Practical Considerations in Managing Variable Annuities

Variable annuities have grown tremendously in recent years, offering life insurers significant growth opportunities. These equity and interest rate structured products offer a broad range of guarantees to the policyholders, and insurers must manage their risks. The insurer’s risk management program must consider modeling and implementation challenges beyond that of the standard capital market approach. This paper proposes solutions to six significant issues: (1) computational efficiency, (2) impact of equity returns and interest rate correlations on the cost of guarantee, (3) uncertain surrendering of policies and withdrawal of account value, (4) internal transfer of funds, (5) suboptimal exercise of options, and (6) a cost/benefit analysis of a hedging program. These solutions are extended from the traditional capital market approach. Specifically, in this paper, we describe the fair valuation of the guarantees using a three factor model incorporating interest rate and equity risks. Then we use the Linear Path Space methodology to simulate and value the risks. Finally, we simulate the effectiveness of using a combined static-dynamic hedging program in dealing with the practical considerations mentioned above.