F1–What Are We Hedging Anyway? GAAP, Stat, or Economics?

20 Pages·2010·0.74 MB·English

Investment Symposium
March 2010

F1: What Are We Hedging Anyway? GAAP, Stat,
or Economics?

Ross Bowen
James Lloyd

Moderator
Jay Musselman
F1–What Are We Hedging Anyway? 
GAAP,, Stat,, or Economic?
Ross Bowen, Allianz Life
March 22, 2010
Hedging VA Risk
Most hedging programs started out hedging GAAP risk
Implementation of C3P2 and AG43 have created a disconnect with
GAAP or pure economics
FAS 157 disconnected GAAP and Economic
Multiple constraints and objectives create the need for an
interdisciplinary team to approach the problem
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Economic
Economic measures look for sensitivities to the value of promises
mmaaddee
Define the value
Present value of claims less fees
Risk neutral framework
Key sensitivities
Change in market levels
Change in rates
Change in volatilities
Need a robust scenario generator
Match observable prices and greeks
GAAP
Most similar to economic –what are the differences?
Treatment of fees
Some companies set the value of the embedded derivative to
zero at issue (cid:206)apply a factor to the fees so PV = 0
Not all VAGLBs are FAS 133
SOP 03-1 applied to GMIB
GMAB clearly FAS 133
GMWB may be a hybrid
Gain on hedges impacts k factor
2
GAAP – FAS 157
FAS 157 Own Credit Risk
Objections –value of promise declines as probability of paying
declines
Release reserves when downgraded?
How to determine own credit risk spread?
CDS market offers view into credit risk
Large writers may have active CDS market
To hedge or not to hedge?
Sell CDS on self? Sell CDS on similar writers?
What is the goal of hedging?
Statutory
Moving from a factor based world to a Principles Based world
AG33 –Base Contract
AG34 -DB
AG39 –Living Benefits, accumulation of fees
There was a need to modernize AG39
C3P2 came first, then AG43 / VACARVM
Real world stochastic
Model hedges in a stochastic on stochastic framework
Standard scenario –comparable values between companies
3
AG43 Hedge Modeling - Stochastic
Stochastic scenarios
CTE70 –worst 30%
Possibility that hedges will cost rather than benefit
Existing hedges may be run off
If CDHS in place, may reflect hedging strategy
CTE Reported = E * CTE Best Efforts –(1-E) * CTE Adjusted
E < 70% or < 30% if hedgges not directlyy modeled
Basis risk, transaction risk, hedging mismatch tolerance…
C3P2 Hedge Efficiency
Stochastic scenarios
CCTTEE9900 –wwoorrsstt 1100%% -mmoorree lliikkeellyy tthhaatt hheeddggeess wwiillll bbeenneeffiitt
Existing hedges may be run off
If CDHS in place, may reflect hedging strategy
CTE Reported = TAR Best Efforts –E * (TAR adj –TAR best
efforts) Adjusted
E >5%
Basis risk, transaction risk, hedging mismatch tolerance…
4
Value of Hedges – AG43 SS
PV of pre-tax cashflows at the one-year CMT rate less statement
vvaalluuee
Must be held to hedge these contracts in compliance with state laws
Assume hedges are liquidated in one year or exercised if mature
prior
Assume returns underlying SS, Black Scholes pricing, rate of five-
year CMT, and solved-for implied volatility
Evaluation of Hedge Instruments
Review the differences between stat, GAAP, and economic
Evaluate hedge performance in the various regimes
Choices
Futures
Puts
Swaps
Swapptions
Calls
5
Evaluation of Hedge Instruments
Futures
Linear in the market
Can be written on different indices
Very effective on standard scenario
13.5% / 20% of notional
Unlimited losses possible in up market
Evaluation of Hedge Instruments
Futures
Futures Performance in AG43
50,000,000
40,000,000
30,000,000
s 20,000,000
Los 10,000,000 mkt gain
n / - Hedge Credit
Gai (10,000,000) 700 800 900 1000 1100 1200 1300 Capital Impact
(20,000,000)
((3300,000000,000000))
(40,000,000)
S&P Level
6
Evaluation of Hedge Instruments
Puts
Provide delta protection in Statutory world
Vega and rho protection in Economic world
Can be very expensive
Out of the money attractive (crash protection)
Sell a deeper OTM to offset cost
Can also fund by selling upside
OTM call
Sell deeper OTM call to limit losses
Puts – “Zero Cost” Collar
Economic payoff

Payoff profile
300
200
100
0
400 500 600 700 800 900 1000 1100 1200 1300 1400
-100
-200
-300
7
“Zero Cost” Collar - Impact
Change in value of options as time passes and market levels
cchhaannggee
Hedge Value
10.0
9.0
8.0
7.0
6.0 ns
o
45..00 milli Hedge Value
33.00 $
2.0
1.0
0.0
600 700 800 900 1000 1100 1200 1300
S&P Level
“Zero Cost” Collar - Impact
Additional value of hedge credit under AG43 standard scenario
Hedge Value plus Hedge Credit
14.0
12.0
10.0
8.0 ons Hedge Value
6.0 milli Value After Credit
4.0 $
22.00
0.0
600 700 800 900 1000 1100 1200 1300
S&P Level
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Principle 5
“The use of …risk management strategies (e.g. hedging)… that
sseerrvvee ssoolleellyy ttoo rreedduuccee tthhee ccaallccuullaatteedd TTAARR… aarree iinnccoonnssiisstteenntt wwiitthh
these principles.
The use of assumptions and risk management strategies should be
appropriate to the business and not merely constructed to exploit
‘foreknowledge’ of the components of the required methodology.”
Summary
Economic, stat, GAAP
All behavior differently under market shocks
Interdisciplinary project
Need input from many financial areas
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