Latest Developments in Risk Management, Hedging andManagement, Hedging and Capital Markets for Insurers

Victor Huang, Milliman &Danny Wong, MillimanDanny Wong, Milliman

© 2012 Milliman

AgendaAgenda• Market update, hedging overviewMarket update, hedging overview• Key developments in risk management

f ifor insurers• Control framework evolution• Trends/implications for products

AgendaAgenda• Market update, hedging overviewMarket update, hedging overview• Key developments in risk management

f ifor insurers• Control framework evolution• Trends/implications for products

Market ThemesMarket Themes• European crisis and austerities• Central Bank’s balance sheet expansionp• China’s less aggressive easing• Increase in overall market volatility

Source: VIX Index (Bloomberg)

Source: US Federal Reserve, ECB (Bloomberg) Source: EuroStat (Bloomberg)

Market ActivityMarket Activity

Source: Bloomberg

Source: Bloomberg

Hedging OverviewHedging Overview• Liability: where does the risk lie?

– GuaranteesProtection– Protection

Source: Milliman MG-HedgeTM

Translating to Market RiskTranslating to Market RiskAccount Currency I t t R tValue> Delta

Currency> Delta

Interest Rate> Rho

Delta

V l tilit C it Basis RiskVolatility> Vega

Convexity> Gamma

Basis Risk> Hedge StrategyStrategy

Derivative Hedge InstrumentsDerivative Hedge InstrumentsInstrument Delta Rho Vega Gamma / Convexity

Equity Index Futures / Total Return Swaps Total Return SwapsCurrency Futures / Forwards Interest Rate Swaps / Bond Futures

Interest Rate Swaptions Variance Swaps / Volatility Futures Equity Options Equity Options (ETO & OTC)

Dynamic Hybrid Static

Milliman Hedge Cost IndexMilliman Hedge Cost Index

Source: Milliman Hedge Cost Index for Variable Annuity Guarantees (Bloomberg: MLHC Index)

New Exchange Traded ProductsNew Exchange Traded Products• SGX China A50 Futures• 10 Year French Govt Bond Futures• S&P500 Super LEAPS Options• VIX Futures

– Nikkei Volatility IndexH S V l tilit I d– Hang Seng Volatility Index

– Emerging Markets ETF Volatility Index– Brazil ETF Volatility IndexBrazil ETF Volatility Index

• ASX Property Index

Impacts of Regulatory p g yDevelopments on Hedging

Regulation ImpactDodd-Frank • Exchange clearing IRS and CDS

• Upfront margin requirement

European Market Infrastructure Regulation (EMIR)

• Exchange clearing for IRS and CDS• Upfront margin requirement

Basel III • Hedge cost likely to increase• Pricing for uncollateralised transactions• More intensive usage of capital

Life and General Insurance Capital • Risk based capital requirementsLife and General Insurance Capital (LAGIC)

• Risk based capital requirements

OTC Trading DevelopmentsOTC Trading Developments• Collateral Posting for OTC Transactions

Credit Support Annex (CSA)– Credit Support Annex (CSA)– Overnight Index Swap (OIS)– Currency– Upfront Margin RequirementsUpfront Margin Requirements

• Disruption Clauses on ISDA Confirmations– Hedging Disruption– Increased Cost of HedgingIncreased Cost of Hedging– Loss of Stock Borrow– Increased Cost of Stock– Optional Termination ProvisionOptional Termination Provision

AgendaAgenda• Market update, hedging overviewMarket update, hedging overview• Key developments in risk management

f ifor insurers• Control framework evolution• Trends/implications for products

Vega Rho Hedging TrendsVega, Rho - Hedging Trends• Volatility Management

– Opportunistic Vega hedging– Variance swaps

R H d i• Rates Hedging– More granular duration

More Active Hedge ProgramsMore Active Hedge Programs• Client demands:

– 24hr real-time coverage of risk positions• Recent market events and industry best practice

driving this demanddriving this demand– Eurozone debt, Fukushima, GFC

• Benefits– Better management of gap risk through minimising periods

where risk thresholds are breached– Approaching the ‘continuous rebalancing’ assumption of modelspp g g p

Operationally how is it implemented?Operationally, how is it implemented?Typical approach previously used by insurers, most basic use of a Global DeskPrimary approach clients are adopting ‐ Makes use of extended futures trading hour

ASXNIKKEIEurostoxx 50FTSE 100S&P 500

ASXNIKKEIEurostoxx 50FTSE 100S&P 500S&P 500Time: 0. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23.S&P 500Time: 0. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23.

A step further ‐ Makes use of proxies when liquidity isn't available

ASXNIKKEIEurostoxx 50FTSE 100

SPX ProxySPX Proxy

Possible need for SPX Proxy

S&P 500Time: 0. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23.

No TradingNormal Trading Reduced liquidity Limited Trading

Models how are they changing?Models, how are they changing?Most current market data, inforce data used for full valuations

Greeks #1 #2

Time: 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 0. 1. 2. 3. 4. 5. 6. 7.

Valuation #1 + real‐time market data =real‐time Greeks used for 24hr hedging

Valuation #2 + real‐time market data =real‐time Greeks used for 24hr hedging

• Move towards more precise intra-day estimation of Greeks– Full Taylor series implementation

F ll D lt fil t dd l k t t– Full Delta profile to address larger market movements– GPU assisted real-time valuation of Greeks

• Smarter, tighter trading thresholds– Risk adjusted thresholds– Thresholds for overall position

Evolving Operational Best PracticesEvolving Operational Best Practices

TradersHedge Assets Database

Pre-filled Trade Execution Broker/

ExchangeFIXTrading

ModelLiability

Valuations System Exchange

F t fi &

Model

R l ti

Valuations

Fat-finger & Security checks Hedge policyReal-time

Market data

AgendaAgenda• Market update, hedging overviewMarket update, hedging overview• Key developments in risk management

f ifor insurers• Control framework evolution• Trends/implications for products

Identifyingand Specifying

the Problem

The eControl Cycle

Developing and Monitor and

Implementing the

solutionresponding to

experience

Performance Attribution

Note: Numbers are illustrative

Sample Real-time Snapshot

Note: Numbers are illustrative

AgendaAgenda• Market update, hedging overviewMarket update, hedging overview• Key developments in risk management

f ifor insurers• Control framework evolution• Trends/implications for products

Product Implications/Emerging TrendsProduct Implications/Emerging Trends• Shift in the product landscape

• Traditional guaranteed products less feasible• Increasing demand for protection amid market uncertainty

E b d l t t i k t• Embed latest risk management technologies into funds directly

• Volatility management provides a stabilised level of risk exposurestabilised level of risk exposure

• Capital protection provides a layer of option-like protection

Source: Milliman

ExamplesExamples• Locally, Fortnum/Wealthsurey

have launched/are launching funds with embedded risk management.

• In the US, Lincoln, Ohio national, etc.

• TOPSTM Protected ETF Portfolios