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JP Morgan Interest Rate Risk in Variable Annuities

JP Morgan Interest Rate Risk in Variable Annuities

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Derivatives Strategy
September 28, 2011Srini Ramaswamy
(1-212) 834-4573Terry Belton (1-312) 325-4650J.P. Morgan Securities LLC
Research Note
Interest Rate Risk in VariableAnnuities
We outline a simple framework for analyzingthe interest rate risk exposure in variableannuities in the aggregate, with a view towardsassessing the likely forward-lookingimplications for the long end of the swaps andTreasury curves. The essence of our approachis to decompose the highly complex variableannuity universe into a weighted combinationof much simpler “VA-lite” instruments, withthe weights themselves being implied frommarket behavior
We estimate that the recent plunge in long-endyields has taken the aggregate duration of theVA universe to all-time highs, although thisweek’s pullback has mitigated this somewhat
Long-end swap spreads have steadily becomeless vulnerable to VA duration, perhapsreflecting hedgers’ growing allocations toTreasury-based instruments, and will likelynot be as impacted by VA hedging flows asthey were in 4Q08. That said, the crowding-outeffect of Operation Twist is likely to result inmodestly greater sensitivity of long-endspreads to VA duration swings
Unlike swap spreads, the slope of the 10s/30scurve shows no declining sensitivity to VAduration
 US fixed income investors, particularly those focusedon the longer end of the Treasury or swaps curve,have come to realize the significant impact that therisk management of variable annuities can have onlong-end yield levels, the slope of the curve, and onswap spreads at the very long end of the curve. To putit simply, flows related to the hedging of the durationrisk in variable annuities have become a force to bereckoned with at the long end of the curve, and as aresult, it behooves investors to better understand theseproducts and their interest rate risk exposures. This factreally burst forth into plain view right after Lehman’sdefault in 2008, when a plummeting stock marketcoupled with falling Treasury yields produced amassive duration shortfall in insurance companies’portfolios, leading to considerable receiving in swapsand causing long-end swap spreads to decline belowzero for the first time. More recently, this has onceagain become evident given the significant receivingflows from insurance companies as long-end yieldsattained new all time lows last week, although some of these flows have reversed since then given the pullback in yields.Variable annuities were first introduced in the 1980’s,and tended to be fairly simple products designed to
Exhibit 1: The variable annuity industry has seensignificant growth over the past decade
Variable annuities assets; $bn
         1         9         9         8         1         9         9         9         2         0         0         0         2         0         0         1         2         0         0         2         2         0         0         3         2         0         0         4         2         0         0         5         2         0         0         6         2         0         0         7         2         0         0         8         2         0         0         9         2         0         1         0         2         0         1         1
 Note: 2011 value is as of 2Q11.Source: “Responding to the Variable Annuity Crisis,” Dinesh Chopra et al, McKinseyWorking Papers on Risk, Number 10, April 2009; Morningstar.
Srini Ramaswamy
Terry Belton(1-212) 834-4573 (1-312) 325-4650srini.ramaswamy@jpmorgan.com terry.belton@jpmorgan.comJ.P. Morgan Securities LLC J.P. Morgan Securities LLCAlberto Iglesias Meera Chandan(1-212) 834-5116 (1-212) 834-4924alberto.d.iglesias@jpmorgan.com meera.chandan@jpmorgan.comJ.P. Morgan Securities LLC J.P. Morgan Securities LLCKimberly Harano(1-212) 834-4956kimberly.l.harano@jpmorgan.comJ.P. Morgan Securities LLC
Derivatives Strategy
September 28, 2011Srini Ramaswamy
(1-212) 834-4573Terry Belton (1-312) 325-4650J.P. Morgan Securities LLC
offer equity market upside along with tax-deferredreturns. Over time, various options and guarantees werebundled in, including death benefits (such as a return of premium in case of death) as well as living benefitssuch as guaranteeing a minimum income (GMIB) forthe policyholder or an account value (GMAB) at afixed point in time. Since the late nineties, minimumwithdrawal benefits either for a predetermined numberof years or for the remainder of the policyholder’s life(GMWB) appear to have been commonly included.Such benefits, together with path-dependent featuressuch as guaranteed roll-ups or ratchets, have madevariable annuities popular products, causing theindustry to experience significant growth (
Exhibit 1
).Of course, these guarantees also imply greater risk tothe underwriters. Conceptually, the insurancecompanies are short equity puts to policyholders, theexercise of which occurs in the form of floored futureannuity payments whose present value depends oninterest rates.The hybrid exposure of these products to the referenceindex (S&P 500) as well as the yield curve, mortalityrisks, and numerous features that create pathdependency all mean that pricing variable annuities is ahighly complex undertaking. However, accuratelypricing these instruments is not our objective in thisresearch note. Our goal is to capture the relativemagnitudes of the duration of the VA universe overtime as accurately as possible, and in a way thatrecognizes the inherent nonlinearities with respect toequities and rates; understanding such nonlinearities iskey to understanding the shifts in VA duration inperiods where equities and/or rates trend towardshistorical extremes. To that end, our approach is gearednot towards modeling the detailed structure of variableannuities in their full richness; rather, we seek to findan effective scheme to approximate the durationexposure of the VA universe (basically the partial deltaof variable annuities with respect to long-term rates) inthe aggregate.The outline of this paper is as follows. First, wedescribe variable annuities, with a focus on the aspectsthat create the interest rate risk exposures we are mostinterested in. Second, we present the essence of ourapproach, which is based on the notion of approximating the complex universe of VAs via anotional-weighted combination of highly simplified“VA-lite” instruments, which we refer to as “VAkernels.” Our approach also relies on an empiricalcalibration to solve for the weights on these individualVA kernels. We then discuss the current exposures of the aggregate VA universe, as well as implications forthe long-end of the US yield curve.
