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August 24, 2009 at 08:00 PM
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.
