North American Actuarial Journal

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Hardy, Mary R. 2003, Investment Guarantees:

Modeling and Risk Management for Equity-Linked
Life Insurance

Frank Bensics F.S.A., Ph. D.

To cite this article: Frank Bensics F.S.A., Ph. D. (2004) Hardy, Mary R. 2003, Investment
Guarantees: Modeling and Risk Management for Equity-Linked Life Insurance , North American
Actuarial Journal, 8:3, 133-136, DOI: 10.1080/10920277.2004.10596164

To link to this article: http://dx.doi.org/10.1080/10920277.2004.10596164

Published online: 03 Jan 2013.

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Download by: [Australian National University] Date: 02 June 2016, At: 01:34
 BOOK REVIEWS
Hardy, Mary R. 2003, Investment
Guarantees: Modeling and Risk Management
for Equity-Linked Life Insurance, John Wiley
and Sons, Inc., Hoboken, New Jersey,
xv ⴙ 286 pages, $95.00 ISBN 0471392901
Actuarial students are first exposed to the sto-
chastic modeling of insurance values through Ac-
tuarial Mathematics (Bowers et al. 1997). The
text replaced Life Contingencies (1967) more fa-
miliarly known as Jordan on Society of Actuaries
Examinations in the early 1980s, with the Casu-
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alty Actuarial Society adopting subsequently.
Traditional (or non-stochastic) life contingencies
under Jordan allowed for the calculation of ex-
pected present values, but gave no insight as to
measurement of risk. The principal innovation of
the new or stochastic approach was the notion
that policy values were random variables, allow-
ing for measurement of value uncertainty, at least
to a limited extent.
Insurance, as with all financial instruments, is
subject to multiple sources of value uncertainty
including; payment likelihood, payment timing,
payment amount and the present value factor
given time of payment. The approach of Actuarial
Mathematics (Bowers et al. 1997) is to explicitly
model likelihood and/or timing uncertainty,
through a survival model (or mortality table in a
discrete context). Payment amounts, and the
present value factors are presumably determinis-
tic functions of time of payment. Values of inter-
est such as premiums and reserves are calculated
as expectations of the time conditional values.
Distributions for values are occasionally found
through transformations of the timing random
variable, or for more basic analysis, quantiles or
standard deviations determined.
While the approach is valuable from a concep-
tual point of view, it is of less practical value.
Mortality, which is the usual contingent event, is
generally only a significant source of risk in cases,
which do not meet the independence assumption
of Actuarial Mathematics (Bowers et al. 1997).
More significantly, for most contemporary life in-
surance products with a savings component,
changing asset values dominate as a source of
risk, either through the asset accumulation sup-
133
porting the policy or through the impact of chang-
ing asset values on benefits paid to policyholders.
While actuarial students are introduced to the
notion of amount risk through the subjects of risk
theory and loss distributions, the context is prop-
erty casualty or health insurance based claims’
payments and the underlying assumption is again
one of independence of outcomes. Exposure to
the notion of investment risk, and the standard
paradigms upon which modern investment the-
ory is based; portfolio theory, the CAPM, and the
Black-Scholes model first comes in a corporate
finance context on the current Course 2, while
product design is introduced on Course 5. The
integration of product and investment risk is gen-
erally not present until Course 8, and there only
to a somewhat ad hoc extent, varying with exam
specialty.
What has been lacking is a cohesive source that
integrates contemporary modeling of investment
risk in the context of modern insurance con-
tracts. Financial Economics: With Applications
to Investments, Insurance, and Pensions (Panjer
et al. 1998) synthesized much of the underlying
theory. However, despite mentioning practical
applications in the title, the focus was clearly on
a more theoretical presentation, providing little
in the way of a bridge from the underlying theo-
retical models to actual application in either a
pricing or risk management context.
Investment Guarantees: Modeling and Risk
Management for Equity-Linked Life Insurance
however, does provide such a bridge, specifically
where the source of risk arises through changing
equity prices. Stochastic interest rates, the sec-
