Indexed Annuity

Product Pricing and Risk Management

Timothy Yi
Enterprise Risk Management
The Hartford
August 4, 2012 2
After this presentation
You will understand
Marketing position of indexed annuity
Basic pricing of indexed annuity
Risk management of indexed annuity including hedging

August 4, 2012 3
Disclaimer
Any opinions in this presentation are mine and do not represent those of
my employer
Products illustrated in this presentation are from public information and
for the illustration purpose only
In order to illustrate the basic key concepts, lots of simplification will be
made
August 4, 2012 4
Annuity overview
Two phases of annuity contracts
Accumulation (deferred) phase
Distribution (payout/income) phase
Annuity usually refers to accumulation phase of the contracts
In US, very few contracts are annuitized from accumulation phase
Similar to certified deposit sold by banks, but usually longer
duration guarantee
August 4, 2012 5
Types of annuity crediting method
Based on 2011 non-captive data, fixed/index/variable are 20%/20%/60% of sales
Fixed (Company declares crediting rate)
Minimum crediting rate
Book-value surrender or Market-value adjustment
Indexed (Crediting rate is linked to index level change)
Minimum crediting rate
Minimum participation
Variable (Crediting rate is based on underlying mutual fund investment
performance)
No minimum crediting rate
Principal protection at death, annuitization or withdrawal
Enhanced principal projection such as step-up or roll-up
August 4, 2012 6
Index annuities can be attractive solutions
Can be attractive solutions for clients who
Are dissatisfied with low interest rates
Are equity averse and want principal protection
Would like the opportunity for higher crediting potential
Want their growth to be tax-deferred
Desire insurance features and benefits, such as a death benefit,
annuity income options (including lifetime options), and a premium
enhancement (not available on all contracts)

August 4, 2012 7
Clients are recognizing the appeal
Index Annuity Sales (in billions)
Source: LIMRA, 4Q 2010 Report
August 4, 2012 8
Inappropriate sales to seniors
Lack of suitability review
Complicated product design
Long surrender charge schedules
Illiquidity for emergencies, including Long
Term Care
Two-tier annuities with illusory benefits
Recent negative press
For transcript of Dateline NBC aired on 4/13/2008
http://www.msnbc.msn.com/id/24095230/
August 4, 2012 9
Risk reward profile of fixed vs. variable
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Reward:
Gains from
bull market
Risk:
Losses from bear
market
(Some principal
guarantee to protect
downside)
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August 4, 2012 10
Risk reward profile of fixed vs. indexed
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Reward:
Gains from
bull market
Risk:
Giving up fixed
return
August 4, 2012 11
Indexed annuity payout
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Purchase an equity
call option to
participate in up-side
Purchas a
bond to fund
the minimum
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August 4, 2012 12
Derivative basics
Derivatives
Derived a payoff from price of other assets
Long position vs. short position
Forward/Future
Option is to take one-side gain for up-front premium payment
Zero-sum Game
If you have a long option position, there will be also option seller
(short position) to make it zero-sum game
August 4, 2012 13
Option basic
The fighting styles of [a bull and a bear] may have a major impact on the
names. When a bull fights it swipes its horns up; when a bear fights it
swipes down on its opponents with its paws. When the market is going
up, it is similar to a bull swiping up with its horns. When the market is
going down it is similar to a bear swinging its paws down. (Wikipedia)
Call-option, right to buy an asset at a fixed strike price, to gain when the
market is up
Put-option, right to sell an asset at a fixed strike price, to gain when the
market is down
If you are bullish, purchase a call option and if you are bearish,
purchase a put option

August 4, 2012 14
Sample of option types
European
American
Basket
Rainbow
Look-back
Asian
Barrier
Binary (digital)
Cliquet (forward starting)
August 4, 2012 15
Sample of strategies involving options
Spread
Bull spread
Bear spread
Butterfly
Straddle
Strangle
Collar
Risk reversal
Covered call


