October 2011

Insights
Variable Annuity Hedging Practices in North America
Selected Results From the 2011 Towers Watson
Variable Annuity Hedging Survey

Introduction
Hedging programs have risen to prominence among
life insurers seeking to manage capital market risks
associated with their products, especially variable
annuities (VAs). These programs rely upon the ability
to acquire effective positions that offset risk across
meaningful time frames. It is generally believed they
offer advantages over more traditional risk management
techniques such as passive diversification strategies,
which offer insufficient capital market risk protection, or
reinsurance options, which have limited availability or
are too expensive.
The importance of hedging in managing VA capital
market risks prompted Towers Watson to conduct two
surveys to explore insurers use of VA hedging practices
the first in early 2009 and the second in early July of
2011. This article presents selected highlights from the
2011 Towers Watson VA Hedging Practices Survey (the
survey). Both the survey and this article focus on:
Program overview
Hedging strategies
Modeling
Systems
Recent program changes
This survey targeted 21 top North American VA writers
as potential participants. Seventeen responded to the
survey, including one company that said it primarily
used reinsurance solutions for VA risk management.
Therefore the numerical and graphical results in this
article assume a universe of 16 respondents. For
example, a reference to half the respondents would
signify eight survey participants.

Program Overview
Participants in the hedging survey cumulatively account
for over $700 billion of VA account value, and the
average across participants is approximately $45 billion.
The age of hedging programs covered by the survey

ranges from about three years to 15 years. However, a

frequency distribution of hedging program age indicates
significant program development immediately following
the tech bubble collapse and the advent of guaranteed
minimum withdrawal benefits (GMWB) early in the
last decade. Approximately 63% of respondent hedge
programs are between six and eight years old.
All living benefit writers participating in the survey
hedge at least some of the risks associated with these
guarantees. However, guaranteed minimum death
benefit (GMDB) and guaranteed minimum income
benefit (GMIB) writers have a more varied treatment
compared with guaranteed minimum accumulation
benefit (GMAB) and guaranteed minimum withdrawal
benefit (GMWB) writers.
The elections made by respondents to hedge specific
guarantees are summarized in Figure 1. Notably, some
GMDB and GMIB writers are electing not to hedge
these benefit types, with accounting mismatch issues
the likely motivation (see more on this below). In
addition, select respondents apply a macro hedge to
cover certain guarantee types, which were counted as
hedged for the purposes of this question.
Figure 1. Guarantees hedged by number of participants
20
15

15
13

10

52

10
8

0
GMDB

Hedged

GMIB

3
0
GMAB

Not hedged

1
0
GMWB
Not written

Insights | October 2011

Just as survey responses provided insights into the

variability of the basic decision to hedge a specific
guarantee, they also provided insights into the
nature of the hedging strategies being pursued, by
both writer and guarantee type, once the decision to
hedge is made.

techniques for these riders. These techniques

typically involve use of out-of-the-money derivatives to
provide protection against severe market movements.

Hedging Strategies
Within the broad area of managing capital market
risks, hedging strategies are largely defined by the
specific strategic objectives under which they operate.
These can range from economic to regulatory as
indicated in Figure 2. Respondents said the most
typical strategic hedging objective for all guarantee
types is economic, and the least typical is AG 43,
with more response variability exhibited for GMDB
and GMIB exposures. As shown in the figure, select
writers use a combination of SFAS-133/157 and SOP
03-1 for living benefit objectives.
Accounting mismatch issues for GMDB and GMIB
riders continue to pose challenges for VA writers.
U.S. GAAP-based reserves for GMDBs and GMIBs
are developed from real-world-based valuations and
accrual methodologies, and do not track well with
the marked-to-market derivative contracts used to
hedge these risks as markets move. Thus many
writers are leaving some of these riders unhedged,
or hedged at percentages notably less than target.
Other respondents indicated use of macro-hedging

