2012 09 Infoline Guaranteed Life Bonds

Risk Management for Guaranteed Life Bonds

Presented byServaas Houben (Prudential)Neil Dissanayake (Milliman)

1

Agenda

Current regulatory and capital framework

Guaranteed life bonds product details and product example

Market risk management

Case study

September 19th 20122

Agenda




Case study


EMIR & Central Clearing Mandatory clearing of all qualifying OTC derivatives at a CCP

• CCP = Central Counterparty Risk mitigation standards for non-centrally cleared derivatives Exemptions:

• Small non-financial firms, below defined thresholds• Pension schemes (for 3-years temporarily)• Foreign exchange (?) (may depend on MIFID2 classification)

Reporting of all derivative transactions to trade repositories CCPs to be regulated on a consistent basis across EU members CCPs subject to capital requirements and transparency

2012 2013

EMIR primarylegislation in-force

EP adopts EMIR

ESMA to submittechnical standards

Expected Go live date for 1st eligible classes of

instruments (including swaps)


EMIR Implications• Costs for end user?

– implementation– margining– CCP costs– reporting

• Will we see reduced…– hedging?– liquidity?– price differentiation?– counterparty risk?

• OIS-curve discounting– Net Receive Fixed

• gain from existing positions

The move to a cleared interest rate swap market has started already.

Source: LCH Clearnet

September 19th 2012 5

Risk Free CurvesSnapshot of market and Solvency II curves

Risk Management Hedging uses assets quoted on OISPricing (Guarantees) Funding for hedging based on OISProvisioning Solvency II based on LIBOR & UFR

– One-off surplus (based on current market environment)– Hedging efficiency and provisioning risk due to LIBOR-OIS basis

EUR 24 August 2012

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

1 11 21 31Term (Years)

EUR / 24 August 2012 / Spot / Annual

Market LIBORMarket OISSolvency II Risk Free

Source: Bloomberg / Milliman


Solvency II-OIS SpreadAnalysis of daily data points

Term 1-year 20-year 30-year

0.5% percentile 34 bps 17 bps 61 bps

Median 56 bps 22 bps 72 bps

99.5% percentile 95 bps 29 bps 93 bps

EUR from 2 Jan 2012

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1.40%

1.60%

1 11 21 31Term (Years) Source: Bloomberg /

MillimanSeptember 19th 2012 7

Capital & Risk ManagementSolvency II • Significant difference between market and Solvency II for discounting long-

term fixed cash-flows• Currently Surplus.

– But… this depends on UFR relative to prevailing market conditions• SCR Capital Charge for this basis and risk of reversal?

Risk Management• Added complexity and potential inefficiency in current hedge strategies.• Are there solutions?

– LIBOR-vs-OIS basis hedge-able via swap– Active markets currently for EUR (liquid to c20 years) plus GBP and USD

• Full Solvency II-OIS more challenging


Regulatory and Capital Framework

Regulations

• Solvency I:• Reserve 4% of unit funds• Focus risk measurement• Different regimes in Europe

• Solvency II:• Standard formula:

• Instantaneous stresses • Rebalancing during stress not

allowed • Favours static hedges

• Internal model:• Uncertainty exact regulations• Use test

Capital

• Value at Risk:• Instantaneous shock• Risk reduction due re-balancing

limited• Benefit from hedged assets in-force

• Conditional Tail Expectation:• Tail Value at Risk: average of VaR• Considers entire lifetime of policy• Risk reduction due to future trading

more effective (in theory)• High computationally intensive• Model approximations may limit the

effectiveness allowed for in practice


Agenda




Case study


Product Details

• Profit sharing mechanisms

• Roll-up rates• Ratchet

• Guaranteed annuity options

• UL + guarantee• WP guarantee

• Flexibility investment mix

• Profit sharing• Hedging

implications

• Guarantee• Withdrawal

benefits• Death benefits• Tax benefits

Life insurance

Investment exposure

OptionalityExamples

11

Examples Dutch Products Features Bonuses non discretionary:

Formula based

Bonuses based on contractual agreements

Board responsible for setting realistic contract rates at start date

Valuation challenges:

Bonuses path dependent

Computer computation power required

No ring fencing arrangements as in UK

Immediate annuities Lump sum at t = 0, payments over time

Most competitive product (cross selling bank products)

Company profit sharing

Annuity guaranteed payment as under immediate annuities, plus

Company profit sharing when return exceeds annuity guarantee

Excess interest, company profit

Max return (Company profit sharing, government bond return x year period)

Interest rate discount When company return is expected to be higher than guaranteed return, policyholder discount given at start of the policy.

