Derivatives Strategy September 28, 2011 Srini RamaswamyAC (1-212) 834-4573 Terry Belton (1-312) 325-4650 J.P.

Morgan Securities LLC

Research Note

Interest Rate Risk in Variable Annuities

We outline a simple framework for analyzing the interest rate risk exposure in variable annuities in the aggregate, with a view towards assessing the likely forward-looking implications for the long end of the swaps and Treasury curves. The essence of our approach is to decompose the highly complex variable annuity universe into a weighted combination of much simpler VA-lite instruments, with the weights themselves being implied from market behavior We estimate that the recent plunge in long-end yields has taken the aggregate duration of the VA universe to all-time highs, although this weeks pullback has mitigated this somewhat Long-end swap spreads have steadily become less vulnerable to VA duration, perhaps reflecting hedgers growing allocations to Treasury-based instruments, and will likely not be as impacted by VA hedging flows as they were in 4Q08. That said, the crowding-out effect of Operation Twist is likely to result in modestly greater sensitivity of long-end spreads to VA duration swings Unlike swap spreads, the slope of the 10s/30s curve shows no declining sensitivity to VA duration

Exhibit 1: The variable annuity industry has seen significant growth over the past decade
Variable annuities assets; $bn

1600 1400 1200 1000 800 600 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
1

Note: 2011 value is as of 2Q11. Source: Responding to the Variable Annuity Crisis, Dinesh Chopra et al, McKinsey Working Papers on Risk, Number 10, April 2009; Morningstar.

products and their interest rate risk exposures. This fact really burst forth into plain view right after Lehmans default in 2008, when a plummeting stock market coupled with falling Treasury yields produced a massive duration shortfall in insurance companies portfolios, leading to considerable receiving in swaps and causing long-end swap spreads to decline below zero for the first time. More recently, this has once again become evident given the significant receiving flows from insurance companies as long-end yields attained new all time lows last week, although some of these flows have reversed since then given the pullback in yields. Variable annuities were first introduced in the 1980s, and tended to be fairly simple products designed to
AC

Introduction
US fixed income investors, particularly those focused on the longer end of the Treasury or swaps curve, have come to realize the significant impact that the risk management of variable annuities can have on long-end yield levels, the slope of the curve, and on swap spreads at the very long end of the curve. To put it simply, flows related to the hedging of the duration risk in variable annuities have become a force to be reckoned with at the long end of the curve, and as a result, it behooves investors to better understand these

Srini Ramaswamy (1-212) 834-4573 srini.ramaswamy@jpmorgan.com J.P. Morgan Securities LLC Alberto Iglesias (1-212) 834-5116 alberto.d.iglesias@jpmorgan.com J.P. Morgan Securities LLC Kimberly Harano (1-212) 834-4956 kimberly.l.harano@jpmorgan.com J.P. Morgan Securities LLC

Terry Belton (1-312) 325-4650 terry.belton@jpmorgan.com J.P. Morgan Securities LLC Meera Chandan (1-212) 834-4924 meera.chandan@jpmorgan.com J.P. Morgan Securities LLC

Derivatives Strategy September 28, 2011 Srini RamaswamyAC (1-212) 834-4573 Terry Belton (1-312) 325-4650 J.P. Morgan Securities LLC

