Indexed Annuity Product Pricing and Risk Management

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