12

Present value fixed and floating bond

• Fixed bond: fixed coupon payments and principal payment at maturity. Present value function of current interest rates (0% profit sharing).

• Floating bond: variable payments depending on interest rate. Present value constant (100% profit sharing).

• Profit sharing is within these extremes.

Present value of 10 year annual coupon 4% bond

60708090

100110120130140150

0% 2% 4% 6% 8%

FixedFloating75% Profit sharing25% Profit sharing

Pres

ent v

alue

liab

ilitie

s

Yield


GLB as combination of fixed bond+callor floating bond+put

• Interest call option with strike value 4%:– Payout option when yield above

4% guarantee– Payout option (yield) = Max(100 –

value fixed bond (yield), 0)• Interest put option with strike

value of 4%:– Payout when yield below 4%

guarantee – Payout option (yield) = Value fixed (yield) – value floating

Present value of 10 year annual coupon 4% bond

0

20

40

60

80

100

120

140

0% 2% 4% 6% 8%

FixedCallBond + call

Pres

ent v

alue

liab

ilitie

s

Yield

September 19th 2012

0

20

40

60

80

100

120

140

0% 2% 4% 6% 8%

FloatingPutFloating + put

14

Company profit sharing – overall payoff

• Example:– Time horizon 10 years– Payment of 100 at time 0– Guarantee 4%– Profit to policyholder 40% above

guarantee– No life insurance, or (other)

operational risks• Fixed bond + call:

– bond (4% guarantee) – call (profit sharing for return

above 4% guarantee)• Floating bond + put:

– Stock (x% profit sharing)– Put (guarantee of 4% return)

Pres

ent v

alue

liab

ilitie

s

Yield

September 19th 2012

60

70

80

90

100

110

120

130

140

150

160

0% 2% 4% 6% 8%

AboveguaranteeBelowguarantee

60

70

80

90

100

110

120

130

140

150

160

0% 2% 4% 6% 8%

Bond

Call

60

70

80

90

100

110

120

130

140

150

160

0% 2% 4% 6% 8%

Stock

Put

15

Hedging ProcessOption value

• Monte Carlo• Replication

portfolios• Differential

equations

Other risks

• Lapse• Operational• Counterparty• Basis • Liquidity

Hedging

• Measurement variables• Capital requirement• P&L volatility• Reserves

• Hedging approach• No hedging• Additional reserves• Hedging solutions


Agenda




Case study


Market Risk Management(using hedging techniques)

September 19th 2012

Delta (& Gamma)(Risk from

underlying fund value)

Rho(Risk from interest

rates)

Vega(Risk from realised

and assumed volatility)

Effectiveness of Hedging

18

Hedge Mapping

September 19th 2012

Underlying Assets(e.g. managed

fund; unit-linked funds)

Guaranteed Life Bond

(LIABILITY)

Liquid Risk Factors

(e.g. FTSE index, GBP rates)

Capital Market Instruments

(ASSETS)

19

Basis Risk

ReplicatingOptionality

Optionality

Delta HedgingDelta Hedging• Hedge instruments: Futures, forwards, total return swaps, ETFs,

delta 1, short-selling stocks, reverse repo + sale• Re-balancing creates convexity to match liability ( gamma risk)• Expected cost from ‘buying-high / selling-low’ funded by hedge

premiums• Key is balancing the trade-off between:

– Liquidity / spread– Roll cost– Threshold– Rebalancing freq.– Hedge Basis

September 19th 2012

-€ 216,000

-€ 212,000

-€ 208,000

-€ 204,000

-€ 200,000

Liability 1% Delta Equity Index20


Rho HedgingRho Hedging• Hedge instruments: OTC interest rate swaps, cleared

interest rate swaps, swaptions• Similarly re-balancing creates convexity ( gamma risk)• Key issues:

– Term structure risk vs liquidity / spread– Roll vs unwind– Valuation issues

• CVA-pricing• OIS vs LIBOR

September 19th 2012

-€ 650,000

-€ 600,000

-€ 550,000

Liability 1bp rho (DV01) EUR 30-year swap rate21


Vega HedgingVega Hedging• Risk characteristics:

