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Document - Finance - Va - JP Morgan - Interest Rate Impacts On Va PDF
Document - Finance - Va - JP Morgan - Interest Rate Impacts On Va PDF
Document - Finance - Va - JP Morgan - Interest Rate Impacts On Va PDF
Research Note
Interest Rate Risk in Variable Exhibit 1: The variable annuity industry has seen
significant growth over the past decade
Annuities Variable annuities assets; $bn
1600
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
market behavior
• We estimate that the recent plunge in long-end Note: 2011 value is as of 2Q11.
yields has taken the aggregate duration of the Source: “Responding to the Variable Annuity Crisis,” Dinesh Chopra et al, McKinsey
Working Papers on Risk, Number 10, April 2009; Morningstar.
VA universe to all-time highs, although this
week’s pullback has mitigated this somewhat products and their interest rate risk exposures. This fact
really burst forth into plain view right after Lehman’s
• Long-end swap spreads have steadily become
less vulnerable to VA duration, perhaps default in 2008, when a plummeting stock market
reflecting hedgers’ growing allocations to coupled with falling Treasury yields produced a
Treasury-based instruments, and will likely massive duration shortfall in insurance companies’
not be as impacted by VA hedging flows as portfolios, leading to considerable receiving in swaps
they were in 4Q08. That said, the crowding-out and causing long-end swap spreads to decline below
effect of Operation Twist is likely to result in zero for the first time. More recently, this has once
modestly greater sensitivity of long-end again become evident given the significant receiving
spreads to VA duration swings flows from insurance companies as long-end yields
attained new all time lows last week, although some of
• Unlike swap spreads, the slope of the 10s/30s these flows have reversed since then given the pullback
curve shows no declining sensitivity to VA
in yields.
duration
Variable annuities were first introduced in the 1980’s,
and tended to be fairly simple products designed to
Introduction
US fixed income investors, particularly those focused Srini Ramaswamy
AC
Terry Belton
on the longer end of the Treasury or swaps curve, (1-212) 834-4573 (1-312) 325-4650
have come to realize the significant impact that the srini.ramaswamy@jpmorgan.com terry.belton@jpmorgan.com
J.P. Morgan Securities LLC J.P. Morgan Securities LLC
risk management of variable annuities can have on
long-end yield levels, the slope of the curve, and on Alberto Iglesias Meera Chandan
swap spreads at the very long end of the curve. To put (1-212) 834-5116 (1-212) 834-4924
it simply, flows related to the hedging of the duration alberto.d.iglesias@jpmorgan.com meera.chandan@jpmorgan.com
J.P. Morgan Securities LLC J.P. Morgan Securities LLC
risk in variable annuities have become a force to be
reckoned with at the long end of the curve, and as a Kimberly Harano
result, it behooves investors to better understand these (1-212) 834-4956
kimberly.l.harano@jpmorgan.com
J.P. Morgan Securities LLC
1
Derivatives Strategy
September 28, 2011
offer equity market upside along with tax-deferred “VA-lite” instruments, which we refer to as “VA
returns. Over time, various options and guarantees were kernels.” Our approach also relies on an empirical
bundled in, including death benefits (such as a return of calibration to solve for the weights on these individual
premium in case of death) as well as living benefits VA kernels. We then discuss the current exposures of
such as guaranteeing a minimum income (GMIB) for the aggregate VA universe, as well as implications for
the policyholder or an account value (GMAB) at a the long-end of the US yield curve.
fixed point in time. Since the late nineties, minimum
withdrawal benefits either for a predetermined number A simple framework to estimate
of years or for the remainder of the policyholder’s life interest rate risk in variable annuities
(GMWB) appear to have been commonly included.
Such benefits, together with path-dependent features Variable annuities, like fixed annuities, may be
such as guaranteed roll-ups or ratchets, have made conceptualized as consisting of an accumulation phase,
variable annuities popular products, causing the during which the policyholder pays either a lump sum
industry to experience significant growth (Exhibit 1). or regular contributions with the aim of producing an
Of course, these guarantees also imply greater risk to accreted future value at some desired point in time, and
the underwriters. Conceptually, the insurance a payoff phase, where the accreted principal is
companies are short equity puts to policyholders, the annuitized by the insurance company as a stream of
exercise of which occurs in the form of floored future regular payments to the policyholder over a designated
annuity payments whose present value depends on time period. Actuarial components (such as embedded
interest rates. life insurance and associated minimum guarantees)
exist, but we ignore them for our purposes since
The hybrid exposure of these products to the reference mortality risk is uncorrelated to market risk, which is
index (S&P 500) as well as the yield curve, mortality our main focus.
