Dynamic Hedging

Life insurance companies face increased market pressure to offer competitively priced variable annuities with enriched guarantee features to their customers. The various equity based guarantees that are being sold under "GMxB" and equity indexed annuity products involve complex embedded options that require a sophisticated and robust risk management infrastructure.

Through the global financial crisis in 2008, the potential long-term sub optimality of certain hedging strategies has been overshadowed by a heightened focus on the absolute gains generated by the hedging portfolio during the market crash, an understatement of the uncertainty associated with mark-to-model hedge effectiveness, and a high emphasis on short-term loss reduction as opposed to long term risk-adjusted profitability.

The overall level of sophistication and confidence with respect to dynamic hedging has grown significantly over the past few years. Notwithstanding, the unprecedented turbulence in the capital markets, failure of major investment banks, and greater scrutiny from equity analysts, regulators and rating agencies, has challenged companies to respond by promptly ramping up their risk management programs. Insurers need to demonstrate that they have a good understanding and control over the management of the risks associated with their in-force and new business.

Risk Management Challenges

Risk management strategies should be formulated and executed within a properly established Enterprise Risk Management ("ERM") framework to achieve the financial objectives and ensure the company is fairly compensated for the risks taken and that these risks are consistent with the risk appetite of the company.

Companies have multiple options at their disposal when considering how to manage the capital market risks embedded in their products. In practice, a number of important questions arise such as:

  • What is the risk profile and what are the full implications of running the risks naked?
  • How much would it cost to hedge or reinsure a portion of the portfolio?
  • When should the hedging program start?
  • What are the gain and loss distributions of different active and passive first and second-order dynamic hedging strategies?
  • How robust is a given risk management strategy to model and input misspecifications?
  • How to achieve the proper balance between economic and accounting results?

In the past, many companies have run the risks naked or outsourced the risk management to a third party. As time passes, the gaps are becoming more evident:

  • Existing risk models may not properly capture equity market risk or counterparty default risk
  • Choice of hedging strategies might be limited to those the vendor software can support
  • Tradeoff between cost and benefit of hedging higher order Greeks is not well defined
  • Certain grouping techniques introduce material bias
  • Strategies that are theoretically effective on an economic basis may not be supported by major stakeholders

As the sophistication of the insurance industry increases, companies are looking for ways to develop the expertise in-house and execute dynamic hedging programs at a strategic level, fully integrated within an ERM framework.

Nexus Risk Management can play an important role in developing your in-house capabilities and intellectual capital to help you achieve you long term objectives.

Our Approach

Nexus Risk Management has been performing a wide variety of dynamic hedging work for a number of insurers for several years. One key differentiator for Nexus Risk Management is the principled based approach we follow to formulate dynamic hedging strategies.

Nexus Risk Management establishes the overall risk framework for our clients so that they can formulate the most effective strategies to achieve their financial goals and help ensure that the risks assumed are appropriate, well understood and consistent with their risk appetite.

We believe that by ensuring a clear focus on financial objectives, risk management can be used to add significant value and gain competitive advantage. Nexus Risk Management works closely with companies to provide them with the tools and expertise needed to help them develop their capabilities in-house.

Our software tools are delivered on the Nexus Risk Platform, fully customized to model clients' liabilities and integrated with their systems.

Copyright © 2013 Nexus Risk Management. All Rights Reserved.