"[Variable annuity] hedging programs save insurers $40B during economic crisis"

[DW Simpson]

http://www.milliman.com/expertise/life-financial/publications/rr/performance-insurance-company-hedging-rr12-01-08.php

[WWSituation]

Nobody puts whipped cream on doo doo like Ken Mungan. I tip my hat to the man.

[Run2standstill]

For the following reasons

1) Look at the stock chart of a few large VA writers like Hartford and Lincoln. Their stock prices were down 80 - 90% year to date, more so in the recent months when their VA strategies backfired.

2) Their CDS spread has widened 8-10 times. For Hartford, the 5-yr CDS spread has increased 10 folds in 3 months to over 1,000 bp as of last week, which means for a 10 mm credit protection, one has to pay 1mm/year for the next 5 years. This is saying the market is betting a higher than 50% chance that the company will default in 5 years. Given there is some technical noise in today's CDS market, that loss-given-default forecast seems a bit high, nonetheless, it is what the market says.

3) because of 1) and 2), people will wonder, if the hedge was so effective, why those insurers did not make a loud noise so that the world knows it instead of watching the stock price down 90%? Especially when WSJ has published a numerious negative articles on VA. (some of the facts or arguments are false though).

4) We know the VA hedge can only deal reasonablly well under a range of market conditions on some selective market risks. For things like policy holder behaviors, there is no way they can hedge that. For example, should a lot more policyholders move their money into cash and keep it there for long (very likely senario), how the insurers will expect to recoupe the loss even when market rebounds?

5) Even for market related risks, the dynamic hedges through the traditional delta-vega-rho hedge does not do a good job in the 6 to 10 stdev event we are in now. And the asset correlations have completely changed. For example, in the past 2 months, the supposely more stable asset class like fixed income has fared even worse than equities. The junk bond is yielding nearly 20% above treasuries, much higher than any equity return assumptions. S&P has a higher dividend than bond, and the swap rates in longer duration bucket has lower yield than the risk free treasuries, which is against the Econ 101, under 99.5% of the market conditions. (the negative Z-spread was due to recession expectation -> lower long term rates expectation -> higher demand for fixed leg of interest rate swaps).

6) The VIX has touched 80% vs. the 10-20% average when lots of the hedging program was set up. VIX has been over 40%, which is roughly the 99% percentile, for 55 consecutive days. The Vega hedge based on the historical or trade inception cannot hedge effectively the spike of VIX that is never seen.

7) When one's parameter, correlations are not right, and dynamic hedge is designed only for in-the-range hedges, how can we believe it will work for something never happened before, and was not foreseen by them?

8) Bear and Lehman are among the largest brokers and dealers on the street to provide either the hedge intruments or being the counterparties of the hedge themselves. Many other small to mid-size hedge funds are doing that too. Now when they were gone, there was a huge amount turmoil on the market. Even in the good scenario that one has a paper gain, but now he might have a tough time to find who actually owes him money, and how can he get paid?

9) I saw another industry survey from a major Wall St. bank yesterday siting almost the opposite that a lot of life insurers did not hedge their VA books properly at all, leading to large losses. Even worse, they have not been quick enough to change their pricing - so their agents are selling at 70 bp for GMWB, but based on today's hedging costs, it should be repriced at 250 bp.



http://www.milliman.com/expertise/life-financial/publications/rr/performance-insurance-company-hedging-rr12-01-08.php

[DW Simpson]

http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20081201/REG/812019977/0/undefined

[Run2standstill]

Do not get me wrong - I hope they are right and every insurer can weather the storm. However, we have just seen the failure of many much more sophicated models or methods in the past year from those govern the complex credit derivative pricing to simple ones that AIG implented. Even for great modelers like Dr. Scholes, his models failed terriably twice in 1998 with LTCM and this year with Grove Plantium. Though as a quant modeler myself, I do not believe the models are the key reasons for the credit and liquidity crisis we are in - it is always the people behind the models that count. And models can only do well for what they are designed for. Extension beyond that is dangerous. Therefore I put my own question mark for reasons I have described and a few more I did not list.

I am not sure how nimble the insurers hedging programs change and whether the markets are all there for various instruments. I hope this is less of an academic excercise that the results are based on a good number assumptions that cannot be really realized in the current market expecially since VIX blew out since Sep 30th, and interest rate swaptions are over 200% across the board in implied volatility (yes, it is 200% not 20%), and long term swap rates are below that of gov't paper.

It will be more convincing if the companies themselves made the claim than the consultant/vendor. (for MG-Hedge users, I have high respect to Milliman people and this software). After all, there appears to be more pain coming for Q4. I hope I am wrong. Best,


http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20081201/REG/812019977/0/undefined

[The President]

They are hedging the guarantees, but what about the base policy fees? The VA writers just saw their VA income cut in half for the forseeable future.

