Derivatives Strategy

September 28, 2011

Srini RamaswamyAC (1-212) 834-4573

Terry Belton (1-312) 325-4650
J.P. Morgan Securities LLC

Research Note
Interest Rate Risk in Variable Exhibit 1: The variable annuity industry has seen
significant growth over the past decade
Annuities Variable annuities assets; $bn

1600

We outline a simple framework for analyzing 1400

the interest rate risk exposure in variable
annuities in the aggregate, with a view towards 1200
assessing the likely forward-looking
implications for the long end of the swaps and
1000
Treasury curves. The essence of our approach
is to decompose the highly complex variable
annuity universe into a weighted combination 800
of much simpler VA-lite instruments, with
the weights themselves being implied from 600

1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
market behavior
We estimate that the recent plunge in long-end Note: 2011 value is as of 2Q11.
yields has taken the aggregate duration of the Source: Responding to the Variable Annuity Crisis, Dinesh Chopra et al, McKinsey
Working Papers on Risk, Number 10, April 2009; Morningstar.
VA universe to all-time highs, although this
weeks pullback has mitigated this somewhat products and their interest rate risk exposures. This fact
really burst forth into plain view right after Lehmans
Long-end swap spreads have steadily become
less vulnerable to VA duration, perhaps default in 2008, when a plummeting stock market
reflecting hedgers growing allocations to coupled with falling Treasury yields produced a
Treasury-based instruments, and will likely massive duration shortfall in insurance companies
not be as impacted by VA hedging flows as portfolios, leading to considerable receiving in swaps
they were in 4Q08. That said, the crowding-out and causing long-end swap spreads to decline below
effect of Operation Twist is likely to result in zero for the first time. More recently, this has once
modestly greater sensitivity of long-end again become evident given the significant receiving
spreads to VA duration swings flows from insurance companies as long-end yields
attained new all time lows last week, although some of
Unlike swap spreads, the slope of the 10s/30s these flows have reversed since then given the pullback
curve shows no declining sensitivity to VA
in yields.
duration
Variable annuities were first introduced in the 1980s,
and tended to be fairly simple products designed to
Introduction
US fixed income investors, particularly those focused Srini Ramaswamy
AC
Terry Belton
on the longer end of the Treasury or swaps curve, (1-212) 834-4573 (1-312) 325-4650
have come to realize the significant impact that the srini.ramaswamy@jpmorgan.com terry.belton@jpmorgan.com
J.P. Morgan Securities LLC J.P. Morgan Securities LLC
risk management of variable annuities can have on
long-end yield levels, the slope of the curve, and on Alberto Iglesias Meera Chandan
swap spreads at the very long end of the curve. To put (1-212) 834-5116 (1-212) 834-4924
it simply, flows related to the hedging of the duration alberto.d.iglesias@jpmorgan.com meera.chandan@jpmorgan.com
J.P. Morgan Securities LLC J.P. Morgan Securities LLC
risk in variable annuities have become a force to be
reckoned with at the long end of the curve, and as a Kimberly Harano
result, it behooves investors to better understand these (1-212) 834-4956
kimberly.l.harano@jpmorgan.com
J.P. Morgan Securities LLC