A simple framework to estimateinterest rate risk in variable annuities
Variable annuities, like fixed annuities, may beconceptualized as consisting of an
phase,during which the policyholder pays either a lump sumor regular contributions with the aim of producing anaccreted future value at some desired point in time, anda
phase, where the accreted principal isannuitized by the insurance company as a stream of regular payments to the policyholder over a designatedtime period. Actuarial components (such as embeddedlife insurance and associated minimum guarantees)exist, but we ignore them for our purposes sincemortality risk is uncorrelated to market risk, which isour main focus.In the case of fixed annuities, the investor’s investmentperformance during the accumulation phase is set to apredetermined interest rate, resulting in a predictablefuture value that can subsequently be annuitized—i.e.,except for actuarial risks, the product conceptually issimilar to purchasing a strip of zero coupon bondsduring the accumulation phase, carefully designed toproduce an annuity during the payoff phase. As such,fixed annuities have interest rate exposures that arerelatively easily understood and hedged.Variables annuities, on the other hand, have twoimportant sources of variability. First, returnsexperienced in the accumulation phase are not fixed orknown
a priori
, and are instead linked to the returns onsome benchmark such as the S&P 500. Second, as aresult of the uncertain nature of returns in theaccumulation phase, VAs commonly embed minimumguarantees as already noted in the previous section.Conceptually, then, one can imagine an elemental VAbuilding-block (or kernel) as consisting of a singlelump-sum premium payment at the start of a fixed-termaccumulation phase, followed by a fixed-termannuitization, with minimum guarantees on thewithdrawal amounts.
Derivatives Strategy
September 28, 2011Srini Ramaswamy
(1-212) 834-4573Terry Belton (1-312) 325-4650J.P. Morgan Securities LLC
In rising equity markets, VAs pose little market risk tothe insurance companies that underwrite them—policyholders’ premiums can be invested in the S&P500, and returns are merely passed through to thepolicyholders. However, the picture is very different inequity bear markets—the more equities fall, the morebinding the minimum guarantee becomes, and theunderwriter is increasingly short a fixed annuity. Thus,insurance companies increasingly need to add durationin periods of falling equity markets. Similarly, a fall inlong-term yields would increase the NPV of theminimum guarantee to the policyholder, making itmore likely that the guarantee will be binding. Thisimplies that an underwriter of VA policies becomesshort duration as yields fall. The combination of boththese events—falling equities and bond yields—represents a perfect storm, and causes duration needsfrom VA hedgers to rise significantly, as was the casein 4Q08 and as has been the case recently.Clearly, pricing variable annuities comprehensivelyand accurately is an exceedingly complex undertaking,requiring the joint modeling of long-term interest ratesas well as equities; in addition, actuarial risksstemming from life insurance-related guarantees, andother features make the product path dependent, addingto the complexity.Recognizing that our objective is not to price variableannuities accurately, but merely to capture the trend intheir duration exposures as well as their nonlinearrelationship with equities/yields, we devise a simplerapproach. Our approximation approach is based onthree principles. First, we start with the assumption thatthe duration of the VA universe may be approximatedby a weighted combination of the durations of muchsimpler VA kernels. This is not unlike “seriesapproximation” techniques commonly used inmathematics to solve difficult problems. One exampleof a VA kernel is a simple product where apolicyholder pays $100 on (say) January 1, 2007,intended to be invested in the equity market for a 15-year (fixed) horizon, with a guaranteed withdrawalamount of $12 per year for the subsequent 20 years;this could be interpreted as a minimum 6% guaranteedannual return during the accumulation phase, followedby a minimum guaranteed 5% annual withdrawal onthe accreted principal (see
Exhibit 2
for an illustrationof a VA kernel). Several VA kernels may be created byvarying the start date, the length of time of the intendedequity investment, and the minimum guarantee amount.Effectively, we decompose the complex VA universeas a linear combination of simpler VA kernels, each of which is priced in a manner that captures thenonlinearities with rates and equities.Second, we calculate the present value of each VAkernel by using an option pricing framework. We useimplied distributions from the swaptions market as wellas long-term S&P vols and correlation estimates tocalculate the price. We then use numerical tweaks tocalculate the partial exposure with respect to long-termswap rates (i.e., duration). Third, we use a calibrationapproach to solve for the appropriate weights on thevarious VA kernels. Our calibration relies on theanecdotally-known fact that VA risk exposures weresignificant influences on long-end swap spreads incertain periods of time, such as 4Q08; we may thussolve for non-negative coefficients for each kernel thatmaximally explain the portion of long-end swap spreadbehavior not explained by other factors in those selectperiods of time. In order to mitigate circularity (sincewe plan to use VA duration estimates to model long-end swap spreads), no data after 2008 has been used incalibration, and out-of-sample performance has beentested and found to be reasonable.
Calibration and results
 As noted above, each VA kernel in our framework iscompletely determined by a start date (on which thepremium is paid in full), the length of the accumulationand payoff phases, and the details of the minimumguarantee. In our empirical work, the kernels weconsidered all had lengths of 15 years for theaccumulation phase and 20 years for the payoff phase,with a minimum guaranteed annual withdrawal of 5%
Exhibit 2: Illustration of a hypothetical VA kernel
1/1/07: $100investment
Accumulation phase
:guaranteed 6% minimunannual return
Payoff phase
: 5% annualwithdrawal for 20 yearsetc...

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