Variable Annuity IndustryChallenges and Opportunities

Canadian Institute of Actuaries - 2009 General MeetingPD-7 Hedging VA/Seg Fund Products

November 19, 2009

Financial Risk ManagementMilliman, Inc.

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Agenda

Valuation Methodology

Risk Management Strategies

Impact of Financial Crisis

VA Hedging Programs

Innovations in Product Design

Future Outlook

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Valuation Methodology - US GAAP US GAAP Methodology

– Valuation methodology varies based on the type of guarantee

– Non-life contingent guarantees (GMWB, GMAB, partial GLWB)

• Risk-neutral valuation under FAS 133/157

• Sensitive to changes in equity markets, interest rates and implied volatility

– Life contingent guarantees (GMDB, GMIB, partial GLWB)

• Real-world with smoothing (SOP 03-01)

• Partial sensitivity to changes in equity markets

– Base product revenues and expenses are earned as operating income (net of DAC amortization)

Impact on hedge strategy

– FAS133/157 : Encourages delta-rho-vega hedging

– SOP03-01 : Encourages partial delta hedging

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Valuation Methodology - STAT Capital Statutory Capital (RBC C3 Phase II)

– All guarantees are treated equivalently

– Incorporates base product revenue and expenses

– Projection on a real-world basis

– Hedge credit for company’s specific hedge program

– Standard scenario impacts may dominate in certain scenarios

Impact on hedge strategy

– Encourage delta hedging

– Mean reversion embedded in scenarios discourages rho hedging (in current market environment)

– Historical calibration discourages vega hedging

– Incorporation of hedge credit makes capital sensitivity neutral to vega and rho hedging

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Valuation Methodology - STAT Reserve

Statutory reserving (VACARVM AG-43) counterpart to RBC C-3 Phase II

– Like C-3 Phase II, AG 43 represents a step closer to a principles-based approach

Adopted by the NAIC in Sept 2008

Replaces AG 34 (GMDB) and AG 39 (GLB) reserving methodologies as of 12/31/2009

– (A slight variation of) AG 33 still used to calculate the Basic Adjusted Reserve component for the Standard Scenario

– If AG 43 produces higher reserves than was the case under prior statutory guidelines, a grade in period of (not to exceed) 3 years may be requested

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AG-43 vs. C-3 Phase 2

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AG-43 vs. C-3 Phase 2

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AG-43 vs. C-3 Phase 2

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AG43 needs to be managed differently from C3P2

Captive off-shore reinsurance and hedging had been effective and popular tools in managing C3P2

– Better yet, use the captive off-shore reinsurance company as the hedging operation center

The two approaches may face challenges in AG43

– Reinsurer needs to show assets backing reinsurance credit for ceding company

– Hedging credit may not reduce AG43 amount much

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Impact of AG43 Implementation for Year End 2009 There is no simple “rule-of-thumb” for the impact of AG43 for year-end 2009

Too many factors affecting the results between CTE(70) and standard scenario amounts and between AG43 and current reserve held

Examples of factors affecting CTE(70) vs. SSA

- Base product fees - Base product surrender charge schedule

- Actual guarantee charges - Policy duration

- Moneyness - Policyholder behavior assumptions

Examples of factors affecting AG43 vs. current reserves

– Cash flow testing methodology

– Year end actual capital market conditions

– Policy duration

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Risk Management Strategies

Stay Naked

– Assume enough capital pays for claims

Semi-Static

– Buy and hold using a portfolio of options

Dynamic

– Need to manufacture the risk management internally

Static

– Exotic derivative to manage capital market risk

Reinsurance

– Mitigate capital market and actuarial risks

GMWB Hedging Strategy By Type

No Hedge5%

Static15%

NA20%

Dynamic60%

Source: Moody’s Survey

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Risk Management Strategies - Trends

Industry trend towards dynamic hedging

– Effective in mitigating risk

– Uses vanilla, liquid instruments resulting low transaction costs

– Hedge positions are continuously updated to reflect policyholder experience

– Minimal transaction costs incurred from adjusting hedge positions to prospective changes in assumptions

– Becoming industry standard practice with best practices evolving

– Regulators and rating agencies recognizing dynamic hedging as risk mitigating techniques

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Risk Management Strategies - Trends

Static hedging

– Increased product innovation

• Basket lookback options

• Levered equity options with higher payouts in low interest rate environments

• Full cashflow matching structures

– Minimal adoption

• High transaction costs

• Doesn’t protect against policyholder behavior risk

• Companies that transitioned away from static customized hedges : Importance to follow on industry standard practices

Reinsurance availability?