ond major source of investment risk, are dealt
with only to the extent that they affect values of
equity-based products. Much of the material is a
consequence of studies undertaken by the Cana-
dian Institute of Actuaries Task Force, here after
referred to as the Task Force.
With investment based insurance products, the
basic idea is to create upside potential with lim-
ited downside risk. Chapter 1 introduces the con-
tractual variations of this concept within various
countries, such as the United States (Variable and
Equity Indexed Annuities), the United Kingdom
(Unit-Linked Insurance), Germany (Equity-
Linked Insurance) and Canada (segregated
 134
funds). While the title of the book refers to life
insurance, it does not deal with the original ver-
sion of the equity based concept, variable life
insurance which appeared in Europe in the 1960s
and the United States in 1970s, or the more re-
cently introduced analog to equity indexed annu-
ities known as Equity Indexed life. The omission
is not serious as the techniques presented mod-
eling investment-dominated contracts are adapt-
able to modeling the equity risk of the insurance
dominated contracts.
Asymmetric loss structures invariably lead to
option analogies. Brennan and Schwartz (1976)
and Boyle and Schwartz (1977) are early exam-
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ples of what the author refers to as the dynamic
hedging approach to risk management in which
an equity based insurance liability is treated as an
option and hedged with a dynamically adjusted
portfolio of marketable assets. The actuarial pro-
fession, at the time, paid little notice as equity
risks were generally fully assumed by policyhold-
ers through separate account funds without guar-
antees. High interest rates in the 1980s, and an
explosion of Single Premium Deferred Annuity
(SPDA) business, created awareness of the invest-
ment risk of long-term guarantees through guar-
anteed deposit rates (call options) and book value
surrender guarantees (put options). Unfortu-
nately, not enough attention was paid in certain
cases, as the author describes the case of the
Equitable (U.K.) where overly generous promises
made to policyholders have led to disastrous con-
sequences. Similar cases in the United States
could have easily been mentioned as well. The
lack of formal analysis is referred to as the ad hoc
approach, which is hopefully diminishing through
either regulatory mandate, or voluntary choice.
The actuarial approach to risk management,
based upon risk theory concepts is an alternative
to dynamic hedging. Under this approach, future
values are projected using real world probabilities
(generally referred to as the P measure), and
funds are invested in risk free assets to reduce the
probability of deficiency to a sufficiently low
level. This approach often referred to as quantile
based, underlies the risk management technique
known as Value at Risk (VaR), which is com-
monly used in the banking community, and pro-
vides the basis for the internal models alternative
for capital requirements under the Basel accord.
In the Introduction, the author expresses no
NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 8, NUMBER 3
preference for the dynamic hedging or actuarial
approaches, stating that both have their merits
and a combination may be best. Conventional
wisdom today implies dynamic hedging as more
appropriate for pricing the guarantees, while the
actuarial approach is more suitable for risk man-
agement purposes. This is consistent with the
quantile-based approach for capital requirements
recommended by the Task Force and described in
chapter 4.
To analyze equity based price risk, a model for
equity values must be assumed. This is the focus
of chapter 2. The traditional model of geometric
Brownian motion for asset prices (implying a log-
normal distribution for future prices, or a normal
distribution for continuous returns) has long
been recognized as deficient in not modeling ex-
treme values or the tails of the distribution. Sev-
eral alternative models explaining the fatter tails,
which are presented, include time series based
models for both returns and volatilities. These
include traditional AR models for returns, as well
as those incorporating stochastic volatility
through GARCH effects, and Wilkie’s Vector AR
approach, integrating several economic variables.
The family of stable distributions is briefly de-
scribed as an approach to model fatter tails, but
these are generally difficult to use as they have
closed form representations for the density func-
