Hedging Variable Annuity Guarantees

Actuarial Society of Hong Kong

Hong Kong, July 30
Phelim P Boyle
Wilfrid Laurier University
Thanks to Yan Liu and Adam Kolkiewicz for useful discussions.

p. 1/4

Outline
Introduction
Dealing with embedded options
Hedging: Some practical spects
The Guaranteed Minimum Withdrawal Benefit(GMWB)
Basic features
Valuation of basic GMWB contract
Semi static hedging
Concluding remarks

p. 2/4

Background: Variable Annuities

Investors like to have possibility of upside
appreciation
Investors also concerned about downside risk
Many insurance and annuity products that
combine both features
Structured products, Equity Indexed Annuities
and Variable Annuities(VA)
These products contain different types of
exotic options

p. 3/4

New product: Sequence of Steps

Aim: Profitable return on capital
Design the contract
Manage the risks
Risk management
Reserving hedging the embedded options
Pricing

p. 4/4

Ways to Hedge
Buy options from another institution
Can be expensive, Lapses
Farm out hedging to a third party
Set up managed account.
Hedge in house
Keeps control. Need resources. Hedging
program can become politicized

p. 5/4

Hedging Program: Issues

Need very clear objectives
P and L should break even. Not a profit
centre
Educate senior management
B of Directors may not fully understand
hedging
Communicating hedging performance
Important
Attribution of performance
Which metrics to use.

p. 6/4

Dynamic Hedging (DH)

Calibrate model to market options
Value embedded options using calibrated
model
Construct portfolio of traded assets with same
Greeks as liability portfolio
Repeat this procedure periodically
Rebalance the asset portfolio each time
Update for lapses and new business

p. 7/4

Features of DH
Does not protect against model risk
Suppose market jumps. Gives rise to gap risk
DH does not work if markets are closed for
some reason eg post nine eleven.
DH can be a challenge if gamma changes
sign frequently (cliquet options)
Dynamic hedging assumes you know the model,
continuous prices, that markets are open and
there is enough liquidity.

p. 8/4

Semi Static Hedging (SSH)

SSH overcomes many of these problems. Use
example
Hedging a ten year European option with a
portfolio of one year standard options
Construct a portfolio of the short term options
that replicates the long term option
There is an exact expression for this.
Assume t < < T . St stock price at t

p. 9/4

SSH Formula
Let Vt (St , T ) be market price at time t, of long
option to be hedged. We have (Carr Wu)

(1)

Vt (St , T ) =

g(k)Pt (St , t,, k)dk

k=0

where Pt (St , t, , k) is the European put price at

time t with maturity and strike k.

p. 10/4

SSH Formula
The coefficients g are given by
2 V (S, , T )
g(k) =
|S=k
2
S
These correspond to the gammas of the long
term derivative at the horizon time with stock
price equal to k. Can approximate this integral
with a finite sum.

p. 11/4

GMWB
GMWB adds a guaranteed floor of withdrawal
benefits to a VA
Provides a guaranteed level of income to the
policyholder.
Suppose investor puts $100,000 in a VA
Policyholder can withdraw a certain fixed
percentage every year until the initial
premium is withdrawn

p. 12/4

GMWB
Assume the withdrawal rate is 7% per annum.
Our policyholder could withdraw $7,000 each
year until the total withdrawals reach
$100,000.
This takes 14.28 years.
Note the policyholder can withdraw the funds
irrespective of how the investment account
performs
Here is an example. Market does well at first
and then collapses.

p. 13/4

Example
Year

Rate

Fund before

Fund after

Amount

Balance

on fund

withdrawal

withdrawal

withdrawn

remaining

10%

110,000

103,000

7,000

93,000

10%

113,300

106,300

7,000

86,000

-60%

42,520

35,520

7,000

79,000

-60%

14,208

7, 208

7,000

72,000

- 2.8857%

7,000

Zero

7,000

65,000

6
..
.

r%
..
.