As the volume of guarantees increase, a combination of strategies will be employed

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Impact of Financial Crisis

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US VA Market Overview

About $1.3 trillion asset under management as of year end 2008

96% offer living benefit guarantees *

Distribution of living benefits are roughly *

*Source: Milliman 2009 GLB survey

Living Benefit Type Market Share

GLWB 60%

GMWB 15%

GMIB 15%

GMAB 10%

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The Recent Financial Crisis has been Severe

Failure of well known financial institutions– Lehman Brothers, Merrill Lynch, Bear Stern

– Credit risk is brought to the fore

Worldwide decline in equity market

Rapid reduction of interest rates

Increased volatility

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Impact of Financial Crisis

Insurance industry was materially impacted by recent market events

Primary drivers were asset impairments and Variable Annuities

– Variable annuity guarantees were highlighted

Key drivers of losses related to VA’s

– DAC unlocking on base product

– Basis risk on actively managed funds

– Exposure from un-hedged guarantees

Hedging of in-force guarantees was fairly effective

– Milliman survey results showed approximately 94% effective between Sept 2008 to March 2009

Costs of issuing new guarantees have increased substantially

– Costs are typically higher than rider charges

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Insurance Industry View on VAs

Variable Annuities and guarantees continue to be a vital part of the insurance industry

– Pure protection business is still important, but asset accumulation & income products dominate sales

– VA guarantees differentiate life insurance companies from mutual fund companies and banks

– Guarantees still provide customers with a good value proposition

– Global opportunities

Creating a sustainable VA business model requires

– 1. Product Design innovation

– 2. Re-evaluation of hedge objectives

– 3. Improvements to hedge program and operations

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VA Hedging Programs

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Hedge Program Objectives

Hedge programs could have conflicting objectives

Selection of hedge program objectives reflects management risk preference and appetite

Trade-offs of objectives are often needed

Fair value protection has historically been most common

Capital protection and macro-hedging gain popularity recently

Distrubtion of Hedge Objectivessource: Milliman survey

Economical 37.5%

US GAAP 25%

IFRS 6.25%

Combination 25%

Statutory cash value 6.25%

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Hedge Strategies

Almost all use a dynamic hedging strategy

More sophisticated companies opportunistically use a combination of strategies

Almost all companies incorporate a delta hedging strategy.

Some also layer on rho and vega hedging strategies

69% of respondents do not hedge all exposures

Distribution of Hedge Strategiessource: Milliman survery

Dynamic 62.5%Static 6.25%

VAR 6.25%

Combination 25%

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Hedge Objectives

Historically hedge objectives focused on managing quarterly GAAP earnings volatility

– Fully hedge equity, interest rate and volatility risk of GMAB, GMWBs and a portion of Lifetime GMWB

– Partially hedge equity exposure of GMDB, GMIB and life-contingent portion of Lifetime GMWB

There are often conflicts between objectives in US GAAP and economic fundamentals

Recent events have brought more focus on statutory balance sheet

– Severe market events have caused companies to shift focus to solvency

– New statutory capital and reserve methodologies are more market sensitive

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Macro / Capital Protection Hedge

Solution has been to overlay a Macro / Capital Protection hedge above core strategy

Complex problem with many dimensions

Different ways to approach it:

– Explicitly hedge capital sensitivity

• Requires revaluation of capital sensitivity and existing hedge program

• Captures detailed dynamics and non-economic behavior (standard scenario, VA-CARVM etc.)