risks, and numerous features that create path
dependency all mean that pricing variable annuities is a In the case of fixed annuities, the investor’s investment
highly complex undertaking. However, accurately performance during the accumulation phase is set to a
pricing these instruments is not our objective in this predetermined interest rate, resulting in a predictable
research note. Our goal is to capture the relative future value that can subsequently be annuitized—i.e.,
magnitudes of the duration of the VA universe over except for actuarial risks, the product conceptually is
time as accurately as possible, and in a way that similar to purchasing a strip of zero coupon bonds
recognizes the inherent nonlinearities with respect to during the accumulation phase, carefully designed to
equities and rates; understanding such nonlinearities is produce an annuity during the payoff phase. As such,
key to understanding the shifts in VA duration in fixed annuities have interest rate exposures that are
periods where equities and/or rates trend towards relatively easily understood and hedged.
historical extremes. To that end, our approach is geared
not towards modeling the detailed structure of variable Variables annuities, on the other hand, have two
annuities in their full richness; rather, we seek to find important sources of variability. First, returns
an effective scheme to approximate the duration experienced in the accumulation phase are not fixed or
exposure of the VA universe (basically the partial delta known a priori, and are instead linked to the returns on
of variable annuities with respect to long-term rates) in some benchmark such as the S&P 500. Second, as a
the aggregate. result of the uncertain nature of returns in the
accumulation phase, VAs commonly embed minimum
The outline of this paper is as follows. First, we guarantees as already noted in the previous section.
describe variable annuities, with a focus on the aspects Conceptually, then, one can imagine an elemental VA
that create the interest rate risk exposures we are most building-block (or kernel) as consisting of a single
interested in. Second, we present the essence of our lump-sum premium payment at the start of a fixed-term
approach, which is based on the notion of accumulation phase, followed by a fixed-term
approximating the complex universe of VAs via a annuitization, with minimum guarantees on the
notional-weighted combination of highly simplified withdrawal amounts.
2
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September 28, 2011
In rising equity markets, VAs pose little market risk to Exhibit 2: Illustration of a hypothetical VA kernel
the insurance companies that underwrite them—
policyholders’ premiums can be invested in the S&P 1/1/07: $100
Accumulation phase:
500, and returns are merely passed through to the inv estment
guaranteed 6% minimun
policyholders. However, the picture is very different in annual return
equity bear markets—the more equities fall, the more
binding the minimum guarantee becomes, and the etc...
underwriter is increasingly short a fixed annuity. Thus, Payoff phase: 5% annual
insurance companies increasingly need to add duration w ithdraw al for 20 y ears
in periods of falling equity markets. Similarly, a fall in
long-term yields would increase the NPV of the
minimum guarantee to the policyholder, making it varying the start date, the length of time of the intended
more likely that the guarantee will be binding. This equity investment, and the minimum guarantee amount.
implies that an underwriter of VA policies becomes Effectively, we decompose the complex VA universe
short duration as yields fall. The combination of both as a linear combination of simpler VA kernels, each of
these events—falling equities and bond yields— which is priced in a manner that captures the
represents a perfect storm, and causes duration needs nonlinearities with rates and equities.
from VA hedgers to rise significantly, as was the case
in 4Q08 and as has been the case recently. Second, we calculate the present value of each VA
kernel by using an option pricing framework. We use
Clearly, pricing variable annuities comprehensively implied distributions from the swaptions market as well
and accurately is an exceedingly complex undertaking, as long-term S&P vols and correlation estimates to
requiring the joint modeling of long-term interest rates calculate the price. We then use numerical tweaks to
as well as equities; in addition, actuarial risks calculate the partial exposure with respect to long-term
stemming from life insurance-related guarantees, and swap rates (i.e., duration). Third, we use a calibration
other features make the product path dependent, adding approach to solve for the appropriate weights on the
to the complexity. various VA kernels. Our calibration relies on the
anecdotally-known fact that VA risk exposures were
Recognizing that our objective is not to price variable significant influences on long-end swap spreads in
annuities accurately, but merely to capture the trend in certain periods of time, such as 4Q08; we may thus
their duration exposures as well as their nonlinear solve for non-negative coefficients for each kernel that
relationship with equities/yields, we devise a simpler maximally explain the portion of long-end swap spread
approach. Our approximation approach is based on behavior not explained by other factors in those select
three principles. First, we start with the assumption that periods of time. In order to mitigate circularity (since
the duration of the VA universe may be approximated we plan to use VA duration estimates to model long-
by a weighted combination of the durations of much end swap spreads), no data after 2008 has been used in
simpler VA kernels. This is not unlike “series calibration, and out-of-sample performance has been
approximation” techniques commonly used in tested and found to be reasonable.