[Student2006]

Their CDS spread has widened 8-10 times. For Hartford, the 5-yr CDS spread has increased 10 folds in 3 months to over 1,000 bp as of last week, which means for a 10 mm credit protection, one has to pay 1mm/year for the next 5 years. This is saying the market is betting a higher than 50% chance that the company will default in 5 years. Given there is some technical noise in today's CDS market, that loss-given-default forecast seems a bit high, nonetheless, it is what the market says.



Where do you obtain CDS spread quotes? Thanks

[Run2standstill]

For individual names, I get it from Bloomberg (use CDSW or CDSH), which may or may not be easy for you. However, you can get a good credit gauge from various CDS indexes or CDXs free from Markit.com

An important result from yesterday was the Itraxx Crossover, the European across the board CDX was over the crutial 1,000 bp thresh-hold, meaning a high market priced in expectation of credit defaults.

Where do you obtain CDS spread quotes? Thanks

[eagleeyes]

When Mungan mentioned 97% hedge effectiveness it's referring to futures gain vs. liab increase due to directional market move. But that's just part of the story -- rebalancing cost, correlation, basis risk, etc. also flow through earnings but for some reason omitted in the report.

The shockingly low capital requirement under hedged situation is so unsupportable and the proposed low hedge cost under current market is also questionable.

http://www.milliman.com/expertise/life-financial/publications/rr/performance-insurance-company-hedging-rr12-01-08.php

[Shaft]

Nobody puts whipped cream on doo doo like Ken Mungan. ....LOL

:yikes::toth::yikes::toth::yikes::toth::yikes:
:yikes::toth::yikes::toth::yikes::toth::yikes:

[Flavia Flav]

LOL

:yikes::toth::yikes::toth::yikes::toth::yikes:
:yikes::toth::yikes::toth::yikes::toth::yikes:

Dude, sssshhh! They're about to eat it! :popcorn:

[thesiver]

It will be more convincing if the companies themselves made the claim than the consultant/vendor. (for MG-Hedge users, I have high respect to Milliman people and this software).Milliman does hedging for VA writers so they have an idea of how much money they've "saved".

[Jack]

Nobody puts whipped cream on doo doo like Ken Mungan. I tip my hat to the man.

You're not kidding.

Of couse the hedging programs were infinately better than going naked but
1) 93% efficacy
a) is that correct?
b) if correct is it good?

[Flavia Flav]

You're not kidding.

Of couse the hedging programs were infinately better than going naked but
1) 93% efficacy
a) is that correct?
b) if correct is it good?

a) possibly
b) possibly

The key is: "93% effective in achieving their goals during the September and October period"

Define the "goals" of the hedge program narrowly enough and sure, why not?

[campbell]

Just got this link this morning:
http://db.riskwaters.com/data/lifepensions/pdf/cutting_edge_0209.pdf

a nice theoretical analysis on VA hedging. I believe the Life & Pensions magazine is from the UK.

[BlackScholes]

a lot of company do dynamic hedging, where I could find information about usually how often they balance their hedging portfolio? Thanks.

http://www.milliman.com/expertise/life-financial/publications/rr/performance-insurance-company-hedging-rr12-01-08.php

[campbell]

Sorry I can't help you BlackScholes, but it looks like this is a good place for this bit of news:
http://www.foxbusiness.com/story/markets/industries/finance/dichotomy-annuities-market-downturn/

Annuities Could Come Back to Bite Insurers, Customers

Investors who benefited from buying annuities before the market crashed last year likely look at these financial products in a far different light from the life insurers who are now footing the bill.

For investors, the market downturn has illustrated how important certain guaranteed benefits available in annuities are for protecting investments that would otherwise have limitless downside when the economy sours.

But for life insurers, the market meltdown intensified their leverage to the daily fluctuations of the S&P 500 and left many companies scrambling to raise billions to plug gaps in their balance sheets. In fact, the government on Thursday started to grant preliminary approval to some life insurers to access TARP money.

....


While some life insurers like MetLife (MET: 29.34, -1.15, -3.77%: 29.34, -1.15, -3.77%) and Principal Financial (PFG: 19.3162, 0.4662, 2.47%: 19.3162, 0.4662, 2.47%) have raised billions of dollars to plug the gap, others like Hartford Financial Group (HIG: 14.56, -0.17, -1.15%: 14.56, -0.17, -1.15%) are at more risk.

“Our published opinion is that the company is not adequately capitalized to face their challenges, and this is one of them,” said Binner, referring to Hartford.

Several life insurers such as Lincoln National (LNC: 16.05, -0.22, -1.35%: 16.05, -0.22, -1.35%) and Genworth Financial (GNW: 4.61, -0.35, -7.06%: 4.61, -0.35, -7.06%) acquired bank holding companies in an effort to receive access to the government’s TARP program.

Until insurers receive TARP cash or raise more cash, their stock prices will continue to be more susceptible to the daily ups and downs of the stock market than other sectors.

Sounds to me like they've not had a good time with the hedging....