Corollaries of Variable Annuity Hedging
Derivatives-based Portfolio Solutions


Since the 1980s, a significant amount of variable annuity products have been sold, particularly in the USA. The size of this market is now over USD 1 Trillion. From the mid- 1990s, these products started to become more complicated and offered guarantees to the purchaser (similar to being long a put). The hedging of these products increases the demand for long-dated downside strikes, which lifts long-dated implied volatility and skew.

With a fixed annuity, the insurance company that sold the product invests the proceeds and guarantees the purchaser a guaranteed fixed return. Variable annuities, however, allow the purchaser to pick which investments they want to put their funds into. The downside to this flexibility is the unprotected exposure to a decline in the market. To make variable annuities more attractive, from the 1990s many were sold with some forms of downside protection (or put). The different types of protection are detailed below in order of the risk to the insurance company.
  1. Return of premium. This product effectively buys an ATM put in addition to investing proceeds. The investor is guaranteed returns will be no lower than 0%.
  2. Roll-up. Similar to return of premium; however, the minimum guaranteed return is greater than 0%. To hedge this product, the insurance company buys a put which is ITM with reference to spot, but OTM compared with the forward.
  3. Ratchet (or maximum anniversary value). These products return the highest value the underlying has ever traded at (on certain dates). The hedging of these products involves options with look-back payouts, more details of which are in the section Look-Back Options.
  4. Greater of ‘ratchet’ or ‘roll-up’. This product returns the greater of the ‘roll-up’ or ‘ratchet’ protection.

Hedging of variable annuity products lifts index term structure and skew

The hedging of variable annuity involves the purchase of downside protection for long maturities. Often the products are 20+ years long, but as the maximum maturity with sufficient liquidity available on indices can only be 3-5 years, the position has to be dynamically hedged with the shorter-dated option. This constant bid for long-dated protection lifts index term structure and skew, particularly for the S&P500 but also affects other major indices (due mostly to relative value trading). The demand for protection (from viable annuity providers or other investors), particularly on the downside and for longer maturities, could be considered to be the reason why volatility (of all strikes and maturities), skew (for all maturities) and term structure are usually overpriced.

Until the TMT bubble burst, guarantees embedded in variable annuity products were often seen as unnecessary ‘bells and whistles’. The severe declines between 2000 and 2003 made guarantees in variable annuity products more popular. When modeling dynamic strategies, insurance companies need to estimate the level of implied volatilities in the future (i.e. hedging short 20-year options with 5-year options). The implied volatility chosen will be based on a confidence interval, say 95%, to give only a 1-in-20 chance that implieds are higher than the level embedded in the security. As the credit crunch caused realized volatility to reach levels that were unforeseeable, implied volatility rose to unprecedented heights. This increase in the cost of hedging has significantly weighed on margins.

The passing of the Dodd-Frank Act in mid-2010 was designed to improve the transparency of derivatives by moving them onto an exchange. However, this would increase the margin requirements of long-dated options, which were previously traded OTC. This made it more expensive to be the counterparty to variable annuity providers. As the act also included the ‘Volker Rule’, which prohibits proprietary trading, the number of counterparties shrank (as prop desks with attractive funding levels were a common counterparty for the long-dated protection required by variable annuity hedgers). The combination of the spinoff of prop desks, and movement of OTC options onto an exchange caused skew to rise in mid-2010, particularly at the far-dated end of volatility surfaces.
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