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A Natural Hedge for Equity Indexed Annuities

Published online by Cambridge University Press:  08 June 2011

Carole Bernard  and
Phelim P. Boyle
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Abstract

Equity linked products are popular in many countries. These contracts generally provide a guaranteed return combined with some participation in the market performance, often computed using a complicated formula. Hedging these contracts often presents a real challenge for insurers in particular during a financial crisis. In this paper, we explain how insurers can benefit from selling a pool of different contracts with different sensitivities to certain key variables to reduce risk exposure. We show how they can diversify their menu of policy designs to stabilize the market value of their liabilities against changes in the market volatility and against estimation error in the volatility parameter. We illustrate the methodology with specific examples of equity annuity contracts with opposite sensitivities to vega risk.

Keywords

Natural hedgingParticipating policiesAnnual guaranteeCliquet optionMaturity guaranteeSolvency IIIFRSLocal capMarket valuation
Type
Papers
Information
Annals of Actuarial Science , Volume 5 , Issue 2 , September 2011 , pp. 211 - 230
Copyright
Copyright © Institute and Faculty of Actuaries 2011

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