offer equity market upside along with tax-deferred returns. Over time, various options and guarantees were bundled in, including death benefits (such as a return of premium in case of death) as well as living benefits such as guaranteeing a minimum income (GMIB) for the policyholder or an account value (GMAB) at a fixed point in time. Since the late nineties, minimum withdrawal benefits either for a predetermined number of years or for the remainder of the policyholders life (GMWB) appear to have been commonly included. Such benefits, together with path-dependent features such as guaranteed roll-ups or ratchets, have made variable annuities popular products, causing the industry to experience significant growth (Exhibit 1). Of course, these guarantees also imply greater risk to the underwriters. Conceptually, the insurance companies are short equity puts to policyholders, the exercise of which occurs in the form of floored future annuity payments whose present value depends on interest rates. The hybrid exposure of these products to the reference index (S&P 500) as well as the yield curve, mortality risks, and numerous features that create path dependency all mean that pricing variable annuities is a highly complex undertaking. However, accurately pricing these instruments is not our objective in this research note. Our goal is to capture the relative magnitudes of the duration of the VA universe over time as accurately as possible, and in a way that recognizes the inherent nonlinearities with respect to equities and rates; understanding such nonlinearities is key to understanding the shifts in VA duration in periods where equities and/or rates trend towards historical extremes. To that end, our approach is geared not towards modeling the detailed structure of variable annuities in their full richness; rather, we seek to find an effective scheme to approximate the duration exposure of the VA universe (basically the partial delta of variable annuities with respect to long-term rates) in the aggregate. The outline of this paper is as follows. First, we describe variable annuities, with a focus on the aspects that create the interest rate risk exposures we are most interested in. Second, we present the essence of our approach, which is based on the notion of approximating the complex universe of VAs via a notional-weighted combination of highly simplified

VA-lite instruments, which we refer to as VA kernels. Our approach also relies on an empirical calibration to solve for the weights on these individual VA kernels. We then discuss the current exposures of the aggregate VA universe, as well as implications for the long-end of the US yield curve.

A simple framework to estimate interest rate risk in variable annuities

Variable annuities, like fixed annuities, may be conceptualized as consisting of an accumulation phase, during which the policyholder pays either a lump sum or regular contributions with the aim of producing an accreted future value at some desired point in time, and a payoff phase, where the accreted principal is annuitized by the insurance company as a stream of regular payments to the policyholder over a designated time period. Actuarial components (such as embedded life insurance and associated minimum guarantees) exist, but we ignore them for our purposes since mortality risk is uncorrelated to market risk, which is our main focus. In the case of fixed annuities, the investors investment performance during the accumulation phase is set to a predetermined interest rate, resulting in a predictable future value that can subsequently be annuitizedi.e., except for actuarial risks, the product conceptually is similar to purchasing a strip of zero coupon bonds during the accumulation phase, carefully designed to produce an annuity during the payoff phase. As such, fixed annuities have interest rate exposures that are relatively easily understood and hedged. Variables annuities, on the other hand, have two important sources of variability. First, returns experienced in the accumulation phase are not fixed or known a priori, and are instead linked to the returns on some benchmark such as the S&P 500. Second, as a result of the uncertain nature of returns in the accumulation phase, VAs commonly embed minimum guarantees as already noted in the previous section. Conceptually, then, one can imagine an elemental VA building-block (or kernel) as consisting of a single lump-sum premium payment at the start of a fixed-term accumulation phase, followed by a fixed-term annuitization, with minimum guarantees on the withdrawal amounts.

Derivatives Strategy September 28, 2011 Srini RamaswamyAC (1-212) 834-4573 Terry Belton (1-312) 325-4650 J.P. Morgan Securities LLC

In rising equity markets, VAs pose little market risk to the insurance companies that underwrite them policyholders premiums can be invested in the S&P 500, and returns are merely passed through to the policyholders. However, the picture is very different in equity bear marketsthe more equities fall, the more binding the minimum guarantee becomes, and the underwriter is increasingly short a fixed annuity. Thus, insurance companies increasingly need to add duration in periods of falling equity markets. Similarly, a fall in long-term yields would increase the NPV of the minimum guarantee to the policyholder, making it more likely that the guarantee will be binding. This implies that an underwriter of VA policies becomes short duration as yields fall. The combination of both these eventsfalling equities and bond yields represents a perfect storm, and causes duration needs from VA hedgers to rise significantly, as was the case in 4Q08 and as has been the case recently. Clearly, pricing variable annuities comprehensively and accurately is an exceedingly complex undertaking, requiring the joint modeling of long-term interest rates as well as equities; in addition, actuarial risks stemming from life insurance-related guarantees, and other features make the product path dependent, adding to the complexity. Recognizing that our objective is not to price variable annuities accurately, but merely to capture the trend in their duration exposures as well as their nonlinear relationship with equities/yields, we devise a simpler approach. Our approximation approach is based on three principles. First, we start with the assumption that the duration of the VA universe may be approximated by a weighted combination of the durations of much simpler VA kernels. This is not unlike series approximation techniques commonly used in mathematics to solve difficult problems. One example of a VA kernel is a simple product where a policyholder pays $100 on (say) January 1, 2007, intended to be invested in the equity market for a 15year (fixed) horizon, with a guaranteed withdrawal amount of $12 per year for the subsequent 20 years; this could be interpreted as a minimum 6% guaranteed annual return during the accumulation phase, followed by a minimum guaranteed 5% annual withdrawal on the accreted principal (see Exhibit 2 for an illustration of a VA kernel). Several VA kernels may be created by

