risk management, hedging and product design in …...core value proposition of with-profits is a...

Life conference and exhibition 2010Michael Payne, Prudential; Joshua Corrigan, Milliman

© 2010 The Actuarial Profession � www.actuaries.org.uk

Risk Management, Hedging

and Product Design in a

With-profits fund

Session C10

7-9 November 2010

Agenda

• Background

• Product and Risk Management Levers

• Practical Considerations

• The Future• The Future

1© 2010 The Actuarial Profession � www.actuaries.org.uk

UK Capital Market ConditionsSource: Bloomberg and Milliman

UK Swap Rates

FTSE Imp Vols


Milliman Hedge

Cost Index

FTSE Rolling 12 month

Price Returns

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

10

-04

1-0

5

4-0

5

7-0

5

10

-05

1-0

6

4-0

6

7-0

6

10

-06

1-0

7

4-0

7

7-0

7

10

-07

1-0

8

4-0

8

7-0

8

10

-08

1-0

9

4-0

9

7-0

9

10

-09

1-1

0

4-1

0

7-1

0

Impact on New Business SalesSource: ABI Statistics and Milliman

15,000

20,000

25,000Single Premium New Business Sales

Variable Annuities

Unit Linked bonds

With-profit bonds


0

5,000

10,000

15,000

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Q2

£m

Capital Requirements

• Guarantees are

capital intensive

on a market

consistent basis

10%

15%

20%

25% 20%-25%

15%-20%

10%-15%

5%-10%

0%-5%

• Capital has

increased as

rates have fallen

and volatilities

increased


Indicative total capital for a 5 year return of premium guarantee

13%

18%

23%

28%

33%

0%

5%

10%

2.3%2.8%

3.3%3.8%

4.3%4.8%

Volatility

Interest Rates

Is with-profits an attractive, viable, and sustainable proposition for consumers and providers?

• Why do we care?

• Customer research is clear... people need and want guarantees

– Universal response across multiple surveys undertaken by product – Universal response across multiple surveys undertaken by product

providers and consulting companies*

• Product innovation has occurred in response to this demand

*Refer publications by Prudential, MetLife, AXA, ING, and Milliman


Where are our choices?

• Reduce or stop selling

• Increase guarantee charges

• Reduce guarantee benefit levels

• Reduce Equity Backing Ratios

Product Management

• Reduce Equity Backing Ratios

• Introduce hedging

• Dynamic volatility management

• Combination of all the above


Risk Management

Impact of Product ManagementIndicative results only – actual results are product specific

Lower BenefitLower EBR

Higher charge

Base With-Profit

Base Non-Profit

15%

20%

Eco

no

mic

Ca

pit

al

(% o

f A

sse

t S

ha

re)


0%

5%

10%

0 20 40 60 80 100 120 140 160

Eco

no

mic

Ca

pit

al

(% o

f A

sse

t S

ha

re)

Hedge Cost (bps p.a. of Asset Share)

Impact of Risk Management


Higher charge

Base With-Profit

Base Non-Profit

15%

20%

Eco

no

mic

Ca

pit

al

(% o

f A

sse

t S

ha

re)


Vol MgmtDelta Rho Vega

Hedge

Delta Rho Hedge

0%

5%

10%

0 20 40 60 80 100 120 140 160

Eco

no

mic

Ca

pit

al

(% o

f A

sse

t S

ha

re)


Equivalent Non-Profit Impact


Higher charge

Base With-Profit

Base Non-Profit

15%

20%

Eco

no

mic

Ca

pit

al

(% o

f A

sse

t S

ha

re)


Vol Mgmt

Lower Benefit

Lower EBRDelta Rho Vega

Hedge

Vol MgmtDelta Rho Vega

Hedge

Delta Rho Hedge

0%

5%

10%

0 20 40 60 80 100 120 140 160

Eco

no

mic

Ca

pit

al

(% o

f A

sse

t S

ha

re)


Core Value Proposition of With-Profits is a Relative One

• The ability to smooth reduces the economic cost of hedging

enabling a structural competitive advantage vs non-profit

guarantee alternatives

• However there is no free lunch:• However there is no free lunch:

– Comes at the cost of lower benefit transparency to the customer

– Implied cost of capital provided by the Estate is lower than the equivalent

cost of capital provided by shareholders for non-profit guarantee

alternatives


General Hedging Considerations

Governance Structure

• Capital market constraints

– Instrument liquidity & costs

– Exchange vs OTC

– Cash flow impact and

uncertainty

Systems and Processes

Trade Management

Expertise and Experience

uncertainty

• New business

– Changing market conditions

– Repricing thresholds

• Systems, processes and

resources (expertise)

• Governance and controls


With-Profits Specific Hedging Considerations

• TCF

• EBR considerations

• What to hedge:

– Cost of Guarantees

– Cost of Smoothing

• Management Actions

• Notional trading

• Guarantee margin requirements

– Set to cover cost of capital

– Leave to Estate to cover the actual cost of hedging


Product Design Considerations

• Risk of Selection

– Surrenders

– Vesting

• Product Sustainability

• Product Features


• Product Features

– Complexity

– Distortion in the Greeks

– Asymmetry in the liability option value

• Projected Capital and P&L distributions

• Other Risks

• Solvency II

What will the future hold?

Market continues to be volatile

Customers continue to demand guaranteesCustomers continue to demand guarantees

Customers only pay for guarantees that are good

Need to maximise benefits within customer budgetsNeed to maximise benefits within customer budgets


guarantees that are good value for money

within customer budgetswithin customer budgets

Capital continues to be constrained

Hedging to become a core pillar of WP risk management

Hedging to become a core pillar of WP risk management

Increased competition from non-profit alternatives

Focus on core value proposition relative to non-

profit alternatives

Focus on core value proposition relative to non-

profit alternatives

Questions or comments?

• What do you think:

– Is there a future for WP?

– How do product features need to change?

– How does risk management need to change?

Michael Payne Joshua Corrigan

Prudential Milliman


– How will SII impact WP?

risk management, hedging and product design in …...core value proposition of with-profits is a...

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