Hedging Will Open Up
Variable Product Design
The overwhelming trend in the variable annuity marketplace, and to a lesser extent in the variable life marketplace, over the past 5 years has been policy guarantees.
These guarantees have taken the form of VA minimum death benefit guarantees (MDBGs), VA guaranteed living benefits (GMIBs, GMABs and GMWBs), and moderate no-lapse guarantees on variable universal life contracts.
Over the last several years, insurers have discovered hedging as a mechanism to manage the risk associated with these guarantees.
Today, hedging programs are becoming a common tool to provide comfort to senior management, to produce earnings stability, to address concerns of rating agencies and regulators, and to lower levels of required surplus.
Hedging programs usually involve the use of futures, options, or swaps, or a combination of the above. The instruments used will depend upon the benefits backed by the hedging assets, the current market environment and the financial implications of the hedges. Although some carriers are more sophisticated than others in their use of hedging, the overall evolution of hedging will produce future opportunities in the designs of variable and related products. Here are a few examples:
Variable guaranteed benefits will become more heterogeneous. Recent VA guaranteed benefits have tended to be rather homogeneous, with a relatively common feel to them, and differences around the edges. As insurers develop greater expertise in hedging, various kinds of hedges will themselves suggest new, innovative product concepts. Accordingly, carriers at the forefront of hedging today could become the product innovators of tomorrow.
EIA/VA guarantee combinations will make sense. VA guarantees are “put-based” benefits, paying off when the market is down. Equity-indexed annuities are “call-based” benefits, paying off when the market goes up. A well-coordinated hedging program that combines risk management of both liability types could allow for efficient, lower cost hedging of both products, leading to more competitive products on both fronts. This opportunity could lead more carriers into offering both EIAs and VAs.
More policyholder options will emerge. A company capable of a tightly managed hedging program can allow more policyholder flexibility, in such areas as fewer fund restrictions, broader benefit utilization windows and greater premium payment flexibility.
Stronger no-lapse guarantees will be possible in variable universal life insurance. VUL contracts have offered less competitive (or shorter) death benefit guarantees than their fixed universal life counterparts. This is not surprising, given the possibility of bear market returns on the variable subaccounts. The ability to hedge the variable subaccounts efficiently could enable VUL insurers to offer competitive lifetime (or extended period) guaranteed premiums at premium levels closer to fixed universal life levels.
Cost savings will result in the long term. Over the short term, a hedging program likely will require significant additional expenditures. Indeed, such programs require a substantial amount of insurer commitment and technology. However, over the long term, particularly as the hedging program operates over up and down market cycles, the existence of a hedging program can create cost savings in terms of actual out-of-pocket costs, and reserve and risk-based capital savings. Such savings can be translated into richer benefits, higher compensation or lower benefit charges.
Contingent guarantees will develop. A strong hedging program will help facilitate the development of policy guarantees that are contingent upon specified events, such as hospitalization, long term care confinement, disability, college enrollment, etc. Such benefits can help differentiate annuities and life insurance further from competing products.
Hedging of benefits in variable products is an exciting area, but it shouldnt just interest the “Wall Street Greed Geeks.” Product creators have much to look forward to as the science develops.
Timothy C. Pfeifer, FSA, MAAA, is a principal in the Chicago office of the Milliman USA actuarial consulting firm. His e-mail is email@example.com.
Reproduced from National Underwriter Life & Health/Financial Services Edition, March 25, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.