Annuity Risk Management with Options: Investment and Hedging - PDF document

Equity-Based Insurance Guarantees Conference Nov. 5-6, 2018 Chicago, IL Annuity Risk Management with Options: Investment and Hedging Perspectives Alex Zeng SOA Antitrust Compliance Guidelines SOA Presentation Disclaimer Sponsored by

Annuity Risk Management with Options: Investment and Hedging Perspectives ALEX ZENG, PHD, CFA, CAIA Head of Risk & Quantitative Strategies, Funds Management Lincoln Financial Group November 5, 2018

Overview of annuity products Equ Equity Ups pside Downside Do 2017 20 Market Ma Value Pr Va Prop oposition Sales (B) 1 rowth 1 Exposure Ex Pote Po tential Prote tecti tion Gro Guaranteed Principal Lifetime Protection Accumulation focused. Tax Income VA VA w/o GLB efficient investing for nonqualified $30.5 -7% + investing flexibility Ann nnuit ity VA VA w/ GLB Guaranteed lifetime income $39.3 -21% Peace of Ind ndexed / Principal protection + growth $9.2 68% Mind Growth VA 2 Hybrid VA Hy potential Potential Tax FIA Principal protection + income $55.0 5% Deferred Principal protection & Fixed-Rate $44.7 1% accumulation 1 Source: 4-Yr sales CAGR (2014-2017), Source data from LIMRA Secure Retirement Institute (U.S Individual Annuity Yearbook 2017) 2 2 Aka: Structured VA

Annuity: account value growth profile Source: Oliver Wyman 3

Annuity risk management • Product design Manage risk • Investment (fund/index design) • Hedging / ALM • Full or partial transfer Transfer risk • Reinsurance • Outsourcing • Not hedged/hedgeable Retain risk • Not transferred Market Ri Mar Risk Insurance Risk Behavioral Risk • Equity • Longevity • Lapse • Interest rate • Mortality • … • Basis… • Morbidity 4

Holistic market risk management through product life cycle and across functional units Product Investment (Fund/Index) Hedging/ALM Risk avoidance through product Diversification among asset classes, Simple put options design markets, sectors, factors, … Static hedging Asset allocation requirements Risk budgeting Advanced dynamic hedging Risk allocation across product Built-in downside protection Customized solutions components and life cycle Explicit risk/volatility control 5

Using options for market risk management In Investment He Hedgin ing • Risk/volatility modeling and Information/Signals for risk forecasting • Hedging strategy design and • management modeling and Investment strategy design for development strategy design better risk-adjusted performance • Complementary option usage • Ins nstruments for risk management FIA/Indexed VA product • Option overlay for risk control implementation manufacturing • Options-based investment • VA hedge program portfolios/funds for VA 6

Growth and maturation of option markets Listed Equit Li ity Op Opti tions Ann nnual Volu lume and and Op Open In Interest 350 5,000 Millions Millions 4,500 300 4,000 250 3,500 3,000 200 2,500 150 2,000 1,500 100 1,000 50 500 0 0 Volume Open Interest Source: Options Clearing Corporation. 2018 volume is estimated pro rata, as of Sep 30 2018. 7

Listed SPX index option market SPX X Opti ptions Average Dail ily y Volu olume (ADV) SPX X Opti ptions ADV Not Notio ional l Valu alue ($B) Source: CBOE 8

Information/Signals: Option-based volatility models • Predictive power of options implied volatility (including VIX) in forecasting future realized volatility • Time-series volatility forecasting models (historical volatility, ARCH class, and stochastic volatility) Source: GSAM, Navigating Market Turbulence: An Analysis of Target Volatility Funds, 2015 9

Vol olatility for orecasting models ls Opti tion-based Tim ime seri ries vola olatility mod odel vola olatility mod odel Hi Historical l vola volati tilit lity ARCH clas ass Stoc ochastic ic vola volatil ilit ity - Volatility index - Historical average - ARCH - Quasi-maximum - Black-Scholes implied likelihood estimation volatility - Random walk - Generalized ARCH - Generalized methods of - Exponential smoothing - Exponential GARCH moments - Exponential weighted - Threshold GARCH or - Monto Carlo integration moving average GJR-GARCH - Heston model - Quadratic GARCH - SABR model - Regime Switching GARCH - Markov chain Source: Poon & Granger. Forecasting Volatility in Financial Markets: A Review. Journal Of Economic Literature, 2003. Practical Issues in Forecasting Volatility. 10 Financial Analysts Journal 2005.

Information/Signals: looking beyond VIX • Informational content of the option market • Implied volatility surface, trading volume, bid- ask spread, put/call ratio… Source of charts: Bloomberg 11

Instruments for VA fund risk management Illustratio ion Imp mple lementatio ion for orm Obje bjectiv ives Optio tion str trategie ies • • Covered call Complementary option Hedge specific risks • • Married put usage Enhance yield / • Protective collar performance • • … Leverage • • Rule-based put buying for Option overlay for risk Mitigate downside risk • control Reduce portfolio downside protection • Others to offset cost of volatility protection • • Covered call Option-based investment Provide unique • Put writing portfolios/funds for VA investment solution • • Spreads Income generation • • Combinations Enhance alpha • Sophisticated trading… 12

Option overlay for risk control • Risk management overlay with linear derivatives (futures, forwards, swaps, etc.) • Widely applied to volatility control strategies (target volatility and capped volatility) • Dilemma between upside capture vs. downside protection • Risk management overlay with options • Nonlinear payoff profile • Rule-based put option buying to mitigate downside risk • Dynamic use of various option strategies to offset cost • Reduce portfolio volatility without precise volatility targeting • Combination / rotation between linear and nonlinear (options) derivatives 13

Option-based funds/indices: performance Source: Bloomberg 14

Option-based funds: AUM growth ($million) Source: Black & Szado, Performance Analysis of Option-Based Equity Mutual Funds, CEFs, and ETFs: An Update, Mar 2018. 15

Instruments for hedging • General account liability • OTC/listed/bespoke options, plus futures • European call, call spread, Asian, cliquet, call spread collar • Separate account liability • Vega hedging: put options, variance swaps • Options to supplement 3-Greek (delta, rho, vega) hedging: basket options, lookback options etc. • Potential of recovering loss with less offsetting of gains 16

Limitations of using options for annuity market risk management • Liquidity and market depth • Transaction cost • Complexity in modeling, execution, and communication • Operational risk • Upfront capital in buying options and risks in writing options • Real world vs. risk neutral 17

Annuity Risk Management with Options: Investment and Hedging Perspectives