tion in only a few cases, such as with the Cauchy
and Normal distributions.
One model considered is the regime switching
lognormal (RSLN). Regime Switching models are
conceptually related to Polya’s notion of an urn of
urns, where on the first draw, an urn is selected,
while on the second a particular value from the
selected urn is taken. This leads to the notion of
a mix of random variables, which is familiar to
actuaries through the notion of parameter risk,
which underlies much of credibility. With a re-
gime-switching model, each regime (or state of
the world) defines a parameter vector from an
assumed distribution. Probabilities for switching
regimes are conditional on the current state, lead-
ing to a Markov Chain of regimes. As the number
of parameters includes a mean and variance for
each regime as well as regime specific switching
probabilities, an n regime model would require n
means, n variances, and n(n-1) switching proba-
bilities, for a total of n squared ⫹ n parameter
 BOOK REVIEWS
estimates. This limits practical consideration to a
two or three regime model.
Chapter 3 describes parameter estimation in
the context of each alternative model using max-
imum likelihood estimation, based upon the tra-
ditional theoretical criteria of consistency and
efficiency when sample sizes are large. The au-
thor is careful to point out that the asymptotic
results do not apply when returns are not station-
ary. She states that the time series used in the
book, equity returns, are stationary, although this
would seem to contradict both regime switching
and time series based models where the return
distributions change over time.
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Alternative models are estimated using returns
on the S&P indices for both Canada and the
United States from 1956 to 1999. As additional
parameters will always improve fit, model selec-
tion criteria which compensate for additional pa-
rameters, such as the Akaike Information Criteria
(AIC) and Schwartz (Schwarz) - Bayes (SBC) are
used to justify the choice of two regime RSLN
model.
One issue that would warrant future investiga-
tion is whether the superior performance of the
model would hold up with either a less diversified
or a more actively traded portfolio of assets, as
segregated funds and variable annuities are not
necessarily invested in index portfolios. If regime
switching represented actual changes in the un-
derlying economic environment, then it should
disaggregate to individual stocks. If it is merely a
statistical device that gives a good fit in one con-
text, then application may be appropriate in spe-
cific cases rather than in general.
As Maximum Loss Expectancy (MLE) empha-
sizes fit where there are the greatest number of
observations, while risk is in the tails, quantile
based matching techniques may be preferable
when distributions are used for risk analysis. This
is the basis for the calibration method used by the
Task Force, which is clearly described in Chapter
4. Under the approach, maximum acceptable
quantiles are specified for accumulation factors
over one, five and ten years. These along with
specifications for the mean and standard devia-
tion over one year are used to find satisfactory
parameters.
Chapter 5, based upon a previously published
paper of the author is one of the more technical in
the book. Bayesian estimation relies on combin-
135
ing sample and prior information. Markov Chain
Monte Carlo Estimation (MCMC) in the context of
the regime-switching model is described along
with the Metropolis Hastings algorithm as an ap-
proach to estimate an intractable posterior. Once
the posterior distribution is estimated, the pre-
dictive distribution for returns and accumulation
factors can be simulated. Chapter 6 begins the
process of using the equity return model, to
model liability Guarantees, illustrating expected
cash-flow projection and Net Previous Value
(NPV) calculation for various guarantee forms.
Chapter 7 is a review of the basic principles of
option pricing and will be familiar to those that
have been subjected to the current Course 6
exam. Option pricing assumes a portfolio of mar-
ketable securities that can replicate the payoff of
the option, leading to valuation through that of
the replicating portfolio. Less obvious is the fact
that the existence of such a portfolio and the
assumption of no arbitrage, allows for valuation
through calculation of the expected present value
under the risk neutral or Q measure with dis-
counting at the risk free rate. European options
can simply be calculated as integrals, analogous
