Life conference and exhibition 2010 Michael Payne, Prudential; Joshua Corrigan, Milliman Risk Management, Hedging and Product Design in a With-profits fund Session C10 7-9 November 2010
Agenda Background Product and Risk Management Levers Practical Considerations The Future 1
UK Capital Market Conditions Source: Bloomberg and Milliman 2 UK Swap Rates FTSE Imp Vols 50% FTSE Rolling 12 month Price Returns Milliman Hedge Cost Index 40% 30% 20% 10% 0% 10-04 1-05 4-05 7-05 10-05 1-06 4-06 7-06 10-06 1-07 4-07 7-07 10-07 1-08 4-08 7-08 10-08 1-09 4-09 7-09 10-09 1-10 4-10 7-10 -10% -20% -30% -40%
Impact on New Business Sales Source: ABI Statistics and Milliman 25,000 20,000 Single Premium New Business Sales Variable Annuities Unit Linked bonds With-profit bonds 15,000 m 10,000 5,000 0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Q2 3
Capital Requirements Guarantees are capital intensive on a market 20% consistent basis 15% 25% 20%-25% 15%-20% 10%-15% 5%-10% 0%-5% 10% Capital has increased as rates have fallen and volatilities increased 5% 0% 2.3% 2.8% 3.3% Interest Rates 3.8% 4.3% 4.8% 23% 18% 13% 33% 28% Volatility Indicative total capital for a 5 year return of premium guarantee 4
Is with-profits an attractive, viable, and sustainable proposition for consumers and providers? Why do we care? Customer research is clear... people need and want guarantees Universal response across multiple surveys undertaken by product providers and consulting companies* Product innovation has occurred in response to this demand *Refer publications by Prudential, MetLife, AXA, ING, and Milliman 5
Where are our choices? Reduce or stop selling Increase guarantee charges Reduce guarantee benefit levels Reduce Equity Backing Ratios Product Management Introduce hedging Dynamic volatility management Risk Management Combination of all the above 6
Impact of Product Management Indicative results only actual results are product specific 20% Base Non-Profit Base With-Profit Economic Capital (% of Asset Share) 15% 10% 5% Lower Benefit Lower EBR Higher charge 0% 0 20 40 60 80 100 120 140 160 Hedge Cost (bps p.a. of Asset Share) 7
Impact of Risk Management 20% Base Non-Profit Base With-Profit Economic Capital (% of Asset Share) 15% 10% 5% Lower Benefit Delta Rho Hedge Vol Mgmt Lower EBR Delta Rho Vega Hedge Higher charge 0% 0 20 40 60 80 100 120 140 160 Hedge Cost (bps p.a. of Asset Share) 8
Equivalent Non-Profit Impact 20% Base Non-Profit Base With-Profit Economic Capital (% of Asset Share) 15% 10% 5% Lower Benefit Delta Rho Hedge Vol Mgmt Lower EBR Delta Rho Vega Hedge Higher charge Vol Mgmt Lower EBR Delta Rho Vega Hedge Lower Benefit 0% 0 20 40 60 80 100 120 140 160 Hedge Cost (bps p.a. of Asset Share) 9
Core Value Proposition of With-Profits is a Relative One The ability to smooth reduces the economic cost of hedging enabling a structural competitive advantage vs non-profit guarantee alternatives However there is no free lunch: Comes at the cost of lower benefit transparency to the customer Implied cost of capital provided by the Estate is lower than the equivalent cost of capital provided by shareholders for non-profit guarantee alternatives 10
General Hedging Considerations Expertise and Experience Governance Structure Trade Management Systems and Processes Capital market constraints Instrument liquidity & costs Exchange vs OTC Cash flow impact and uncertainty New business Changing market conditions Repricing thresholds Systems, processes and resources (expertise) Governance and controls 11
With-Profits Specific Hedging Considerations TCF EBR considerations What to hedge: Cost of Guarantees Cost of Smoothing Management Actions Notional trading Guarantee margin requirements Set to cover cost of capital Leave to Estate to cover the actual cost of hedging 12
Product Design Considerations Risk of Selection Surrenders Vesting Product Sustainability Product Features Complexity Distortion in the Greeks Asymmetry in the liability option value Projected Capital and P&L distributions Other Risks Solvency II 13
What will the future hold? Market continues to be volatile Customers only pay for guarantees that are good value for money Capital continues to be constrained Increased competition from non-profit alternatives Customers continue to demand guarantees Need to maximise benefits within customer budgets Hedging to become a core pillar of WP risk management Focus on core value proposition relative to nonprofit alternatives 14
Questions or comments? What do you think: Is there a future for WP? How do product features need to change? How does risk management need to change? How will SII impact WP? Michael Payne Prudential Joshua Corrigan Milliman 15