Exhibit 2: Illustration of a hypothetical VA kernel

1/1/07: $100 inv estment Accumulation phase: guaranteed 6% minimun annual return etc... Payoff phase: 5% annual w ithdraw al for 20 y ears

varying the start date, the length of time of the intended equity investment, and the minimum guarantee amount. Effectively, we decompose the complex VA universe as a linear combination of simpler VA kernels, each of which is priced in a manner that captures the nonlinearities with rates and equities. Second, we calculate the present value of each VA kernel by using an option pricing framework. We use implied distributions from the swaptions market as well as long-term S&P vols and correlation estimates to calculate the price. We then use numerical tweaks to calculate the partial exposure with respect to long-term swap rates (i.e., duration). Third, we use a calibration approach to solve for the appropriate weights on the various VA kernels. Our calibration relies on the anecdotally-known fact that VA risk exposures were significant influences on long-end swap spreads in certain periods of time, such as 4Q08; we may thus solve for non-negative coefficients for each kernel that maximally explain the portion of long-end swap spread behavior not explained by other factors in those select periods of time. In order to mitigate circularity (since we plan to use VA duration estimates to model longend swap spreads), no data after 2008 has been used in calibration, and out-of-sample performance has been tested and found to be reasonable.

Calibration and results

As noted above, each VA kernel in our framework is completely determined by a start date (on which the premium is paid in full), the length of the accumulation and payoff phases, and the details of the minimum guarantee. In our empirical work, the kernels we considered all had lengths of 15 years for the accumulation phase and 20 years for the payoff phase, with a minimum guaranteed annual withdrawal of 5%

Derivatives Strategy September 28, 2011 Srini RamaswamyAC (1-212) 834-4573 Terry Belton (1-312) 325-4650 J.P. Morgan Securities LLC

of the accreted future value of the premium paid (which is itself guaranteed based on a 6% compounded annual return during the accumulation phase). Varying these choices did not materially alter our empirical results, and therefore we fix all of these parameters. Thus, each VA kernel is specified by its start date, and we include one VA kernel for each calendar year (with the start date assumed to be at the beginning of the year). This simplification also makes it easier to develop intuition regarding the results. Notably, VA kernels initiated in 2000 (at the peak of the stock market, and with much less time remaining in the accumulation phase currently) carry greater interest rate risk than VA kernels initiated in lower equity environments (such as in 2003see Exhibit 3). Similarly, for VA kernels originated in similar equity environments, kernels originated in higher yield environments carry greater interest rate risk than kernels originated in lower yield environments; this is seen in comparing the partial interest rate deltas of the kernels corresponding to origination in 2002 and 2004 (Exhibit 4). Taken together, VA kernels originated in the late nineties (such as 1997, a higher yield, lower equity environment) and (say) 2007 (which represents a higher equity, lower yield period) arguably represent the two extremes in terms of VA kernels. Perhaps unsurprisingly, as a result, our calibration approach suggests that these two kernels suffice in order to adequately model the duration risk of the VA universe. Our calibration involves solving for the non-negative weights on each kernel, such that the weighted sum of kernel durations (i.e., the estimated duration of the VA universe, within a scale factor) maximally explains movements in 30-year swap spreads (together with the 10s/30s Treasury curve and 10-year swap spreads as other factors) in selected periods of time. In other words, we seek to find those non-negative weights that best explain the portion of movements in long-end swap spreads that are not accounted for by other drivers (i.e., the general level of swap spreads and the slope of the long end of the Treasury curve), in periods where VA hedging flows are anecdotally known to have played a significant role in driving long end swap spreads. As it turns out such a calibration suggests that a weighted combination of VA kernels corresponding to the origination years 1997 and 2007 (16:84 weighted) produces the best estimate of the VA