For a given strategic objective, the computation of

the risk offsetting positions required by a hedging
strategy relies critically on the valuation of the
guarantee embedded in a VA contract, and, in
particular, the sensitivities of the hedged guarantee
to specific changes in market parameters. These
sensitivities, referred to as Greeks, are defined as
the rates of change, or derivatives, of the guarantee
value with respect to the relevant market parameters.
The Greeks are of central importance within
hedging programs because neutralizing exposure
to a given market risk is tantamount to creating
positions, through hedging transactions, that have
little aggregate sensitivity to that risk, or (near) zero
net value of the associated Greek. In practice, it is
not possible to maintain aggregate Greeks that are
identically zero so that hedging strategies will typically
specify trading tolerances, or risk limits, to bound the
size of aggregate Greeks. The key Greeks that are
typically considered for hedging are:
Equity Delta and Gamma. First- and second-order
derivatives, respectively, of guarantee value with
respect to equity price level
Rho and Convexity. First- and second-order
derivatives, respectively, of guarantee value with
respect to interest rates

Figure 2. Primary hedging strategic objectives

10
8
6

6
9 9
8

8
5

2 2
1

0
N/A
GMDB

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1
Economic

0
SFAS 133
GMIB

2
22015
0 1

SFAS 157

SOP 031
GMAB

1 1 1 1
AG 43
GMWB

11 12
1
Other

Insights | October 2011

Vega. First-order derivative of guarantee value with

respect to (equity) volatility
Foreign Exchange (FX) Delta and FX Gamma.
Defined similarly to the analogous equity
quantities, but for foreign exchange rates these
are less often utilized in the context of VA hedging
Decisions regarding which specific Greeks to hedge,
and the frequency with which hedging transactions
occur in order to maintain stipulated risk limits,
depend upon the risk appetite of the writer, and are
properly made with a consideration of the relative
costs and benefits associated with hedging the
particular risks associated with a specific guarantee.
Certain trends were observed in the survey
responses for each guarantee type:
For GMWB, the most widely offered VA guarantee,
all respondents that write the guarantee hedge
Delta, most typically either intraday or once
per day. More than three-quarters of the survey
participants hedge Rho, most typically intraday
or once per day, but hedging also occurs weekly
or with another frequency. About a third of
respondents hedge Vega and Gamma. Among
these, specified frequencies include intraday, daily,
weekly, monthly and other. A little more than a
third of respondents hedge FX Delta, with most of
these hedging intraday.
For GMAB, all respondents that write the
guarantee hedge Delta, with the typical frequency
being intraday or once per day. About two-thirds of
respondents hedge Rho, with frequencies ranging
from intraday to weekly, though other frequencies
also occur. Most survey participants do not hedge
Vega, but those that do hedge intraday or daily.
About a third of the respondents hedge Gamma
and FX Delta, with frequencies ranging from
intraday to monthly and other periods.
For GMIB, a little more than half of respondents
hedge Delta, typically intraday or once per day.

About a third of respondents hedge Rho and FX

Delta, with specified frequencies being intraday,
monthly or other. Most survey respondents
do not hedge Vega. Among those that do,
specified frequencies include daily, monthly and
other.
For GMDB, most respondents hedge Delta, and
this is most often done intraday or once per day.
A little less than half of respondents hedge Rho,
and more than half hedge intraday, with others
hedging weekly or with another frequency. About a
third of the respondents hedge FX Delta, with half
of these hedging intraday. Most respondents do
not hedge Vega or other sensitivities.

Macro

hedging techniques
typically involve use of
out-of-the-money derivatives
to provide protection against
severe market movements.

Modeling
Valuation of the guarantees embedded in a
VA contract for hedging purposes is typically
accomplished within a Monte Carlo framework
in which risk-neutral economic scenarios are
generated using parameters appropriate to current
market conditions. For example, parameters used
to model equities typically include spot levels and
volatilities, while those used for interest rates would
generally include the current yield curve and perhaps
additional parameters such as mean reversion rates
and volatilities. Though FX risk is not frequently
explicitly modeled in VAs, the market variables
generally used to parameterize this risk include FX
spot levels and volatilities.
Once these economic scenarios are constructed,
they are used with a detailed model of the structural
features of the guarantee and policyholder
information to value the guarantee as the expected
value of the present value of its future cash flows.
Greeks associated with the guarantee are then
calculated using a finite difference approximation.
This involves valuation of the guarantee at closely
spaced values of the market parameters defining

Respondents

said the most typical strategic hedging objective for

all guarantee types is economic, and the least typical is AG 43,
with more response variability exhibited for GMDB and GMIB
exposures.