to stop loss premium in risk theory, relegating the
original Black-Scholes approach of solution of the
no arbitrage partial differential equation, to pri-
marily historical interest.
Chapter 8 applies a Black-Scholes formulation
to model the various fund guarantees available in
segregated funds, assessing both costs and poten-
tial for hedging error. This is especially important
if hedging is based upon a lognormal model while
actual returns follow a RSLN.
Chapter 9 introduces the notion of risk mea-
sures. VaR does not satisfy the rationality axiom
known as sub-additivity, which requires that the
risk measure for a sum of risks be less than or
equal to the sum of the individual risk measures.
Conditional tail expectation (CTE) also known as
tail VaR or expected shortfall incorporates loss
severity and does satisfy the axiom. Both quantile
and CTE based measures are illustrated under
both the actuarial and dynamic hedging risk man-
agement strategies.
Chapter 10 compares the strategies through
simulated emerging costs and CTE based capital
requirements. The basic conclusion is that the
dynamic hedging approach is more cost effective
at all but the lowest discount rates.
 136
Chapter 11 is entitled “Forecast Uncertainty.”
The author characterizes three reasons why a
forecast could be wrong. The first is the error
inherent in any random process. In a simulation
context, even if we are drawing from the correct
distribution, the fact that outcomes are defined
by random numbers creates uncertainty. The
standard variance reduction techniques used to
generate random numbers are designed to miti-
gate the uncertainty. As such techniques were
designed to improve convergence when estimat-
ing the mean, the author points out that use when
estimating tail values may prove counter produc-
tive.
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As an appropriate conclusion, the final two
chapters are devoted to application of Techniques
to two alternative equity linked contracts. Chap-
ter 12 deals with contracts having annuitization
guarantees, introducing the risk that annuity
prices at time of annuitization, which may in-
crease above guaranteed rates. While economic
evidence is far from conclusive as to links be-
tween interest rates and equity returns, the au-
thor estimates correlations, using U.K. data, and
applies the regime-switching concept to interest
rates as well as equity returns.
Chapter 13 concludes the book with a descrip-
tion and analysis of the more common participa-
tion designs under equity linked annuities. The
chapter begins with an insightful comparison of
Variable and Equity linked contracts, with the
primary difference being that the former is an
equity with a possible put option, while the latter
is a fixed contract with added call features. While
hedging is costs and error is estimated, it may
have been useful to compare results with a more
complete hedge matching delta and higher order
“Greeks.”
NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 8, NUMBER 3
With the exception of a few typos that the
author has corrected on her web site, the book is
almost flawless. It flows seamlessly, from chapter
to chapter, and is a balanced presentation of the-
ory and application, which is somewhat unique
for an actuarial text. For students, it demon-
strates that many of the things that they encoun-
ter on the exam syllabus are actually useful in the
so called real world.
While the focus on interest rate risk seems to
have diminished somewhat due to low market
rates and reduced sales of fixed annuities, a re-
turn to higher and more volatile rates is inevita-
ble. An analogous book modeling interest rate
risk in the context of product design would pro-
vide a valuable complement to Professor Hardy’s
contribution.
REFERENCES
BOWERS, NEWTON, ET AL. 1997. Actuarial Mathematics. Schaum-
burg, Ill.: Society of Actuaries.
BOYLE, PHELIM P., AND EDUARDO S. SCHWARTZ. 1977. “Equilibrium
Prices of Guarantees under Equity Linked Contracts,”
Journal of Risk and Insurance 44(4): 639 – 60.
BRENNAN, MICHAEL J., AND EDUARDO S. SCHWARTZ. 1976. “The Pricing
of Equity-Linked Life Insurance,” Journal of Financial
Economics 3: 195–213.
JORDAN, CHESTER W. 1967. Life Contingencies. 2nd edition.
Schaumburg, Ill.: Society of Actuaries.
PANJER, HARRY H., ET AL. 1998. Financial Economics: With Appli-
cations to Investments, Insurance, and Pensions.
Schaumburg, Ill.: The Actuarial Foundation.
Frank Bensics F.S.A., Ph. D.
Department of Mathematics
Central Connecticut State University
1615 Stanley Street
New Britain, Connecticut