Insurance Seminar on Economic Capital April 2008 Case StudyReflecting Hedging in EC

Hubert B. Mueller

Insurance Seminar on Economic Capital

Case Study: Reflecting Hedging in EC
April 2 3, 2008

Hong Kong Hubert Mueller Principal

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Overview
Hedging Economic Risk Fair Value Using Hedging when calculating Economic Capital (EC)

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Market risk in many of todays life insurance products

Market risk used to be borne mainly by policyholders Low interest rate guarantees Limited or no equity guarantees Many popular life and annuity insurance products today contain market-based

guarantees Variable annuity (VA) guaranteed minimum death and living benefits (GLBs), having exposure to equity market performance and volatility Universal life with secondary guarantees (ULSG), containing exposure to longterm interest rate risk Indexed products (equity market performance and volatility)

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Case Study: ULSG stochastic pricing results show significant tail risk
25.00% 20.00%

Expected Return on Equity Expected Return

15.00% 10.00% 5.00% 0.00% -5.00% -10.00% -15.00% -20.00% Interest Rate Scenario

Product has average RoE of 12% over set of stochastic scenarios A small number of scenarios have negative returns Poor scenarios have low projected interested rates
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Hedging can significantly reduce market risk and economic capital

These products contain significant tail risk Economic capital (EC) stresses key market risks Would lead to significant amounts of required EC without any management

action
EC process helps identify areas where capital market solutions could be beneficial Good example of where risk measurement process leads to risk management Hedging is common for large writers of variable annuities with guarantees and

equity-indexed products
Opportunity exists for including benefit of hedging long-term interest guarantees in

USLG products as well

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Companies typically focus on hedging the economic risk first, to minimize risk-based capital Comparison Hedged vs. Unhedged Annualized Profit/Loss as a % of Fund Value
0.60%

0.40% 0.20%

Hedged (Gain) Loss

0.00% 1 -0.20% 101 201 301 401

Naked (Gain) Loss

-0.40% -0.60%

Hedged (Gain) Loss with 2X trades

-0.80% -1.00%

-1.20% -1.40%

-1.60%

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Case Study: USLG illustrative summary of stochastic pricing results after hedging
25.00% 20.00% Expected Return Expected Return on Equity 15.00% 10.00% 5.00% 0.00% -5.00% -10.00% -15.00% -20.00% Interest Rate Scenario
Average RoE is slightly lower over set of stochastic scenarios Ends up being a cost for most scenarios as option expires with no value Significantly improves tail scenarios, lowering required EC
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Most U.S. stock companies focus on hedging both tail risk and GAAP earnings volatility

Hedge tightly matches changes in GAAP liability

Hedge significantly reduces GAAP net income volatility

Note: Based on $10 billion block of new business with GMWB benefits issued in 1st quarter of 1995. Source: Hartford Life.
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Fair Value

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What is fair value?

In the US, guarantees with life contingencies do not get market value treatment

(SOP03-1) Disconnect between economic and accounting risk

There is no active market for insurance liabilities SFAS 157 (US GAAP) Defines fair value and provides guidance on how to measure assets and

liabilities at fair value

Fair Value = Exit Value: The price that would be received to sell an asset or paid

to transfer a liability between market participants

IASB has varying views on this subject IAS 39: Fair Value = Entry Value, but IASB Discussion Paper now favors Exit Value for insurance liabilities Market-consistent Embedded Value (MCEV) Fair Value = Hedging Cost (Exit Value concept) Using EC as basis for required capital

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What is the fair value option (FVO)?

FAS 159 provides a one-time option to make an irrevocable election to mark certain

financial assets and liabilities to market Allows entities to measure eligible financial instruments at fair value Available only for the first 120 days of a fiscal year
Developed in response to the problems with FAS 133 and SOP03-1 Designed to achieve convergence with IAS 39 Effective for fiscal years beginning after 11/15/2007

U.S. GAAP is starting to move towards IFRS

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Implications for industry projected timeline for fair value reporting

U.S. Gaap Deliverables

First FAS 159 sub-annual accounts

First full FAS 159 accounts

Comparative figures

First full accounts

IFRS Implementation Deliverables

First sub-annual accounts

Possible Stages of an IFRS Implementation Project

Knowledge build-up

Impact study

Implementation

Dry runs

Calculations

2007

2008

2009

2010

2011

2012

IFRS Phase II Timeline

Discussion paper 3 May 2007 End of comment period 16 November 2007

Exposure draft End 2008

Effective date [1 January 2011] Final standard 2010

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Implementation of the FVO

Opportunity to achieve consistency between hedge (economic) goals and

accounting treatment Will encourage companies to hedge life-contingent benefits Requires the entire contract to be marked to market
Increased international convergence between FASB and IASB Adopting fair value provides a better transition to the adoption of the new IFRS

(implementation expected for 2011 2012)

Reporting and disclosure requirements Expecting more announcements from FASB FASB may join IFRS Phase II this summer

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Using Hedging When Calculating EC

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Using hedging when calculating EC

Hedging is typically used in the following areas Variable annuity guarantees Equity-indexed annuities Fixed annuities ULSG When calculating EC, focus is on tail risk Developing tail scenarios from limited data Key topics to be considered when modeling impact of hedging: Basis risk Gap risk Liquidity risk Hedge effectiveness Transaction cost / dealer margin Allowance for gap / liquidity risks can be made by extending exposure periods

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Case Study: In a principles-based world, hedging typically reduces capital, but may increase reserves
Total Assets for No Hedge VA
TAR 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 1 2 3 4 5 6 7 8 9 10 Projection Year Capital Reserve TAR 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 1 2 3 4 5 6 7 8 9 10 Projection Year

Total Assets for Hedged VA

Hedging reduces capital but increases reserves (=CTE65) at time 0; capital plus
Key Points

reserves (=CTE90) is lower with hedging

Capital (=CTE90 CTE65) reduces over time for both, eventually going to 0 due to

moneyness of GLB guarantee and overall fee revenue

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An informal industry survey of 20 large US VA players indicates that all companies are hedging VA guarantees

Dynamic hedging beyond Delta: 8 (40%)

Dynamic hedging Delta only: 11 (55%)

Static hedging only: 1

Source: Tillinghast Survey 2008
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Lessons learned to date (US)

Even the larger companies have only been hedging VA guarantees for a few years,

mainly in a bull market Many companies still only hedge Delta risk Few companies hedge Vega Ability to assess/improve hedge effectiveness will become a key differentiator for success
Regulators and rating agencies are only allowing partial credit for hedging when

defining capital requirements Typically, only 50% credit is allowed Focus is on hedge effectiveness in the tail
Third and fourth quarter 2007 showed significant spikes in volatility A real stress test for hedging programs, mainly from having to true-up volatility Several companies reported > $10 million losses from hedging programs Hedging may enable a reduction in risk-based capital and EC, but may increase

reserves Need to evaluate effectiveness of the hedge in reducing tail risk Implementing smart modeling techniques will expedite processing of large stochastic models
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Contact

Hubert Mueller, FSA CERA MAAA Principal Towers Perrin 175 Powder Forest Drive Weatogue, CT 06089-9658 Telephone: 1-860-843-7079 Fax: 1-860-843-7001 E-Mail: hubert.mueller@towersperrin.com Internet: www.towersperrin.com/tillinghast

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