Variable-Annuity Hedging Lifts Treasury Demand

[freshwoman]

Just saw this news story headline and quote below.

“And with equities selling off and rates falling, it’s requiring them to buy a lot more duration in the back end of the yield curve"

Can someone explain to me why VA writers are buying treasuries and what guarantees this is for? I'm not a VA expert but interested in why they need to buy duration in this sitaution.

Thanks

[Guilty Bystander]

Link to source, please.

[Abused Student]

Just an educated guess. A lot of companies have gone to New Money rates which means when people dump in money it gets the current rate for a period of time, say 5 years. This is instead of using the portfolio rate where it could change as the portfolio rate changes.

So, there is money out there that is getting say 5% for say 4 more years. However, the yield rate on 30 years is only 3.5% last I checked. The 4 year rate is below 1.

So, do they try and match the yield rate closer and be off on the duration, or do they match duration and take a bath on the yield rate?

[freshwoman]

Sorry I don't have a link just an article. I have put the article below

Sept. 2 (Bloomberg) -- Life insurers' demand for long-term Treasuries as a hedge is surging as falling equities and bond yields pressure the companies to meet returns guaranteed to clients on variable annuities.
The CHART OF THE DAY shows a JPMorgan Chase & Co. index of the amount of Treasuries that insurance companies need to buy to protect against risks associated with variable annuities they've sold to clients. The gauge uses the equivalent in 20-year U.S.
bonds to smooth out differences in maturities. Purchases rose 22 percent since the end of June as the Standard & Poor's 500 Index fell 8.8 percent and Treasury yields slid to records, making it more difficult for insurance carriers to meet targeted returns.
"Insurance companies are managing the risk in the variable-annuities books they have," Terry Belton, global head of fixed-income and foreign-exchange research at JPMorgan in New York, said in a video message e-mailed to clients on Aug. 30.
"And with equities selling off and rates falling, it's requiring them to buy a lot more duration in the back end of the yield curve," he said.
The demand, combined with risks associated with the sovereign-debt crisis in Europe and the potential for further steps by the Federal Reserve to ease monetary policy, will keep 10-year yields near current levels in September, Belton said.
Yields will rise to 2.6 percent by year-end, the bank forecast.
Treasuries had the biggest monthly return in August since December 2008, 2.8 percent, according to a Bank of America Merrill Lynch index. Ten-year note yields, which touched a record low 1.97 percent on Aug. 18, traded at 2.13 percent yesterday in New York. Thirty-year bond yields were at 3.50 percent, compared with 4.08 percent on Aug. 1.
Annuities are insurance contracts that offer steady streams of income. In variable annuities, customers can choose investments such as stock and bond funds and the account value will fluctuate with the market. For MetLife Inc. and Prudential Financial Inc., the top two U.S. life insurers, the hottest product this year also offers a guarantee of income for life, even if an account balance falls due to market declines.

[sgtr]

Here is what I think...
VA writers are essentially put option writers. With rates and equity markets falling, these options become more in the money. Thus the sensitivity of the liability book with interest rates (rho) increases . To hedge those liabilities you need to have more rho in the asset side too. Since the VA products are usually long term product, the sensitivities to the longer term interest rates (15 and 20 yr points and 30 yr to some extent) are more. Hence insurers are buying longer term treasuries to add rho to the asset book.
You can buy swap to add rho in the asset book. But swap spreads also increased last few days....so that will add to swap spread basis risk.
You can also buy treasury futures (long bond and ultra) to add rho. I think a lot of insurers are doing that too.

[Eimon Gnome]

Originally Posted by sgtr

Here is what I think...
VA writers are essentially put option writers. With rates and equity markets falling, these options become more in the money. Thus the sensitivity of the liability book with interest rates (rho) increases . To hedge those liabilities you need to have more rho in the asset side too. Since the VA products are usually long term product, the sensitivities to the longer term interest rates (15 and 20 yr points and 30 yr to some extent) are more. Hence insurers are buying longer term treasuries to add rho to the asset book.
You can buy swap to add rho in the asset book. But swap spreads also increased last few days....so that will add to swap spread basis risk.
You can also buy treasury futures (long bond and ultra) to add rho. I think a lot of insurers are doing that too.

Pretty darn good answer.

Even if they aren't trying to rho match at key rates - they will increase their dollar duration with long dated fixed income - hence closing the apparent interest rate risk in the equation. There isn't a lot of long dated issuance in corp bonds, so governments are the instrument of choice.