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

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

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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

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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

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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

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Overview of annuity products

Va Value Pr Prop

  • position

Equ Equity Ex Exposure Ups pside Po Pote tential Do Downside Prote tecti tion 20 2017 Sales (B) 1 Ma Market Gro rowth1 VA VA w/o GLB Accumulation focused. Tax efficient investing for nonqualified + investing flexibility $30.5

  • 7%

VA VA w/ GLB Guaranteed lifetime income $39.3

  • 21%

Ind ndexed / Hy Hybrid VA VA 2 Principal protection + growth potential $9.2 68% FIA Principal protection + income $55.0 5% Fixed-Rate Principal protection & accumulation $44.7 1%

Ann nnuit ity

Guaranteed Lifetime Income Principal Protection Growth Potential Peace of Mind Tax Deferred

1 Source: 4-Yr sales CAGR (2014-2017), Source data from LIMRA Secure Retirement Institute (U.S Individual Annuity Yearbook 2017) 2 Aka: Structured VA

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SLIDE 4

3

Annuity: account value growth profile

Source: Oliver Wyman

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Annuity risk management

Manage risk Transfer risk Retain risk

  • Product design
  • Investment (fund/index design)
  • Hedging / ALM
  • Full or partial transfer
  • Reinsurance
  • Outsourcing
  • Not hedged/hedgeable
  • Not transferred

Mar Market Ri Risk

  • Equity
  • Interest rate
  • Basis…

Insurance Risk

  • Longevity
  • Mortality
  • Morbidity

Behavioral Risk

  • Lapse
  • …
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Holistic market risk management

through product life cycle and across functional units Product

Risk avoidance through product design Asset allocation requirements Risk allocation across product components and life cycle

Investment (Fund/Index)

Diversification among asset classes, markets, sectors, factors, … Risk budgeting Built-in downside protection Explicit risk/volatility control

Hedging/ALM

Simple put options Static hedging Advanced dynamic hedging Customized solutions

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Using options for market risk management

In Investment He Hedgin ing

Information/Signals for risk management modeling and strategy design

  • Risk/volatility modeling and

forecasting

  • Investment strategy design for

better risk-adjusted performance

  • Hedging strategy design and

development Ins nstruments for risk management implementation

  • Complementary option usage
  • Option overlay for risk control
  • Options-based investment

portfolios/funds for VA

  • FIA/Indexed VA product

manufacturing

  • VA hedge program
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Growth and maturation of option markets

Source: Options Clearing Corporation. 2018 volume is estimated pro rata, as of Sep 30 2018.

500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 50 100 150 200 250 300 350

Millions Millions

Li Listed Equit ity Op Opti tions Ann nnual Volu lume and and Op Open In Interest

Volume Open Interest

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SPX X Opti ptions Average Dail ily y Volu

  • lume (ADV)

SPX X Opti ptions ADV Not Notio ional l Valu alue ($B)

Source: CBOE

Listed SPX index option market

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Information/Signals: Option-based volatility models

Source: GSAM, Navigating Market Turbulence: An Analysis of Target Volatility Funds, 2015

  • 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)
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Source: Poon & Granger. Forecasting Volatility in Financial Markets: A Review. Journal Of Economic Literature, 2003. Practical Issues in Forecasting Volatility. Financial Analysts Journal 2005.

Vol

  • latility for
  • recasting models

ls

Tim ime seri ries vola

  • latility mod
  • del

Hi Historical l vola volati tilit lity

  • Historical average
  • Random walk
  • Exponential smoothing
  • Exponential weighted

moving average ARCH clas ass

  • ARCH
  • Generalized ARCH
  • Exponential GARCH
  • Threshold GARCH or

GJR-GARCH

  • Quadratic GARCH
  • Regime Switching

GARCH Stoc

  • chastic

ic vola volatil ilit ity

  • Quasi-maximum

likelihood estimation

  • Generalized methods of

moments

  • Monto Carlo integration
  • Heston model
  • SABR model
  • Markov chain

Opti tion-based vola

  • latility mod
  • del
  • Volatility index
  • Black-Scholes implied

volatility

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Information/Signals: looking beyond VIX

Source of charts: Bloomberg

  • Informational content of the option market
  • Implied volatility surface, trading volume, bid-ask spread, put/call ratio…
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Instruments for VA fund risk management

Illustratio ion Imp mple lementatio ion for

  • rm

Obje bjectiv ives Optio tion str trategie ies Complementary option usage

  • Hedge specific risks
  • Enhance yield /

performance

  • Leverage
  • Covered call
  • Married put
  • Protective collar
  • …

Option overlay for risk control

  • Mitigate downside risk
  • Reduce portfolio

volatility

  • Rule-based put buying for

downside protection

  • Others to offset cost of

protection Option-based investment portfolios/funds for VA

  • Provide unique

investment solution

  • Income generation
  • Enhance alpha
  • Covered call
  • Put writing
  • Spreads
  • Combinations
  • Sophisticated trading…
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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
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Option-based funds/indices: performance

Source: Bloomberg

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Option-based funds: AUM growth ($million)

Source: Black & Szado, Performance Analysis of Option-Based Equity Mutual Funds, CEFs, and ETFs: An Update, Mar 2018.

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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
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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
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Annuity Risk Management with Options: Investment and Hedging Perspectives