Exhibit 3: VA kernels initiated in high equity environments such as 2000 carry greater interest rate risk than VA kernels initiated in lower equity environments such as 2003
Partial delta* of VA kernels associated with origination years 2000 and 2003; $
-0.00 -0.02 -0.04 -0.06 -0.08 -0.10 -0.12 -0.14 -0.16 2007 2009 2011 2000 2003

* Defined as the change in price of each VA kernel for a 1-bp tweak in long-term rates. Each VA kernel is sized to a $1 lump-sum premium at inception.

Exhibit 4: while kernels originated in higher yield environments carry greater interest rate risk than kernels originated in lower yield environments
Partial delta* of VA kernels associated with origination years 2002 and 2004; $
-0.00 -0.02 -0.04 -0.06 -0.08 -0.10 -0.12 -0.14 -0.16 2007 2009 2011 2002 2004

* Defined as the change in price of each VA kernel for a 1-bp tweak in long-term rates. Each VA kernel is sized to a $1 lump-sum premium at inception.

universe duration for our purposes. Last, such a calibration approach can only produce relative estimates; we separately estimate a suitable scaling that results in a true estimate for the aggregate duration of the VA universe.

Impact on long end spreads

With respect to the impact on long-end swap spreads, three conclusions are worth highlighting currently.

Derivatives Strategy September 28, 2011 Srini RamaswamyAC (1-212) 834-4573 Terry Belton (1-312) 325-4650 J.P. Morgan Securities LLC

Exhibit 5: The aggregate duration exposure of the VA universe is now at an all-time high
Estimated duration of the VA universe*; $bn of 20-year equivalents
280 260 240 220 200 180 160 140 120 100 Jan 07 Dec 07 Nov 08 Nov 09 Oct 10 Sep 11

Exhibit 6: The sensitivity of long end swap spreads to the duration of the VA universe has been declining steadily in magnitude
Partial beta of maturity matched 30-year swap spreads with respect to VA universe duration*; bp per $bn of 20-year equivalents
0.0 -0.2 -0.4 -0.6 -0.8 -1.0 Sep 09 Feb 10 Jul 10 Dec 10 Apr 11 Sep 11

* Estimated from a weighted combination of the deltas of all the VA kernels, which is then scaled to represent the aggregate VA universes duration in billions of 20-year swap equivalents

First, as seen in Exhibit 5, the aggregate duration exposure of the VA universe is now at an all-time high, even higher than in 4Q08. Second, the sensitivity of long-end swap spreads to VA hedging needs has steadily lessened (in magnitude) over time (Exhibit 6), but VA duration remains an important driver of the long end of the yield curve; this might reflect the fact that hedgers have been steadily increasing Treasury market allocations (whether via cash instruments, futures, or other derivatives). Last, this broad declining trend in the sensitivity of long-end spreads to VA duration needs masks a more nuanced picture that emerges due to Fed purchases. This is highlighted in Exhibit 7, which looks at the same partial beta shown in Exhibit 6 on a de-trended basis, with special focus on the periods corresponding to the Feds Treasury purchases under QE1 and QE2. As can be seen, periods when the Fed has been purchasing Treasuries have resulted in increased sensitivity of long-end spreads to VA duration needs (adjusted for the broader declining trend); this most likely reflects a crowding-out effect in the Treasury market, forcing duration buyers into the swaps market. Looking forward, although the Fed is not embarking upon more quantitative easing, Operation Twist is likely to resemble prior QE periods in terms of its net impact on the long end, which is the sector of most interest for insurance companies hedging VA exposure. Thus, we would expect a crowding-out effect again over the next nine months, which should

* Based on rolling 2-year regressions, with the 10s/30s Treasury curve and the stock of outstanding long end Treasuries (ex Fed purchases) as other factors.