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Insights | October 2011

Figure 3. Stochastic processes used for equity

index modeling
68%
13%
13%
6%

6%
13%

Lognormal
Mixed
Stochasitc volatilty
Other

13%
68%

Figure 4. Interest rate modeling approach

13%
6%

19%

56%

6%

56% Deterministic
6% Stochastic,
one-factor model
19% Stochasitc,
two-factor model
6% Stochastic,
multifactor (greater
than two) model
13% Other

the relevant rate of change, differencing these

guarantee values and dividing by the parametric
spacing to approximate the appropriate derivative.
Because of the innate complexity associated
with the valuation of VA guarantees, there are a
number of modeling decisions that writers must
make regarding the trade-off between fidelity and
simplicity. The nature of the stochastic process
used to model equity risk is a case in point. The
range of choices made by respondents is shown in
Figure 3.
As seen in the figure, respondents predominantly
use a lognormal process for modeling equity risk.
Lognormal models are easy to implement and offer
operational tractability, but cannot capture certain
aspects of the empirically observed behavior of
equity derivative markets. In particular, the wellknown dependence of equity implied volatility on an
option strike, referred to as the volatility smile (or
skew), cannot be captured by such models. Hence
the choice of a lognormal model favors a trade-off
of simplicity over fidelity. A quarter of respondents
use more complex models such as mixed lognormal
or stochastic volatility (typically Heston) to capture
volatility skews.
As depicted in Figure 4, interest rate modeling for
VA hedging bears certain qualitative similarities
to equity modeling. The simplest choice that can
be made in this case is the use of a deterministic
interest rate model, and this choice is in fact made
by a bit over half of the survey respondents.
Obviously, the observed random character of
interest rates and the attendant complexities of
interest rate dynamics cannot be captured by such
models. The decision to use deterministic interest
rate models offers another example of favoring
simplicity over fidelity, with the loss of fidelity
arguably more significant than when lognormal
models in equities are used. Perhaps this accounts
for the fact that the proportion of respondents
choosing to make use of more complex interest rate
models, with the ability to achieve greater fidelity, is
somewhat greater for interest rate than for equity
models. It should be noted that more than 31% of
survey participants say they use stochastic interest
rate models, while other respondents cited HullWhite, Black-Karasinski, Hull-White II, Libor Market
Model and not applicable (use of a stat-based
strategy).

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Insights | October 2011

In both cases, it is important for the insurer to have

a clear understanding of the risks unaccounted
for in a choice of an equity or interest rate model,
and quantification of the potential impact on hedge
targets and Greeks if there is a switch to a more
sophisticated model.

Systems
Due to the computational intensity of the Monte
Carlo calculations typically used for VA hedging, and
the need to perform these calculations in a capitalmarket-driven operational environment, hedging
valuation systems tend to be quite specialized.
Notably, almost all survey respondents identified
use of a modeling solution specifically designed for
hedging, whether developed in-house or acquired
from an external vendor, rather than generalpurpose actuarial modeling software to support their
hedging operations. It is noteworthy that no survey
participants outsourced the calculation process
itself, supporting the supposition that outsourcing
of the calculation function, to the extent that it
occurs, may be limited to small to midsize market
participants.

Figure 5. Techniques used to accelerate hedging

calculations
0

12

IT-distributed processing techniques

11

Unique scenario generation by policy

10
Model point compression
5
Advanced math techniques
2
Other

Not applicable
1

In response to the great demands for processing

speed, hedging programs use a wide range of
techniques to accelerate the processing speed of
hedge ratio calculations, as indicated in Figure 5.
In this figure, responses indicate that unique
scenario generation by policy rivaled distributed
processing. Much has been written about the use
of advanced mathematical techniques such as
accelerated Monte Carlo or replicating portfolio
techniques to improve computational efficiency.
But survey responses suggest that, so far, these
methods have not gained traction in the industry.
While the majority of survey responses indicate
at least some use of distributed processing
networks to achieve greater processing speed in
hedging calculations, a closer look at the survey
results suggests a noticeable size polarity in these
responses. A little over 56% of respondents used
over 250 computing nodes to support their hedging
programs. However, a little over a quarter of the
respondents use 25 or fewer nodes.

