Category Archives: Hedging

Progress in managing equity-market risk

Best’s Review (subscription required) looks at the question of how to shore up equity-market risk, and how insurance-linked products have improved in this respect. Here is an excerpt:

In terms of equity-market risk, insurers fared better during the financial crisis that started in 2008 than during the market collapse in 2002, said Scott Hawkins, vice president and annuity analyst at Conning Research & Consulting. In 2008, separate accounts in individual annuities decreased by 21%, and general reserves increased by $75 billion. By contrast, in 2002, when fewer contracts were in force and account values fell by 13%, general reserves had to be increased by $92 billion. “What happened between those years was that insurers created hedging programs,” he said. “Milliman did a study of those hedging programs and concluded that more than 90% of those they evaluated were successful.”

In a recent white paper on financial risk management, Prudential Annuities identifies common risks as market, actuarial and investor behavior. Market risk includes equity, interest-rate and credit risks. Actuarial risk includes both longevity risk–that the policyholder may live longer than expected–and mortality risk–that the individual will die sooner and that the company will have to pay a guaranteed minimum death benefit. Investor behavior risk has to do with how investors utilize product features, such as when to begin drawing a GLWB, and asset allocation risk, the chance that an investor will choose an aggressive allocation that could cause a big difference between contract value and the protected withdrawal value.

Revisiting asset allocation strategies

The global financial crisis has called into question a lot of commonly held assumptions about retirement planning, especially when it comes to tried and true asset allocation models.

In light of these developments, Andrew Fisher and Wade Matterson of Milliman’s Australian Financial Risk Management practice revisit asset-allocation strategies for defined contribution retirement plans. Their article details some “promising approaches” for fund managers to lessen risk through diversification, hedging, and insurance—framed, respectively, as administration strategies, derivative strategies, and insurance/outsourcing strategies.

The authors examine the types of risk—longevity, market, inflation, health, and behavioral—that affect risk management strategies in light of “the long-term nature of retirement . . . and the fiduciary responsibilities of fund trustees” that complicate traditional insurance-based approaches to risk management.

Hedging the individual investor

Ken Mungan, Milliman’s Financial Risk Management practice leader, is quoted extensively in an article about Milliman’s customized hedging strategies for individual accounts, in the March 16 edition of Retirement Income Journal (access to the entire article requires login).

“We’re seeing the emergence of a client account on a platform with a protection strategy that would contain hedge aspects,” according to Mungan. “So many people have withdrawn from the market. This would give them protection.”

Milliman’s new service is driven by three factors: the failure of diversification during the recent global financial crisis, low bond returns, and the need for Baby Boomers to invest in equities in order to make up for their failure to save enough for retirement.

Mungan explains that Milliman’s approach offers investors a middle path—between advisory services with unprotected portfolios and complete market exposure, on one hand, and variable annuities with living benefits, on the other. Individual investors can participate in uncomplicated hedges that protect against severe downturns without abandoning gains if markets rise. It’s an approach uniquely suited to investors with anxieties about entering a volatile equities markets still feeling the effects of the recent financial crisis.

Does this service compete with some of Milliman’s traditional clients, such as insurers offering VA products?

Not really. In fact, Mungan thinks Milliman’s approach will actually create new business for insurance companies—by increasing the demand for unbundled living benefit riders, aka stand-alone living benefits (SALBs).

More details on the approach can be found at “Overcoming challenges through portfolio protection” on the Milliman website, an article Mungan co-authored with his Chicago colleagues Ghalid Bagus and Matt Zimmerman (who is also quoted in the RIJ article).