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 (
).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
, 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.