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Robert O. Young, Anshul A. Shah
Limitations of hedging in mitigating riskWhile insurers may not have to pay out any claims on their guarantees until years into the life of a VA contract (if at all), they must hedge their ongoing exposures to key risk factors associated with VA contracts – primarily equities, interest rates and volatility – in order to avoid the potential for devastating losses in the future.As a number of insurers can unfortunately attest, hedging is not a foolproof risk management tool. First, risk exposures are calculated by models that are subject to many assumptions, and any inaccuracy in the assumptions can lead to under- or over-hedging. Two of the major problem areas are (1) accurately estimating policyholder behavior (e.g., lapse and withdrawal) and (2) basis risk that comes from mapping investment sub-accounts to index proxies.Second, managing hedge programs can be challenging, particularly during times of market stress. Hedge portfolios may require frequent rebalancing and are subject to slippage during large market moves. They are also likely to leave some risks unhedged.Finally, many insurers are hesitant to fully hedge their economic exposures because they face a “multiple lens” problem: the need to consider not only economics but also accounting regimes that vary in their treatment of hedging. For example, under U.S. accounting rules (GAAP), hedge assets are marked-to-market while some guarantee types follow relatively smooth liability accounting under Statement of Position (SOP) 03-1. Hence, full economic hedging can lead to significant balance sheet and earnings volatility. In addition, under U.S. statutory accounting rules, companies may not get full hedging credit when calculating reserves and risk-based capital.The upshot is that while hedging is necessary, it is fraught with challenges. Moreover, when guarantee costs exceed guarantee fees, as can happen in periods of high volatility and low interest rates, hedging may only help to lock in a loss.
All investments contain risk and may lose value. All guarantees, including optional benefits, are backed by the claims-paying ability of the issuing insurance company and do not apply to the underlying investment options. Guarantees do not apply to the safety or investment performance of the underlying subaccounts in the variable annuity. Investment returns of the underlying investment options will fluctuate and the principal value, when redeemed, may be worth more or less than the original investment. Optional benefits have certain investment, holding period, liquidity and withdrawal limitations and restrictions. The benefit fees are in additional to fees and charges associated with the basic annuity.PIMCO does not offer insurance guaranteed products or products that offer investments containing both securities and insurance features. PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns.This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2012, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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