company sells a variable annuity guarantee to a policyholder, it is taking on capital market risk. Typically the big risks for these products are if stocks or interest rates drop or if market volatility increases. Additionally, some of the richer benefits also offer guaranteed growth (roll up) rates, and there is a risk that these rollup rates outpace the underlying fund growth.

While insurance companies are in the business of taking on risk, they are most comfortable in risk that can be pooled. For example, in car insurance, insurers have a pretty good idea, that for every 1,000 16 year old boys they insure, x% will get into an accident that on average will result in say $5,000 in claims. It's not fortune telling, it's just using statistics to know that if you have a large enough group of people with similar characteristics, the insurer can estimate the total cost of claims for the group and then charge each person in the group appropriately to have a high likelihood of covering all claims. This is how insurance works most of the time. However, a guarantee on the stock market is not a poolable risk because generally speaking all policyholders have a guarantee on the same stock market. If the S&P goes down, then everyone has claims. There is no law of averages.

Fortunately, hedging techniques can be used to successfully manage this risk.

Q: Do insurers try to make a profit with hedging?
A: No. It is common to confuse the concept of hedging with hedge funds. These are totally different concepts. Hedging is a technique used by insurance companies to mitigate risk. In contrast hedge fund managers use fancy investment strategies and try to get filthy rich.

Q: In layman's terms, how does hedging work?
A: Hedging is complex, no doubt about it.

First, lets start with a product to hedge, so you can picture the risk. The simplest (and most boring) of the guarantees is a Guaranteed Minimum Accumulation Benefit (GMAB). Let's say there is a 10 year deferral period and very basic return of premium guarantee. This means the policyholder invests a premium - say $100,000. This money goes into mutual fund type investments. The insurer will guarantee the policyholder that at the end of 10 years, they will receive at a minimum their initial $100,000 investment or their account value at year 10, if it has appreciated (I don't think a product this boring is actually sold by any major insurers, but it's easy to understand).

So what is the risk to the insurance company? It is the risk that at the end of 10 years, the investor's account is worth less than $100,000. So if the value drops to $90,000 the insurer would have to pay a claim in year 10 of $10,000. Simple enough, right? Now if the insurer didn't hedge, they would have an unknown claim amount when they issued the policy. Or they could transfer the risk to the derivatives market and lock in a fixed cost that would cover claims regardless of what happens in the future. Still with me? Let me use an analogy to illustrate what I'm talking about.

Lets say in January of this past year, you walk into a gas station and they are selling gift certificates that if you pay $2, the gift certificate allows you to receive 1 gallon of gasoline at a point in time in the future. Over this past year, we've seen gas prices rise and fall, but if you owned this certificate, you would be able to get that gallon of gas for the $2 you paid, regardless of what the price of gas is actually at. Therefore you locked in the future price of gas at $2 and transferred the risk of gas prices changing to whomever sold you the certificate. In other words, you hedged against the future price of gas changing... making something that was uncertain now certain.

The same concept is applied with hedging guarantees, only a bit more complicated than buying a gift certificate at a gas station (or else I'd be out of a job)... The insurer uses fancy computers and sophisticated financial modeling techniques to figure out which hedge assets they should invest in, so when the markets move, the change in asset value will offset the change in their expected claim (liability) value. Using this technique, regardless of market fluctuations they can then lock in a fixed cost of issuing the guarantee.

So let's put this all together now in terms of the GMAB product discussed above. The insurer calculates the hedge cost (expected claims if hedged) they would expect to pay on a policy, let's say this is $1,000 at issue. They can then lock in the cost of issuing the guarantee by purchasing hedge assets that would insulate the insurer from any changes in the markets. So if after they lock in the hedge say that the stock market drops and by the time year 10 comes around, the policyholder's account value has dropped to 90,000. This means the insurer must pay them $10,000. Fortunately, the insurer has this money. They set aside $1,000 for the hedge cost. In addition, the hedge assets they "purchased" have increased by $9,000. Adding these together provides the insurer with $10,000 to pay the claim. Similarly, had the policyholder's account value dropped to 80,000, the insurer would owe 20,000. This 20,000 would be funded with the $1,000 they set aside for the hedge cost plus the $19,000 increase in the hedge assets. Thus, by hedging, insurers transfer the market risk to the derivatives market.

At a high level this is how hedging works. The uncertain risk is transferred for a more certain set of cashflows by entering into hedge assets whose payoff help to offset the change in liability cashflows that are owed to the policyholder. Hedging isn't perfect, and there will be some mismatch between the asset and liability cashflows, but in my next post, we'll take a look at how effective hedging has been in this recent period of declining markets and high volatility.