Indexed Annuity Product Pricing and Risk Management
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Transcript of Indexed Annuity Product Pricing and Risk Management
Indexed AnnuityProduct Pricing and Risk Management
Timothy YiEnterprise Risk ManagementThe 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
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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
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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
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Types of annuity crediting methodBased 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
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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)
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Clients are recognizing the appeal
Index Annuity Sales (in billions)
Source: LIMRA, 4Q 2010 Report
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Inappropriate sales to seniorsLack of suitability reviewComplicated product designLong surrender charge schedulesIlliquidity for emergencies,
including Long Term CareTwo-tier annuities with illusory
benefits
Recent negative press
For transcript of Dateline NBC aired on 4/13/2008http://www.msnbc.msn.com/id/24095230/
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Risk reward profile of fixed vs. variable
Acc
ount
Val
ue
Time
Equity Bear Market
Equity B
ull Marke
t
Reward:Gains from bull market
Risk: Losses from bear
market(Some principal
guarantee to protect downside)
Fixed Annuity Return
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Risk reward profile of fixed vs. indexed
Acc
ount
Val
ue
Time
Minimum
Equity Bear Market
Equity B
ull Mark
et
Fixed Annuity Return
Reward:Gains from bull market
Risk: Giving up fixed
return
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Indexed annuity payoutA
ccou
nt V
alue
Time
Minimum
Equity Bear Market
Equity B
ull Mark
etPurchase an equity
call option to participate in up-side
Purchas a bond to fund the minimum
Fixed Annuity Return
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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
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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
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Sample of option types European American Basket Rainbow Look-back Asian Barrier Binary (digital) Cliquet (forward starting)
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Sample of strategies involving options Spread
Bull spread Bear spread
Butterfly Straddle Strangle Collar
Risk reversal Covered call
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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
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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
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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
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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
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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
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Risk management consideration
Nothing Hedging
Static hedging Dynamic hedging
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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
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Observation In an arbitrage-free frame-work, can’t 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
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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