0
..
.

0
..
.

7,000
..
.

58,000
..
.

14

r%

7,000

2000

p. 14/4

The GMWB
The GMWB guarantees a fixed level of
income no matter what happens to the market
Fee for the GMWB is expressed as a
percentage (say fifty basis points) of either
The investment account or
The outstanding guaranteed withdrawal
benefit.

p. 15/4

Assumptions
Perfect frictionless market
Ignore lapses, partial withdrawals mortality etc.
Assume max amount taken each year
Fixed term contract over [0, T ].
Index investment fund dynamics
dIt = It dt + It dBt
where Bt is a Brownian motion under P
is the drift
is the volatility.

p. 16/4

Investors account
Let At be the value of the investors account at time t.
A has an absorbing barrier at zero. Suppose first time it hits zero is .
Dynamics of A for 0 < t < are
dAt = [( q)At g]dt + At dBt
where q is the fee and g is the withdrawal rate.
If the initial investment amount is A0 then
g=

A0
.
T

p. 17/4

Pricing the contract

Put Option decomposition
Investment often in mutual fund.
Insurer guarantees to pay remaining withdrawal benefits if A(t) reaches zero in
[0, T ].
Guarantee provided by the insurance is a put option with random exercise time.
If policyholders investment account stays positive there is no payment under the
put option.
The option is exercised automatically when the account balance first becomes
zero.

p. 18/4

Put Option decomposition

When this happens the insurer agrees to pay
the remaining stream of withdrawal benefits
of g per annum.
Z T
g eru du

Put option has a random exercise time . Put

is funded by the fee payable until time .
Guarantees backed solely by the claim paying
ability of XYZ insurance Co.

p. 19/4

A reaches zero in year 11

100
90
80

Account value

70
60
50
40
30
20
10
0

Exercise
0

10

15

Time

p. 20/4

Valuation of GMWB
Use numerical methods to value the contract
(Monte Carlo or pde)
Here we just value a very simple contract
assuming full utilization.
We ignore lapses and mortality and utilization
choice. (Could include them .)
Assume simple lognormal model for
convenience and deterministic interest rates.

p. 21/4

Numerical Example
Benchmark contract, fifteen year term. No lapses no deaths. All policyholders start to
withdraw funds at max rate from the outset. Input parameters are
Parameter

Symbol

Benchmark value

Initial investment

A0

100

Contract term

15 years

Withdrawal rate

6.6667

Volatility

0.20

Riskfree rate

0.05

Now compute pv contributions and put prices for different values of q.

p. 22/4

Put values for basic GMWB

Value of q

Present value of

Put option

basis points

Contributions

3.98

10

0.96

4.07

25

2.36

4.20

48

4.40

4.40

75

6.79

4.67

100

8.87

4.91

200

16.33

5.98

300

22.63

7.17

p. 23/4

Contributions and put option

25

20

15

10

0.005

0.01

0.015

0.02

0.025

0.03

p. 24/4

No arbitrage Values
For this example the no arbitrage Value of q is
q = 0.004751
Contributions and Put values when q = 0.004751
Entity
Value (sd)
Value of contributions 4.4012(0.0003)
Value of put option
4.4014(0.0008)

p. 25/4

Sensitivity to interest rate

Suppose we have benchmark contract. Fix q = 0.004751.
Explore sensitivity of put value and present value of
contributions to inputs. First vary the interest rate
Interest Assumption

Present Value of

Put Option

Contributions
0.04

4.29

6.14

0.05

4.40

4.40

0.06

4.50

3.09

p. 26/4

Sensitivity to interest rate

7
6.5

Contribution & put values

6
5.5
5
4.5
4
3.5
3
2.5
2

4.2

4.4

4.6

4.8

5
5.2
Interest rate

5.4

5.6

5.8

p. 27/4

Sensitivity to volatility
Now vary the volatility
Volatility
Present Value of
Assumption Contributions
0.15
0.20
0.25

