Session 10 PD, Managed Volatility Indices and Funds. Moderator: Simpa A. Baiye, FSA, CFA, MAAA. Presenters: Joshua David Dobiac Philip Prince

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1 Session 10 PD, Managed Volatility Indices and Funds Moderator: Simpa A. Baiye, FSA, CFA, MAAA Presenters: Joshua David Dobiac Philip Prince

2 Controlled Volatility Funds

3 Meeting you today Josh Dobiac J.D., M.S., CAIA Consultant E: CURRENT RESPONSIBILITY Josh is a consultant in the Seattle Life Practice of Milliman. He joined the firm in EXPERIENCE Josh specializes Asset/Liability Management, particularly with respect to Variable Annuities and other Unit-Linked products. He also has substantive experience in Quantitative Finance an the modeling of complex financial assets and liabilities. Josh also have several years experience with evaluating, modeling, and managing the risks of volatility controlled funds within Variable Annuities and Fixed Index Annuities. Prior to Milliman, Josh had close to 7 years of ALM and financial & statistical modeling experience in the life insurance markets of the U.S., Europe and Asia. Josh holds a Masters of Science in Mathematics from the University of California at Irvine, as well as a J.D., with a specialization in Insurance Law, from the University of Connecticut, wher he was also the Managing Editor of the Connecticut Insurance Law Journal. His academic background puts him in an excellent position to consult on hedging, derivative valuation and simulation, stochastic modeling and regulatory developments in insurance. PROFESSIONAL DESIGNATIONS Chartered Alternative Investment Analyst, CAIA Association

4 Volatility Control Funds Key Risks Fund Strategy Risk Modelling Risk Financial Risk Operational Risk

5 Fund Strategy Strategy Performance Strategy Risks Market Risks The sustainability and effectiveness of a fund strategy i critical to the long-term health an stability of a VA business. There are many different method for managing volatility Many are based upon realized volatility, but some make use of implied volatility or even variance swap strike levels. Strategy Sustainability/Scalability Backtest Performance

6 Fund Strategy Key Considerations Operational Risk encompasses many non-market exposures. VCF funds have unique operational exposures, in that they are heavily dependent on the efficacy of their strategy over time. Once the funds are live, there is limited control over strategy, which can leave insurers exposed to unanticipated long-term costs. We live in a global economy and reputation is everything. Choosing the right fund manager is critical and the reputational cost of not getting it right can be difficult to overcome. The world is constantly changing and potential new legal or regulatory constraints can substantially reduce or eliminate a fund s ability to implement its algorithm. Staying on top of new regulatory/legal developments is critical for implementing fund strategies effectively for the long-term.

7 Modeling Impacts Modelling Pricing So the fund has a great strategy, comes from an excellent fund manager, provides superior risk-adjusted returns and reduces the cost of the guarantee. Great news! But can you model it? Review Assess Build Hedging Valuation Capital

8 Modeling Impacts - Example VCF equity allocation is determined by the following formula: w equity t = min( σ target σ equity, 100%) t Here, σ target is the target volatility and σ t equity is an estimate of the realized volatility of the equity index. Finally, realized volatility is measured using an Exponentially-Weighted Moving Average (EWMA): (σ t equity ) 2 = λ(σ equity t Δt ) 2 + (1 λ) 1 Δt (ln( S t )) 2 S t 1 With S t reflecting the price of the index at time t. We are also assuming that the time step is one day and that λ = 0.99, which gives a mean age for the data of 0.4 years. * Charts taken from Guarantees and Target Volatility Funds, B&H Research with Moody s Analytics, by Steven Morrison, PhD & Laura Tadrowski, PhD

9 Modelling Impacts * Charts taken from Guarantees and Target Volatility Funds, B&H Research with Moody s Analytics, by Steven Morrison, PhD & Laura Tadrowski, PhD

10 Modelling Impacts * Charts taken from Guarantees and Target Volatility Funds, B&H Research with Moody s Analytics, by Steven Morrison, PhD & Laura Tadrowski, PhD

11 Modelling Impacts * Charts taken from Guarantees and Target Volatility Funds, B&H Research with Moody s Analytics, by Steven Morrison, PhD & Laura Tadrowski, PhD

12 Modelling Impacts - Valuation * Chart by Zohair Motiwalla, FSA, MAAA

13 Volatility Controlled Funds and Valuation xxx Challenges Monthly returns vs daily volatility measure Realized vs implied volatility Total volatility vs equity volatility Model explicitly within valuation system vs external to it. Protecting the prosperity of clients and the people they serve. Pursuing innovation in the marketplace Risks Mismodelled funds may not reduce capital or reserves as much as expected (or even increase them) If funds are modelled explicitly, runtime issues may be created Fidelity to strategy vs operational considerations Our advice, products and client service adhere to the highest standards of quality.

14 Financial Impacts A critical component to Volatility Controlled Funds is their ability to reduce the cost of the guarantee insurers provide. Proper modeling helps assess whether the fund improves the guarantee cost under each lens of interest and, if so, it can also help provide a breakdown of the drivers that provide those benefits. Capital Improvement Hedge Cost Balance sheet impact If done incorrectly, it s difficult to capture fully the benefits associated with the strategy. This results in higher capital, less favorable pricing and inaccurate hedge cost projections. Comprehensive hedge strategy review

15 FIA vs VA VCF xxx VA VCF Protecting the prosperity of clients and the people they serve. Tend to invest in more traditional asset classes (Domestic equities, highly rated credits, etc.) Target volatility tends to be moderate (8%-12%) Rebalancing is either through trading underlying securities or (increasingly much more common) futures or ETFs. Pursuing innovation in the marketplace FIA VCF Tend to invest in a wider array of assets (commodities, international, etc.) Target volatility tends to be low (4%-6%) Our advice, products and client service adhere to the highest standards of quality. Hedging is generally done through bespoke options or futures written directly on the underlying vol control index by the same investment bank that created the index. Minimal basis risk as a result. Exchange-traded options still in infancy.