Exhibit 7: but could modestly increase as Operation Twist commences, likely due to a crowding-out effect at the long end due to Fed purchases
De-trended partial beta* with respect to VA duration; bp per $bn of 20-year equivalents; highlighted areas indicate QE periods
-0.8

-0.9 -1

-1.1

QE1

QE2

-1.2 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11

* Based on rolling 2-year regressions, with the 10s/30s Treasury curve and the stock of outstanding long end Treasuries (ex Fed purchases) as other factors. Beta has been detrended over the period shown.

cause long-end spreads to exhibit greater vulnerability to VA hedging needs.

Impact on the 10s/30s curve

Variable annuity hedging flows impact the very long end of the Treasury curve as well. Exhibit 8 presents our fair value model of the 10s/30s Treasury yield curve, estimated over five years of data. As can be

Derivatives Strategy September 28, 2011 Srini RamaswamyAC (1-212) 834-4573 Terry Belton (1-312) 325-4650 J.P. Morgan Securities LLC

seen, VA duration is a significant driver of the curve, in addition to other factors (the level of short-term Treasury yields, 5Yx5Y forward inflation expectations from the inflation swap market and the total amount of outstanding Treasury debt in the 17- to 30-year sector of the curve). Specifically, the model suggests that a $50bn 20-year equivalents increase in VA duration would flatten the 10s/30s curve by around 16bp (-0.32 x 50). It is also worth noting that the slope of the 10s/30s curve shows no declining sensitivity to VA duration. Exhibit 9 shows the evolution of the partial beta of the 10s/30s curve with respect to VA duration over time. As can be seen, the slope of the long end of the curve remains vulnerable to swings in VA duration, with no diminishing sensitivity evident (as was the case for long-end swap spreads). This is likely the result of growing allocations by insurance companies to Treasury-based hedges, whether via cash instruments such as bonds and long-end STRIPS or via Treasury futures or other derivatives.

Exhibit 8: A fair value model of the 10s/30s Treasury curve

10s/30s Treasury yield curve (bp) fair value model

Variable Intercept 3-year yields; % 5yx5y inflation swap rates; % JPM index of variable annuity hedging flows; $bn of 20-year equivalents Treasuries outstanding with maturities greater than 17-years; $bn
5-year regression; R2 = 93.4%

Coefficient 114.2 -24.2 10.8 -0.32 0.11

T-statistics 17.2 -48.7 7.3 -18.3 28.7

Exhibit 9: Unlike with long end swap spreads, the sensitivity of the slope of the 10s/30s curve to the duration of the VA universe shows no declining trend
Partial beta of the 10s/30s Treasury curve with respect to VA universe duration*; bp per $bn of 20-year equivalents
-0.25 -0.30 -0.35 -0.40 -0.45 -0.50 -0.55 -0.60 -0.65 -0.70 -0.75 Mar 10 Sep 10 Mar 11 Sep 11

Conclusions
In this paper, we have devised a relatively simple way of estimating the duration exposure of the highly complex variable annuity market. This is significant since VA duration remains a significant influence on the slope of the long end of the curve. In addition, although long-end swap spreads have steadily become less sensitive to VA duration, the crowding-out effect from the Feds Operation Twist is likely to cause swap spreads to exhibit increased sensitivity to VA duration as well, albeit not to the extent seen in 4Q08.

* Based on rolling 2-year regressions, with front end yields, 5Yx5Y inflation expectations and the outstanding stock of long-end Treasuries as other factors.

Derivatives Strategy

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