4.37
4.40
4.44

Put Option
2.08
4.40
7.07

p. 28/4

Sensitivity to volatility
8

Contribution & put values

2
15

16

17

18

19

20
Volatility

21

22

23

24

25

p. 29/4

Sensitivity to Account Value

Vary A0 and keep g fixed at
100
= 6.6667
15
Present Value of Put Option
Contributions
90
3.73
6.10
100
4.40
4.40
110
5.07
3.20
Conclusion: Moneyness matters
A0

p. 30/4

Semi static Hedging SSH

Hedge the risk with a portfolio of one year
options
Re hedge after one year
This overcomes some of the disadvantages
of delta hedging
SSH hedging is more robust than delta
hedging
For GMWB there is mild path dependence

p. 31/4

Distribution of Index in one year

200
180
160
140
120
100
80
60
40
20
0
40

60

80

100

120

140

160

180

200

220

240

p. 32/4

Evolution of A over year

Pick one sample path. Withdraw 1.667 per
quarter.
Time t It
At
0
100 100.00
0.25 110 108.33
0.50 120 116.52
0.75 110 105.14
1.00 100 93.91
A1 = 93.91 for up down path.

p. 33/4

Evolution of A over year

Pick another sample path. Withdraw 1.667 per
quarter.
Time t It
At
0
100 100
0.25
90 88.33
0.5
80 76.85
0.75
90 84.79
1
100 92.55
A1 = 92.55 for down up path.

p. 34/4

Distribution of Liability in one year

For each value of the index at time one I1
there is a range of A1 .
Conditional on I1 the future GMWB liability
V1 (I1 ) takes a range of values .
There is a different value of V1 (I1 ) for each
A1 . So we can write V1 = V1 (I1 , A1 )
Very messy simulation to get them all
Two ways. First way use Brownian bridge
construction

p. 35/4

Ten paths of a Brownian bridge

2
1.5
1
0.5
0
0.5
1
1.5
2

0.5

1.5
2
2.5
Time in quarters

3.5

p. 36/4

Liability Calculation
Fix I1
Use Brownian bridge to get distribution of
A1 |I1
For each pair (A1 , I1 ) find the GMWB liability
at time one
Find average value of liability given I1
(2)

V (I1 ) = EA1 [V1 (I1 , A1 )]

Use put options with different strikes to

construct SS Hedge based on V (I1 ).

p. 37/4

Distribution of A1
Fix a value of the index at time one I1 .
Conditional on I1 find the distribution of A1 |I1 .
We have seen that A1 is path dependent.
Next graph assumes I1 = 100 and gives
distribution of A1

p. 38/4

Distribution of A1| I1 = 100

1200

1000

800

600

400

200

0
91

91.5

92

92.5

93

93.5

94

94.5

p. 39/4

Distribution of A1
We can get all the moments of A1 |I1 in
closed form
It turns out that A1 |I1 is almost normal.
We fix I1 and write
A1 = A1 + A z
where A1 = E[A1 ] and where z has mean
zero and variance one.

p. 40/4

V1 as a function of A1
Fix I1 .
We have
V (I1 , A1 ) = V (I1 , A1 + A z)
Using Taylor series and taking expectations
we have
(3)

2)
(

EA1 [V (I1 , A1 )] = V (I1 , A1 ) + A V (I1 , A1 )

2

p. 41/4

SS Hedging
Two expressions for EA1 [V (I1 , A1 )] The last one
equation (3) is much more convenient.
Find portfolio of put options to replicate
average liability EA1 [V (I1 , A1 )].
Optimization procedure or apply equation (1).
Repeat after one year

p. 42/4

Profile of average net liability

40

Green line net liability

30

20

10

10

20
40

60

80

100

120
140
160
180
Index value after one year

200

220

240

p. 43/4

Summary and future work

We discussed
Semi static hedging
Application to GWMB
Future work
deal with path dependent structure
Stochastic volatility
Other products
Natural hedges

p. 44/4