F1–What Are We Hedging Anyway? GAAP, Stat, or Economics?
Investment Symposium March 2010
F1: What Are We Hedging Anyway? GAAP, Stat, or Economics?
Ross Bowen James Lloyd
Moderator
Jay Musselman
F1?What Are We Hedging Anyway? GAAP, Stat, or Economic? Ross Bowen, Allianz Life March 22, 2010
Hedging VA Risk
Most hedging programs started out hedging GAAP risk Implementation of C3P2 and AG43 have created a disconnect with GAAP or pure economics FAS 157 disconnected GAAP and Economic Multiple constraints and objectives create the need for an interdisciplinary team to approach the problem
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Economic
Economic measures look for sensitivities to the value of promises made Define the value
Present value of claims less fees Risk neutral framework Key sensitivities Change in market levels Change in rates Change in volatilities Need a robust scenario generator Match observable prices and greeks
GAAP
Most similar to economic ? what are the differences? Treatment of fees
Some companies set the value of the embedded derivative to zero at issue ? apply a factor to the fees so PV = 0 Not all VAGLBs are FAS 133 SOP 03-1 applied to GMIB GMAB clearly FAS 133 GMWB may be a hybrid Gain on hedges impacts k factor
2
GAAP ? FAS 157
FAS 157 Own Credit Risk Objections ? value of promise declines as probability of paying declines Release reserves when downgraded? How to determine own credit risk spread?
CDS market offers view into credit risk Large writers may have active CDS market To hedge or not to hedge? Sell CDS on self? Sell CDS on similar writers? What is the goal of hedging?
Statutory
Moving from a factor based world to a Principles Based world AG33 ? Base Contract AG34 - DB AG39 ? Living Benefits, accumulation of fees
There was a need to modernize AG39 C3P2 came first, then AG43 / VACARVM
Real world stochastic Model hedges in a stochastic on stochastic framework Standard scenario ? comparable values between companies
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AG43 Hedge Modeling - Stochastic
Stochastic scenarios CTE70 ? worst 30% Possibility that hedges will cost rather than benefit Existing hedges may be run off If CDHS in place, may reflect hedging strategy CTE Reported = E * CTE Best Efforts ? (1-E) * CTE Adjusted E < 70% or < 30% if hedges not directly modeled Basis risk, transaction risk, hedging mismatch tolerance...
C3P2 Hedge Efficiency
Stochastic scenarios CTE90 ? worst 10% - more likely that hedges will benefit Existing hedges may be run off If CDHS in place, may reflect hedging strategy CTE Reported = TAR Best Efforts ?E * (TAR adj ? TAR best
efforts) Adjusted E >5% Basis risk, transaction risk, hedging mismatch tolerance...
4
Value of Hedges ? AG43 SS
PV of pre-tax cashflows at the one-year CMT rate less statement value Must be held to hedge these contracts in compliance with state laws Assume hedges are liquidated in one year or exercised if mature prior Assume returns underlying SS, Black Scholes pricing, rate of fiveyear CMT, and solved-for implied volatility
Evaluation of Hedge Instruments
Review the differences between stat, GAAP, and economic Evaluate hedge performance in the various regimes Choices
Futures Puts Swaps Swaptions Calls
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Evaluation of Hedge Instruments Futures
Linear in the market Can be written on different indices Very effective on standard scenario
13.5% / 20% of notional Unlimited losses possible in up market
Evaluation of Hedge Instruments Futures
Futures Performance in AG43
Gain / Loss
50,000,000 40,000,000 30,000,000 20,000,000 10,000,000
(10,000,000) 700 800 900 1000 1100 1200 1300 (20,000,000) (30,000,000) (40,000,000)
S&P Level
mkt gain Hedge Credit Capital Impact
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Evaluation of Hedge Instruments Puts
Provide delta protection in Statutory world Vega and rho protection in Economic world Can be very expensive
Out of the money attractive (crash protection) Sell a deeper OTM to offset cost Can also fund by selling upside OTM call Sell deeper OTM call to limit losses
Puts ? "Zero Cost" Collar
Economic payoff
Payoff profile 300 200 100
0 400 500 600 700 800 900 1000 1100 1200 1300 1400
-100 -200 -300
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