– Defining a more transparent and easy to calculate target

• Defining as package of options

• Directly hedging guarantee benefits not included in core strategy

• Using a deductible approach on guarantee benefits

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Hedge Effectiveness Results in Two Studies

Milliman conducted two studies of hedging program effectiveness during the turbulent period between September 2008 and March 2009.

Milliman found the average effectiveness to be 93% during September 2008 and October 2008

– S&P decreased 24.5% from 1283 to 969

– Very rapid movements

– Realized volatility as high as 60%

Milliman found the average effectiveness to be 94% between November 2008 and March 2009

– S&P decreased 17.6% from 969 to 798

– Market shown more stabilized decline

Hedge effectiveness is defined as

(hedge asset payoff) / (liability fair value increase due to hedged risks)

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Bifurcation of Hedging Results

Bottom line : How much a hedging program has recovered total losses?

– Question 1: How effective is the hedging program in recovering losses it is designed to cover?

– Question 2: How much loss is not covered by a hedging program?

Milliman’s studies covered the first question, and not the second one.

It is critical to distinguish these two questions

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What Has Worked Insurance company hedging programs are designed to reduce the

exposures to capital market risks

– Do not take risks to make a profit

Use simple hedging instruments

– Futures contracts

– Plain vanilla options

– Little counterparty risk

Be highly transparent

– Open discussion of hedging methodologies

– Reviewed and audited by multiple parties

– Contained operational risks

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What Hasn’t Worked

Leave critical exposure unhedged

Follow accounting peculiarities blindly

– US GAAP SOP03-1, Canadian GAAP are not fair valued

– Following non-fair value accounting rules blindly hurt the economic fundamentals

Deviate from sound risk management principles

– Under pricing

– Unchecked fund allocation

Keep hedging practice as a secret

– Leaving blind spots in hedging programs

Basis risk must be controlled

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Enhancements to Hedging Programs

Basis risk management

Expanding hedging program to uncovered risks

Macro hedging

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Expand Hedge Instrument Universe & Adopt 24 Hour Market Coverage

Risks:EQUITY

S&P 500

Russell

NASDAQ

DJ Industrials

Canada S&P TSX

DJ Eurostoxx 50

FTSE

Nikkei

Topix

Hang Seng

Hang Seng China Enterprise

Korea Kospi

Taiwan TWSE

India Nifty

Brazil Bovespa

Emerging Markets

Australia S&P ASX 200

Contracts:Equity Index Futures

Equity Total Return Swaps

Interest Rate Swaps

Interest Rate Futures

Swaptions

CMS/Libor caps/floors

Volatility Futures

Variance Contracts

OTC Equity Options

Exchange-traded equity options

Hybrid derivatives

Inflation Swaps

Fixed Income Total Return Swaps

Credit-Related Swaps

Currency Forwards

Currency Futures

INTEREST RATES

Canadian Interest Rates

Euro-zone Interest Rates

UK Interest Rates

Swiss Interest Rates

Japan Interest Rates

CURRENCY CROSSES

On Rate Pairs From Above

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Innovations in Product Design

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April 18, 2023

Milliman Hedge Cost Index The overall cost of hedging has increased substantially

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Latest Trends in VA GLB – Late 2008 To 2009 With effective date through mid May09, 33 VA writers filed changes on 125

existing products; 8 VA writers filed 12 new products.

Summary of 2009 VA product changes:A. Summary by nature of changes

B. Summary by number of changes

# of Changes (from the above 4 categories) # of Products # of Companies

1 90 15

2 31 15

3 4 3

Total 125 33

Change Category # of Products # of Companies

Sales Discontinued or Restricted 42 18

Fee Increased 62 29

Product Features Scaled Back 44 19

Asset Allocation Changed/Restricted 16 10

Total 125 33

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Industry Trends

Filing requirements provide some flexibility for minor product changes, major product changes require re-filing

The more immediate changes are:

– Rider Fees : Increases between 15-30bps on both existing and new business

– Withdrawal Rates• Increased earliest withdrawal age to 65

• Adjusted age bands, still 5% at age 65

– Reduction in features• Removal of “doubler”