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Insights | October 2011

Recent Program Changes

The survey focused on program changes prompted
by the global financial crisis (GFC) and the adoption
of AG-43 for VA statutory reserving. In general, the
results, as expected, found that the GFC prompted
more programmatic changes than the adoption of
AG-43. The most dramatic changes from the GFC
occurred on the product side. Traditional approaches
(fee increases, limiting fund access, reducing
benefit richness) were adopted by almost all survey
participants. However, newer product-based risk
management techniques also emerged and continue
to gain traction in the marketplace (CPPI, target
volatility funds, among others).
With respect to hedging, the GFC highlighted the
potential for problems in dynamic hedging programs
associated with large adverse market movements
occurring over a short time period. These arise in
connection with abrogation of the small change
assumption. The assumption underlies the use of
first-order Greeks to neutralize market risks. These

We have already introduced a new, or strengthened an existing, macro-hedging program

5
We have already introduced a new, or strengthened an existing, counterparty credit risk
management program
4
We are planning to introduce a new, or strengthen an existing, macro-hedging program
over the next year but have not yet done so
3
We are planning to introduce a new, or strengthen an existing, counerparty credit risk
management program over the next year
0
Other
7

6 towerswatson.com

The need for effective counterparty credit risk

management was emphasized during the GFC by a
number of conspicuous counterparty defaults, or
near defaults. Survey responses indicated some
programmatic impact related to this experience,
which is highlighted in Figure 6.
Other notable post-GFC hedging program
modifications include modifying the instruments
used to hedge (indicated by 38% to 56% of
participants, varying by guarantee) and hedging more
Greeks (indicated by 13% to 19% of participants,
varying by guarantee).
Programmatic changes resulting from AG-43 were
generally more muted. Two of the more notable
changes evident in the survey results were:

Figure 6. GFC Strategy for managing market/credit events

0

risks can lead to hedge slippages and liquidity

issues that can impair or prevent execution of
hedging transactions. Macro-hedging techniques,
which typically pre-position out of the money
hedging assets, attracted more attention post GFC
as companies looked to add new, or bolster existing,
capabilities. Half of the survey respondents have
introduced, or plan to introduce or strengthen, a
macro-hedging program in response to the GFC.

10

Some reduction in the number of Greeks hedged

(indicated by 0% to 13% of participants, varying
by guarantee) due to the deleterious effects some
multiple Greek hedging strategies had on statutory
reserve requirements
A modification of instruments used in hedging
(indicated by 13% to 19% of participants, again
varying by guarantee)
AG-43 responses found a mixed treatment of
hedging within the statutory reserve valuation.
Almost half the respondents did not recognize their
hedging strategy within the valuation. Some of these
companies strategies did not qualify as a clearly
defined hedging strategy (CDHS) under the AG-43
requirements, while some companies strategies
did qualify as a CDHS but were still not recognized
within the valuation.

Insights | October 2011

Towers Watsons View

The GFC presented VA hedging programs
with significant challenges. As a result of the
crisis, VA providers have a more seasoned
perspective regarding their risk management
protocols, while program stakeholders
expectations of both the day-to-day and longerterm effectiveness of these programs may be
more accurately calibrated than in the past.
The survey suggests an increased level of
sophistication employed by hedging programs,
including, but not limited to:
The increased interest in and/or use of
macro-hedging techniques
Some increased focus on counterparty credit
risk management
The expansion of Greeks hedged in certain
instances
VA writers continue to take positive product
development steps to develop new or tailor
existing designs that better incorporate risk
management-related considerations. These
include target volatility funds and CPPI-like fund
transfer dynamics.

already difficult accounting mismatch problem.

While a large number of writers continue to
use simplistic interest rate and equity models
for valuation, some have moved to more
sophisticated models, and this may emerge
as a trend for the future. Demands on hedging
programs continue to be great, and we view
best-in-class programs as having the operational
discipline in place to promote continual
program improvement and to establish tools
and analytics to help confront these challenges
head on.

Further information
The full report of survey findings is available to
participants only. For help with questions about
this article or the survey, please contact:
Dave Czernicki
+1 312 201 5683
dave.czernicki@towerswatson.com
David J. Maloof
+1 212 309 3764
david.maloof@towerswatson.com

Challenges with respect to hedging still remain.

The deleterious effects hedging has on statutory
reserving requirements add complexity to an

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About Towers Watson

Towers Watson is a leading global professional services
company that helps organizations improve performance
through effective people, risk and financial management.
With 14,000 associates around the world, we offer
solutions in the areas of employee benefits, talent
management, rewards and risk and capital management.

The information in this publication is of general interest

and guidance. Action should not be taken on the basis of
any article without seeking specific advice.
Copyright 2011 Towers Watson. All rights reserved.
TW-EU-2011-22047. October 2011.

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