Even though hedging programs helped preserve billions of dollars of assets for insurers, increasing losses in those programs were still a main contributor to deterioration of insurers’ net financial results in late 2008 and early 2009.

Consequently, hedge programs are now a critical focus for senior management, rating agencies and investors.

The question is, where to go from here?

This is a question that financial advisors should be asking, too, since advisors will be working with the results of decisions made involving hedging.

First, some background. Market risk has always been a component of the risk portfolios of many life insurers. But in recent times, policyholder riders and guarantees offered in variable annuities have taken market exposure to new levels. Hedge programs steadily evolved as a way to manage the risks associated with this exposure while still enabling insurers to offer attractive benefits to policyholders.

Most insurers have traditionally hedged to economic targets or accounting (mainly Generally Accepted Accounting Principles) targets. Here, the focus has primarily been on reducing profit and loss volatility.

Companies achieved desired results through various strategies, with some firms choosing not to hedge one or more risks. The types of instruments used also varied, depending on cost, liquidity and to some extent familiarity. This variety and the inherent differences in underlying liability portfolios meant that market movements impacted the bottom lines of VA writers differently.

In recent quarters, several VA writers posted multimillion-dollar hedge program losses. Contributing factors include equity market decline, increases in volatility and decreases in interest rates. While VA hedge programs have played a role in offsetting a substantial portion of the increase in each of these exposures, the level of protection provided in a volatile environment was significantly less than expected.

Not only have company profits suffered, but recent events have shown that the hedges have not been as effective on a statutory basis, particularly at protecting capital.

Although the responsibility to reassess current hedging strategies lies with life insurers’ executive management, advisors should be aware of the issues.

In particular, advisors will increasingly need to understand the ongoing implications of evolving hedging strategies. This is because significant potential exists for these changes to impact the development and pricing of products the advisors present to clients.

Not surprisingly, hedge programs are now under close scrutiny.

Senior management is demanding more information about sources of profits and losses. Attribution analyses are being enhanced to include items previously small enough to be lumped into a catch-all group. Insurers are rethinking how they can map the underlying policyholder funds to the indices they can model and against which they can purchase hedge assets.

Companies are even considering product designs based primarily on indexed funds to help control this risk.

Because basis risk contributed so greatly to recent losses, minimizing asset-risk mismatches should help reduce future losses.

In addition, overall hedge strategies are being reviewed specifically to look at the impact of increased volatility. Insurers whose programs did not include volatility-specific hedges before the financial downturn incurred more significant balance sheet losses as increased volatility drove their liabilities higher. These insurers also incurred higher hedge costs as the cost of the derivatives used for rebalancing rose.

While the cost of hedging volatility is high, companies may look at opportunistically purchasing volatility-specific hedges when the price or the need is right. They will also look to hedge programs as a tool in protecting against further capital losses.

The challenge is to ensure that the strategies adopted optimize the protection on all fronts. This is difficult given the differences in accounting.

An equally complex hurdle is integrating hedging into the development and pricing of variable annuities.

Already, insurers are working to improve the robustness of their hedging strategies, effectiveness and program governance, as well as operations.

With life insurers now carrying billions of dollars in derivatives and related liabilities on their balance sheets, improving hedging strategies as well as execution in VA risk management is critical.

Going forward, there may be more emphasis on mitigating economic risks and protecting the company in tail scenarios, and less emphasis on reducing near-term GAAP earnings volatility. Because VA guarantees are deep in the money and volatility remains high, transitioning to more robust hedging strategies will involve tough (and expensive) choices.

The recent environment, while trying for VA writers, has provided unprecedented information on the durability of hedge strategies in extreme scenarios as well as the design and pricing of products. The turmoil has also provided many more data points for VA issuers to assess such nonhedgeable risks as policyholder behavior and basis risk more accurately.

Insurers should not lose sight of these opportunities to collect data and improve their strategies and processes.

Coming out of the crisis, insurers need to move aggressively to strengthen their risk management controls, both at operations and enterprise levels. They must also take on the dual challenges of revising their capital management and hedging strategies to deal more effectively with unexpected volatility.

Tom Crawford and Al Dal Porto are executives in the Insurance and Actuarial Advisory Services practice of Ernst & Young’s Financial Services Office, in the New York City and Chicago offices, respectively. Their email addresses are, respectively, tom.crawford@ey.com and al.dalporto@ey.com