• Reduced bonus rates, typically 1-2% reduction

• Reduced length of bonus period or age restrictions

– Asset Allocation• Removal of most aggressive asset allocation model

• Use of more index funds

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Product Design

Design changes to date have been incremental adjustments to current products

Next generations of designs should consider:– Guarantees that adapt to capital market conditions

– Including hedges inside separate accounts

– Asset allocation models that target a specific volatility

– Revaluate compensation structure

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Existing VA Business Model

Stocks

Bonds

Guarantee Fee

Funds

Insurer Balance Sheet

■Guarantee Liability■Hedge Assets■P&L Volatility

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Sustainable VA Business Model

Stocks

Bonds&

Hedges

ReducedGuarantee Fee

Funds Insurer Balance Sheet

■Reduced & Stabilized Guarantee Liability

■Reduced P&L Volatility

■ Transfer of Hedge Breakage & Basis Risk to Policyholder

■ Reduced Behavior Risk

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Asset Allocation Models – Current Approach

Asset allocation models are widespread in the VA market

– Typically: Conservative, Moderately Conservative, Moderate, Moderately Aggressive, Aggressive

– Each model targets a specific equity allocation (ie 20, 40, 60, 80, 100%)

– Current models do not consider VA hedging programs

– Quarterly model updates lead to GAAP income volatility for VA writers

– This approach exposes VA writer to material P&L volatility

• Increases in implied volatility

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Asset Allocation Models – Alternative

Conservative, Moderately Conservative, Moderate, Moderately Aggressive, Aggressive models constructed to target a specific risk level

– Target a constant volatility level for the account value

– Much better integration with VA hedging programs

– Volatility target used directly in GAAP reserve calculation

– Asset allocation process reflected in VA-CARVM & RBC C3P2 calculations

• Stabilizes statutory reserves and capital

– Eliminates exposure to implied volatility

• Reduces cost of VA hedging programs via elimination of OTC risk margin

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Comparison of Asset Allocation Models

Comparison of Asset Allocation Models

From July, 1999 to May, 2009

Performance MeasureConstant Equity %

Target Volatility

Cumulative return 3.1% 19.3%

Realized volatility 12.3% 11.8%

Average equity allocation 60.0% 74.9%

Standard deviation of monthly volatility 6.3% 3.0%

Average allocation by fund

Large Cap US Equity Fund 40.0% 50.0%

Technology Opportunity Fund 10.0% 12.5%

International Equity Fund 10.0% 12.5%

Fixed Income Fund 40.0% 25.1%

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Monthly Realized Volatility

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Jul 1

999

Jan

2000

Jul 2

000

Jan

2001

Jul 2

001

Jan

2002

Jul 2

002

Jan

2003

Jul 2

003

Jan

2004

Jul 2

004

Jan

2005

Jul 2

005

Jan

2006

Jul 2

006

Jan

2007

Jul 2

007

Jan

2008

Jul 2

008

Jan

2009

Constant Equity %

Target VolatilityVol-of-Vol Reduced by 52%

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Move Hedges into Customer AccountA Sustainable Manufacturing Process

Embedded derivative largely disappears from insurer B/S

– Quarterly P&L volatility is dramatically reduced

Customer owns the hedges

– Hedges are an asset allocation choice, NOT expressed as a fee

– Customer’s account value is supported during market declines

Basis risk & other hedge noise is absorbed in the customer account value

– Actively managed funds work well under this approach

Behavior risk is dramatically reduced

Process accommodates full spectrum of guarantee designs

Guarantee fee is reduced & stabilized

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Future Outlook Key Risks In the VA Industry

Sustained decline in equity market

Increase in interest rates leading to disintermediation

Irrationally rich benefits for better market share– High rollup rates

Policyholder behavior risk– Lapse assumption not materializing

Underpriced products requiring large capital causing long term low ROE

Hedging programs can only protect risks in the future

Milliman, IncFinancial Risk Management71 S. Wacker Drive, 31st Floor Chicago, IL 60606Ph: +1 312.726.0677Fx: +1 312 499.5700www.milliman.com