Annuity Risk Management with Options: Investment and Hedging Perspectives. Alex Zeng
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1 Equity-Based Insurance Guarantees Conference Nov. 5-6, 2018 Chicago, IL Annuity Risk Management with Options: Investment and Hedging Perspectives Alex Zeng SOA Antitrust Compliance Guidelines SOA Presentation Disclaimer Sponsored by
2 Annuity Risk Management with Options: Investment and Hedging Perspectives ALEX ZENG, PHD, CFA, CAIA Head of Risk & Quantitative Strategies, Funds Management Lincoln Financial Group November 5, 2018
3 Overview of annuity products VA w/o GLB Value Proposition Accumulation focused. Tax efficient investing for nonqualified + investing flexibility Equity Exposure Upside Potential Downside Protection 2017 Sales (B) 1 Market Growth 1 $30.5-7% VA w/ GLB Guaranteed lifetime income $ % Guaranteed Lifetime Income Annuity Principal Protection Indexed / Hybrid VA 2 Principal protection + growth potential $9.2 68% FIA Principal protection + income $55.0 5% Growth Potential Tax Deferred Peace of Mind Fixed-Rate Principal protection & accumulation $44.7 1% 1 Source: 4-Yr sales CAGR ( ), Source data from LIMRA Secure Retirement Institute (U.S Individual Annuity Yearbook 2017) 2 Aka: Structured VA 2
4 Annuity: account value growth profile Source: Oliver Wyman 3
5 Annuity risk management Manage risk Transfer risk Retain risk Product design Investment (fund/index design) Hedging / ALM Full or partial transfer Reinsurance Outsourcing Not hedged/hedgeable Not transferred Market Risk Insurance Risk Behavioral Risk Equity Interest rate Basis Longevity Mortality Morbidity Lapse 4
6 Holistic market risk management through product life cycle and across functional units Product Risk avoidance through product design Asset allocation requirements Risk allocation across product components and life cycle Investment (Fund/Index) Diversification among asset classes, markets, sectors, factors, Risk budgeting Built-in downside protection Explicit risk/volatility control Hedging/ALM Simple put options Static hedging Advanced dynamic hedging Customized solutions 5
7 Using options for market risk management Investment Hedging Information/Signals for risk management modeling and strategy design Risk/volatility modeling and forecasting Investment strategy design for better risk-adjusted performance Hedging strategy design and development Instruments for risk management implementation Complementary option usage Option overlay for risk control Options-based investment portfolios/funds for VA FIA/Indexed VA product manufacturing VA hedge program 6
8 Millions Millions Growth and maturation of option markets Listed Equity Options Annual Volume and Open Interest 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1, Volume Open Interest Source: Options Clearing Corporation volume is estimated pro rata, as of Sep
9 Listed SPX index option market SPX Options Average Daily Volume (ADV) SPX Options ADV Notional Value ($B) Source: CBOE 8
10 Information/Signals: Option-based volatility models Predictive power of options implied volatility (including VIX) in forecasting future realized volatility Time-series volatility forecasting models (historical volatility, ARCH class, and stochastic volatility) Source: GSAM, Navigating Market Turbulence: An Analysis of Target Volatility Funds,
11 Volatility forecasting models Time series volatility model Option-based volatility model Historical volatility ARCH class Stochastic volatility - Volatility index - Historical average - Random walk - Exponential smoothing - Exponential weighted moving average - ARCH - Generalized ARCH - Exponential GARCH - Threshold GARCH or GJR-GARCH - Quadratic GARCH - Regime Switching GARCH - Quasi-maximum likelihood estimation - Generalized methods of moments - Monto Carlo integration - Heston model - SABR model - Markov chain - Black-Scholes implied volatility Source: Poon & Granger. Forecasting Volatility in Financial Markets: A Review. Journal Of Economic Literature, Practical Issues in Forecasting Volatility. Financial Analysts Journal
12 Information/Signals: looking beyond VIX Informational content of the option market Implied volatility surface, trading volume, bid-ask spread, put/call ratio Source of charts: Bloomberg 11
13 Instruments for VA fund risk management Illustration Implementation form Objectives Option strategies Complementary option usage Hedge specific risks Enhance yield / performance Leverage Covered call Married put Protective collar Option overlay for risk control Mitigate downside risk Reduce portfolio volatility Rule-based put buying for downside protection Others to offset cost of protection Option-based investment portfolios/funds for VA Provide unique investment solution Income generation Enhance alpha Covered call Put writing Spreads Combinations Sophisticated trading 12
14 Option overlay for risk control Risk management overlay with linear derivatives (futures, forwards, swaps, etc.) Widely applied to volatility control strategies (target volatility and capped volatility) Dilemma between upside capture vs. downside protection Risk management overlay with options Nonlinear payoff profile Rule-based put option buying to mitigate downside risk Dynamic use of various option strategies to offset cost Reduce portfolio volatility without precise volatility targeting Combination / rotation between linear and nonlinear (options) derivatives 13
15 Option-based funds/indices: performance Source: Bloomberg 14
16 Option-based funds: AUM growth ($million) Source: Black & Szado, Performance Analysis of Option-Based Equity Mutual Funds, CEFs, and ETFs: An Update, Mar
17 Instruments for hedging General account liability OTC/listed/bespoke options, plus futures European call, call spread, Asian, cliquet, call spread collar Separate account liability Vega hedging: put options, variance swaps Options to supplement 3-Greek (delta, rho, vega) hedging: basket options, lookback options etc. Potential of recovering loss with less offsetting of gains 16
18 Limitations of using options for annuity market risk management Liquidity and market depth Transaction cost Complexity in modeling, execution, and communication Operational risk Upfront capital in buying options and risks in writing options Real world vs. risk neutral 17
19 Annuity Risk Management with Options: Investment and Hedging Perspectives
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