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Indexed Annuity Product Pricing and Risk Management

Indexed Annuity Product Pricing and Risk Management. Timothy Yi Enterprise Risk Management The Hartford. After this presentation. You will understand Marketing position of indexed annuity Basic pricing of indexed annuity Risk management of indexed annuity including hedging. Disclaimer.

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Indexed Annuity Product Pricing and Risk Management

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  1. Indexed AnnuityProduct Pricing and Risk Management Timothy Yi Enterprise Risk Management The Hartford

  2. After this presentation • You will understand • Marketing position of indexed annuity • Basic pricing of indexed annuity • Risk management of indexed annuity including hedging

  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

  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

  5. 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

  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)

  7. Clients are recognizing the appeal Index Annuity Sales (in billions) Source: LIMRA, 4Q 2010 Report

  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/

  9. Risk reward profile of fixed vs. variable

  10. Risk reward profile of fixed vs. indexed

  11. Indexed annuity payout

  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

  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

  14. Sample of option types • European • American • Basket • Rainbow • Look-back • Asian • Barrier • Binary (digital) • Cliquet (forward starting)

  15. Sample of strategies involving options • Spread • Bull spread • Bear spread • Butterfly • Straddle • Strangle • Collar • Risk reversal • Covered call

  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

  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

  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

  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

  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

  21. Risk management consideration • Nothing • Hedging • Static hedging • Dynamic hedging

  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

  23. 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

  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

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