August 4, 2012 16
Illustration of profitability of indexed annuity
Example based on a 7-year surrender-charge period product
Revenue
Risk-free rate
Credit spread less expected default
Contingent surrender charge to recover acquisition expenses
Expenses
Acquisition cost
Maintenance cost
Minimum crediting rate
Cost of capital charge plus profit margin
Option budget
August 4, 2012 17
Illustration of profitability of indexed annuity
Revenue
7-year risk-free rate = 3% (300 bps)
Credit spread less expected default = 2.5% (250 bps)
7-year contingent surrender charge
(7%/6%/5%/4%/3%/2%/1%/0%)
Expenses
5% acquisition cost (72 bps / year)
0.25% maintenance cost (25 bps / year)
Minimum crediting rate (100 bps / year)
Cost of capital charge plus profit margin (190 bps)
Option budget (to solve for) = 163 bps
= 300 + 250 72 25 - 100 190 = 163 bps

August 4, 2012 18
Basic design: point-to-point
Credited rate = Max (minimum, index return) where index return =
Index(T+1)/Index(T)
Index returns are usually price returns excluding reinvestment of
dividends
European call option to hedge index return
A call option on a price return index will be cheaper than a total return
index
Based on the option budget, determine either participation rate or cap on
index return
August 4, 2012 19
Hedging: point-to-point
Purchase an European call option (or call spread) to hedge
Call spread is combination of long at-the-money call and short out-of-money call
If the minimum crediting rate is 1% and cap on point-to-point return is 6% then buy
101% strike call and sell 106% strike call
Can average caps and purchase a single call spread for given cohort
1/3 of 105, 1/3 of 106, and 13 of 107 cap purchase 106 cap
Payoff @ Actual Hedged Slippage
104 4 4 0
105 5 5 0
106 5.67 6 +0.33
107 6 6 0
108 6 6 0
August 4, 2012 20
Basic design: monthly cliquet
Each of monthly returns is capped or floored also, the global cap or floor
is applied for the annual return
Example: 2% monthly cap, no monthly floor, 1% annual cap
Monthly return scenario 1:
+5/+5/+5/+5/+5/+5/+5/+5/+5/+5/+5/+5/
+2/+2/+2/+2/+2/+2/+2/+2/+2/+2/+2/+2/ = +24%/year
Monthly return scenario 2:
+5/+5/+5/+5/+5/+0/+0/+0/+0/+5/+5/+5/
+2/+2/+2/+2/+2/+0/+0/+0/+0/+2/+2/+2/ = +16%/year
Monthly return scenario 3: +5/+5/+5/+5/+0/+0/+0/+0/+0/-5/-5/-
5/
+2/+2/+2/+2/+2/+0/+0/+0/+0/-5/-4/+0/ = +1%/year



August 4, 2012 21
Risk management consideration
Nothing
Hedging
Static hedging
Dynamic hedging
August 4, 2012 22
Dynamic hedging: monthly cliquet
Example: 2% monthly cap, no monthly floor, 1% annual cap
Monthly return scenario 3: +5/+5/+5/+5/+0/+0/+0/+0/+0/-5/-5/-
5/
+2/+2/+2/+2/+2/+0/+0/+0/+0/-5/-5/+1/ = +1%/year
Beginning of month (BoM) 1: buy 1 month 100/102 call spread
BoM 2: buy 1 mo 100/102 call spread & sell 1 mo 100/98 put spread
BoM 3: buy 1 mo 100/102 call spread & sell 1 mo 100/96 put spread

BoM 10: buy 1 mo 100/102 call spread & sell 1 mo 100/90 put spread
BoM 11: buy 1 mo 100/102 call spread & sell 1 mo 100/95 put spread
BoM 12: buy 1 mo 101/102 call spread




August 4, 2012 23
Observation
In an arbitrage-free frame-work, cant earn credit spread in excess of
expected default cost
Option pricing is built upon an arbitrage-free concept
These two concepts are not fully comparable, but in practice mixed in the
pricing
Need to consider additional option cost for credit protection
August 4, 2012 24
Traditional asset liability challenges
Minimum crediting rate guarantee
Need to invest longer duration to minimize reinvestment risk at lower
rate (duration L)
Book value surrender
Need to invest shorter duration to minimize market value loss when
selling a bond at higher rate (duration S)
Mixed challenges
Invest in a duration between L and S
Purchase options to protect
Need to revise the profitability to additional interest rate option
cost