– Re-balancing strategy cost (buy-high / sell-low) higher than priced for in pricing and provisioning assumptions

– Changes in mark-to-market of liability on balance sheet due to changes in market assumed volatility

• Hedge instruments: ETOs, OTC index options, variance swaps, swaptions

• Key issues:– Long-term risk vs Short-term liquidity– Implied Vol (and broker-dealer premium) vs Realised Vol

(and uncertain gamma risk)– Counterparty risk – Skew (ATM vs ITM or OTM)


Agenda




Case study


Hedge Effectiveness(Case Study)

September 19th 2012

• Aggregation of actual European performance data

• Analysis Period = 1 June to 1 September 2011

• Mixture of minimum withdrawal, accumulation and death guarantees

• Mixture of single and regular premium business

• Normalised to un-hedged loss of EUR 100 million for the period

24

Hedge EffectivenessLIABILITY ASSETS P&L

Market Risk - HedgedEquity Delta € 27,311,224 € 25,622,682 -€ 1,688,542 94%Bond Delta -€ 5,841,967 -€ 5,925,252 -€ 83,286 101%FX Delta -€ 2,409,184 -€ 2,286,173 € 123,011 95%IR Rho € 71,538,920 € 66,098,359 -€ 5,440,561 92%IR Vega € 3,763,508 € 4,614,651 € 851,143 123%

93%Market Risk - UnhedgedEquity Vega € 697,434 -€ 697,434Cross -€ 615,171 € 878,452 € 1,493,623Theta (net premiums) -€ 2,586,752 € 1,037,040 € 3,623,792TC / Interest -€ 98,343 -€ 856,713 -€ 758,370

Net P&L (exc. Basis Risk) € 91,759,670 € 89,183,045 -€ 2,576,624 97%

Fund Mapping Basis € 8,240,331 -€ 8,240,331

Net Capital Markets P&L € 100,000,000 € 89,183,045 -€ 10,816,955 89%


Source: Milliman

Hedge Effectiveness

September 19th 2012

Time Series of WeeklyP&L Impacts

Impacts Graphed:• Equity Delta

• Bond Delta

• FX Delta

• Rho

• IR Vega

• Cross Effects & Theta

Graphs on same scale

Clear Reduction in Volatility

-€ 40,000,000

-€ 30,000,000

-€ 20,000,000

-€ 10,000,000

€ 0

€ 10,000,000

€ 20,000,000

€ 30,000,000

€ 40,000,000

10-Jun 17-Jun 24-Jun 01-Jul 08-Jul 15-Jul 22-Jul 29-Jul 05-Aug 12-Aug 19-Aug 26-Aug 02-Sep

Unhedged P&L (no hedge assets)

Equity Delta Bond Delta FX Delta Interest Rate Rho Interest Rate Vega Theta Cross Effects

-€ 40,000,000

-€ 30,000,000

-€ 20,000,000

-€ 10,000,000

€ 0

€ 10,000,000

€ 20,000,000

€ 30,000,000

€ 40,000,000

10-Jun 17-Jun 24-Jun 01-Jul 08-Jul 15-Jul 22-Jul 29-Jul 05-Aug 12-Aug 19-Aug 26-Aug 02-Sep

Hedged P&L (with hedge assets)

Equity Delta Bond Delta FX Delta Interest Rate Rho Interest Rate Vega Theta Cross Effects

26Source: Milliman

Summary

September 19th 2012

• Broad range of products with embedded long-term guarantees and significant market risk exposure

• Regulatory change via EMIR and Solvency II and uncertainty over implementation of some of these rules is making hedging more challenging

• However, hedging on a dynamic basis is still a powerful method to mitigate market risk for long-term guaranteed life bonds

27

References

S. Loisel, Variable annuities: confronting points of views of insurers and bankers, with an emphasis on surrender risk, March 2011 Central Bank of Ireland, Requirements on Reserving and Risk Governance for Variable Annuities, 2010 ESMA press release on EMIR, http://www.esma.europa.eu/system/files/2012-403_0.pdfContact details:

Servaas [email protected], http://actuaryabroad.wordpress.com/+44 (0)207 548 2774

Neil [email protected]+44 (0)20 7847 1557


2012 09 Infoline Guaranteed Life Bonds

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