mathematics to solve difficult problems. One example
of a VA kernel is a simple product where a Calibration and results
policyholder pays $100 on (say) January 1, 2007,
intended to be invested in the equity market for a 15- As noted above, each VA kernel in our framework is
year (fixed) horizon, with a guaranteed withdrawal completely determined by a start date (on which the
amount of $12 per year for the subsequent 20 years; premium is paid in full), the length of the accumulation
this could be interpreted as a minimum 6% guaranteed and payoff phases, and the details of the minimum
annual return during the accumulation phase, followed guarantee. In our empirical work, the kernels we
by a minimum guaranteed 5% annual withdrawal on considered all had lengths of 15 years for the
the accreted principal (see Exhibit 2 for an illustration accumulation phase and 20 years for the payoff phase,
of a VA kernel). Several VA kernels may be created by with a minimum guaranteed annual withdrawal of 5%
3
Derivatives Strategy
September 28, 2011
of the accreted future value of the premium paid (which Exhibit 3: VA kernels initiated in high equity
is itself guaranteed based on a 6% compounded annual environments such as 2000 carry greater interest rate
return during the accumulation phase). Varying these risk than VA kernels initiated in lower equity
choices did not materially alter our empirical results, environments such as 2003…
Partial delta* of VA kernels associated with origination years 2000 and 2003; $
and therefore we fix all of these parameters.
-0.00
2000
Thus, each VA kernel is specified by its start date, and -0.02 2003
we include one VA kernel for each calendar year (with
-0.04
the start date assumed to be at the beginning of the
year). This simplification also makes it easier to -0.06
develop intuition regarding the results. Notably, VA -0.08
kernels initiated in 2000 (at the peak of the stock -0.10
market, and with much less time remaining in the
-0.12
accumulation phase currently) carry greater interest
rate risk than VA kernels initiated in lower equity -0.14
4
Derivatives Strategy
September 28, 2011
Exhibit 5: The aggregate duration exposure of the Exhibit 6: The sensitivity of long end swap spreads to
VA universe is now at an all-time high the duration of the VA universe has been declining
Estimated duration of the VA universe*; $bn of 20-year equivalents steadily in magnitude …
Partial beta of maturity matched 30-year swap spreads with respect to VA
280 universe duration*; bp per $bn of 20-year equivalents
260 0.0
240
220 -0.2
200
180 -0.4
160
140 -0.6
120
100 -0.8
5
Derivatives Strategy
September 28, 2011
seen, VA duration is a significant driver of the curve, in Exhibit 8: A fair value model of the 10s/30s Treasury
addition to other factors (the level of short-term curve
Treasury yields, 5Yx5Y forward inflation expectations 10s/30s Treasury yield curve (bp) fair value model
from the inflation swap market and the total amount of Variable Coefficient T-statistics
outstanding Treasury debt in the 17- to 30-year sector Intercept 114.2 17.2
of the curve). Specifically, the model suggests that a 3-year yields; % -24.2 -48.7
$50bn 20-year equivalents increase in VA duration 5yx5y inflation swap rates; % 10.8 7.3
would flatten the 10s/30s curve by around 16bp (-0.32 JPM index of variable annuity hedging
-0.32 -18.3
x 50). flows; $bn of 20-year equivalents
Treasuries outstanding with maturities
It is also worth noting that the slope of the 10s/30s 0.11 28.7
greater than 17-years; $bn
curve shows no declining sensitivity to VA duration. 5-year regression; R2 = 93.4%
Exhibit 9 shows the evolution of the partial beta of the
10s/30s curve with respect to VA duration over time. Exhibit 9: Unlike with long end swap spreads, the
As can be seen, the slope of the long end of the curve sensitivity of the slope of the 10s/30s curve to the
remains vulnerable to swings in VA duration, with no duration of the VA universe shows no declining trend
Partial beta of the 10s/30s Treasury curve with respect to VA universe duration*;
diminishing sensitivity evident (as was the case for bp per $bn of 20-year equivalents
long-end swap spreads). This is likely the result of
-0.25
growing allocations by insurance companies to
-0.30
Treasury-based hedges, whether via cash instruments
-0.35
such as bonds and long-end STRIPS or via Treasury
-0.40
futures or other derivatives.
-0.45
-0.50
Conclusions
-0.55
-0.60
In this paper, we have devised a relatively simple way
-0.65
of estimating the duration exposure of the highly
-0.70
complex variable annuity market. This is significant
-0.75
since VA duration remains a significant influence on
Mar 10 Sep 10 Mar 11 Sep 11
the slope of the long end of the curve. In addition,
although long-end swap spreads have steadily become * Based on rolling 2-year regressions, with front end yields, 5Yx5Y inflation expectations
and the outstanding stock of long-end Treasuries as other factors.
less sensitive to VA duration, the crowding-out effect
from the Fed’s Operation Twist is likely to cause swap
spreads to exhibit increased sensitivity to VA duration
as well, albeit not to the extent seen in 4Q08.
6
Derivatives Strategy
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