How do Insurance Companies

hedge their Variable Annuity Contracts with Guarantees? Am interested because the insurance companies report something called as the Net Amount at Risk (NAR), which is the Guaranteed Amount - Account Value. Let’s say to support this type of product, these insurance companies invest in bond mutual fund portfolios and with the widening of the credit spreads the value of these bond mutual fund portfolios keep falling, with the Guaranteed Amount remaining the same. How will these guarantees be affected as the NAR keeps increasing? Will there be a capital requirement issue if there is a hedge breakage? Thanks for your replies.

If the assets fall below the liabilities by a certain amount the portfolio is underfunded and they just move assets in from surplus. Your average insurance company isn’t that savvy with hedges/derivatives probably they will need to become more so given the current debacle.

sid, it was interesting on a recent Hartford CC that mgmt said they suffered basis risk on their hedging program. apparently the sub accounts in their VAs dropped more than the indexes they were hedging. Hartford just did an investor day after which their stock went up 100%. it would probably be helpful to review that material.

Thanks guys. When an insurance company says that they can hedge basis risk completely that’s just a load of crap. It is not possible for them to do so, especially at the STAT level because STAT is not hedged but GAAP is. HIG is bull-shitting like crazy. They just revised their assumptions to “FORECAST” a better RBC ratio at year end. Again, this is a forecast by the company. And market reacted insanely. So, now we are in a situation where we take a management’s view at face value. The same management which also says that, “although the bonds are trading at 40 cents on the dollar, it’s all right. They are all money good. We will get back every cent on the dollar. Market is irrational. All these unrealized losses are meaningless. Take a chill pill.” The rebalancing that purealpha is talking about is what comapnies like PRU does, where PRU dynamically hedges its portfolios by moving in and out of stocks and transferring separate account money to general account and vice-versa. But my question is still not answered. Under Actuarial Guidelines (AG) 34 (Death Benefits) and more for AG39 (Living Benefits) the reserves would increase if the NAR increases. This in turn will have an impact on the C-3 Phase II component of the C3 capital, which is a concept of total required capital. This in turn affects the Risk Based Capital (RBC) and eventually the RBC ratio which is looked by the rating agencies. C-3 Phase II component of the C3 capital does a stochastic scenario of Conditional Tail Expectations (CTE) 90, where the stress testing is done to take into consideration the average of the worst 10% of claims. My question is will the scenario I put forward have any impact on this calculation i.e. will the STAT capital requirement increase for these insurance companies? P.S. All this is for STAT purposes only. There is no such crazy jargon or requirement at the GAAP level.

I would imagine there is a lot of BSing going on these days, their unrealized losses must be massive, most carry something like 40%MBS/CMO, but usually “high quality” stuff. Most guys carry the portfolio available for sale but largely they end up holding the stuff till maturity unless they need cashflow or just want to get out of a specific credit. Of course they will just say “oh chill out it is all unrealized” but umm ya. Do you analyze this market, or are you an actuary or something? I’d be interested to know what kind of carnage you are seeing out there. BTW, I just want to say STAT vs GAAP differences are a royal pain. Some companies have almost zero GAAP/STAT differences and that makes things real nice, other companies like those who purchased a portfolio and marked the entire thing to market have tons of ugly differences. Preparing two sets of financials and reconciling the two is not fun.

Even the high quality stuff is blowing up. Take a look at five and 10 year AAA corporate spreads over treasury. BBB is totally out-of-control. Am in ER following this boring, yet extremely vibrant industry. The accounting and acturial stuff I have to keep track of for this industry is just insane. I feel like blowing my brains out. This industry has got to be one of the most technical yet highly boring industry. The VA products offered by these industries are, however, very interesting to follow. The way these insurance companies hedge (or atleast try to) is quite interesting. Having said that, the VA business is heading for a doom given the current market conditions. Hedge breakages are inevitable. Hedging costs will go through the roof causing an increase in the price of these VA products, the sales of which Y-O-Y have fallen dramatically. It’s a catch-22 situation for insurance companies. Either sell this VA business or risk being wiped out. How many insurance companies survive this financial tsunami will be interesting to watch. Companies that did not de-mutalize in the late 90’s are having the, supposed, last laugh. STAT is a pain especially the various reserving requirements. And given that all 50 states have their own requirements, it gives me and most people a migrain to keep track of all the important requirements. NY, as usual, does everything different from other states.