1
Derivatives Strategy
September 28, 2011
Srini RamaswamyAC (1-212) 834-4573
Terry Belton (1-312) 325-4650
J.P. Morgan Securities LLC
offer equity market upside along with tax-deferred
returns. Over time, various options and guarantees were
bundled in, including death benefits (such as a return of
premium in case of death) as well as living benefits
such as guaranteeing a minimum income (GMIB) for
the policyholder or an account value (GMAB) at a
fixed point in time. Since the late nineties, minimum
withdrawal benefits either for a predetermined number
of years or for the remainder of the policyholders life
(GMWB) appear to have been commonly included.
Such benefits, together with path-dependent features
such as guaranteed roll-ups or ratchets, have made
variable annuities popular products, causing the
industry to experience significant growth (Exhibit 1).
Of course, these guarantees also imply greater risk to
the underwriters. Conceptually, the insurance
companies are short equity puts to policyholders, the
exercise of which occurs in the form of floored future
annuity payments whose present value depends on
interest rates.
The hybrid exposure of these products to the reference
index (S&P 500) as well as the yield curve, mortality
risks, and numerous features that create path
dependency all mean that pricing variable annuities is a
highly complex undertaking. However, accurately
pricing these instruments is not our objective in this
research note. Our goal is to capture the relative
magnitudes of the duration of the VA universe over
time as accurately as possible, and in a way that
recognizes the inherent nonlinearities with respect to
equities and rates; understanding such nonlinearities is
key to understanding the shifts in VA duration in
periods where equities and/or rates trend towards
historical extremes. To that end, our approach is geared
not towards modeling the detailed structure of variable
annuities in their full richness; rather, we seek to find
an effective scheme to approximate the duration
exposure of the VA universe (basically the partial delta
of variable annuities with respect to long-term rates) in
the aggregate.
The outline of this paper is as follows. First, we
describe variable annuities, with a focus on the aspects
that create the interest rate risk exposures we are most
interested in. Second, we present the essence of our
approach, which is based on the notion of
approximating the complex universe of VAs via a
notional-weighted combination of highly simplified
VA-lite instruments, which we refer to as VA
kernels. Our approach also relies on an empirical
calibration to solve for the weights on these individual
VA kernels. We then discuss the current exposures of
the aggregate VA universe, as well as implications for
the long-end of the US yield curve.
A simple framework to estimate
interest rate risk in variable annuities
Variable annuities, like fixed annuities, may be
conceptualized as consisting of an accumulation phase,
during which the policyholder pays either a lump sum
or regular contributions with the aim of producing an
accreted future value at some desired point in time, and
a payoff phase, where the accreted principal is
annuitized by the insurance company as a stream of
regular payments to the policyholder over a designated
time period. Actuarial components (such as embedded
life insurance and associated minimum guarantees)
exist, but we ignore them for our purposes since
mortality risk is uncorrelated to market risk, which is
our main focus.
In the case of fixed annuities, the investors investment
performance during the accumulation phase is set to a
predetermined interest rate, resulting in a predictable
future value that can subsequently be annuitizedi.e.,
except for actuarial risks, the product conceptually is
similar to purchasing a strip of zero coupon bonds
during the accumulation phase, carefully designed to
produce an annuity during the payoff phase. As such,
fixed annuities have interest rate exposures that are
relatively easily understood and hedged.
Variables annuities, on the other hand, have two
important sources of variability. First, returns
experienced in the accumulation phase are not fixed or
known a priori, and are instead linked to the returns on
some benchmark such as the S&P 500. Second, as a
result of the uncertain nature of returns in the
accumulation phase, VAs commonly embed minimum
guarantees as already noted in the previous section.
Conceptually, then, one can imagine an elemental VA
building-block (or kernel) as consisting of a single
lump-sum premium payment at the start of a fixed-term
accumulation phase, followed by a fixed-term
annuitization, with minimum guarantees on the
withdrawal amounts.
2
Derivatives Strategy
September 28, 2011
Srini RamaswamyAC (1-212) 834-4573
Terry Belton (1-312) 325-4650
J.P. Morgan Securities LLC
In rising equity markets, VAs pose little market risk to
the insurance companies that underwrite them
policyholders premiums can be invested in the S&P
500, and returns are merely passed through to the
policyholders. However, the picture is very different in
equity bear marketsthe more equities fall, the more
binding the minimum guarantee becomes, and the
underwriter is increasingly short a fixed annuity. Thus,
insurance companies increasingly need to add duration
in periods of falling equity markets. Similarly, a fall in
long-term yields would increase the NPV of the
minimum guarantee to the policyholder, making it
more likely that the guarantee will be binding. This
implies that an underwriter of VA policies becomes
short duration as yields fall. The combination of both
these eventsfalling equities and bond yields
represents a perfect storm, and causes duration needs
from VA hedgers to rise significantly, as was the case
in 4Q08 and as has been the case recently.
Clearly, pricing variable annuities comprehensively
and accurately is an exceedingly complex undertaking,
requiring the joint modeling of long-term interest rates
as well as equities; in addition, actuarial risks
stemming from life insurance-related guarantees, and
other features make the product path dependent, adding
to the complexity.
Recognizing that our objective is not to price variable
annuities accurately, but merely to capture the trend in
their duration exposures as well as their nonlinear
relationship with equities/yields, we devise a simpler
approach. Our approximation approach is based on
three principles. First, we start with the assumption that
the duration of the VA universe may be approximated
by a weighted combination of the durations of much
simpler VA kernels. This is not unlike series
approximation techniques commonly used in
mathematics to solve difficult problems. One example
of a VA kernel is a simple product where a
policyholder pays $100 on (say) January 1, 2007,
intended to be invested in the equity market for a 15-
year (fixed) horizon, with a guaranteed withdrawal
amount of $12 per year for the subsequent 20 years;
this could be interpreted as a minimum 6% guaranteed
annual return during the accumulation phase, followed
by a minimum guaranteed 5% annual withdrawal on
the accreted principal (see Exhibit 2 for an illustration
of a VA kernel). Several VA kernels may be created by
Exhibit 2: Illustration of a hypothetical VA kernel
1/1/07: $100
Accumulation phase:
inv estment
guaranteed 6% minimun
annual return
etc...
Payoff phase: 5% annual
w ithdraw al for 20 y ears
varying the start date, the length of time of the intended
equity investment, and the minimum guarantee amount.
Effectively, we decompose the complex VA universe
as a linear combination of simpler VA kernels, each of
which is priced in a manner that captures the
nonlinearities with rates and equities.
Second, we calculate the present value of each VA
kernel by using an option pricing framework. We use
implied distributions from the swaptions market as well
as long-term S&P vols and correlation estimates to
calculate the price. We then use numerical tweaks to
calculate the partial exposure with respect to long-term
swap rates (i.e., duration). Third, we use a calibration
approach to solve for the appropriate weights on the
various VA kernels. Our calibration relies on the
anecdotally-known fact that VA risk exposures were
significant influences on long-end swap spreads in
certain periods of time, such as 4Q08; we may thus
solve for non-negative coefficients for each kernel that
maximally explain the portion of long-end swap spread
behavior not explained by other factors in those select
periods of time. In order to mitigate circularity (since
we plan to use VA duration estimates to model long-
end swap spreads), no data after 2008 has been used in
calibration, and out-of-sample performance has been
tested and found to be reasonable.
Calibration and results
As noted above, each VA kernel in our framework is
completely determined by a start date (on which the
premium is paid in full), the length of the accumulation
and payoff phases, and the details of the minimum
guarantee. In our empirical work, the kernels we
considered all had lengths of 15 years for the
accumulation phase and 20 years for the payoff phase,
with a minimum guaranteed annual withdrawal of 5%
3
Derivatives Strategy
September 28, 2011

Srini RamaswamyAC (1-212) 834-4573

Terry Belton (1-312) 325-4650
J.P. Morgan Securities LLC

of the accreted future value of the premium paid (which Exhibit 3: VA kernels initiated in high equity
is itself guaranteed based on a 6% compounded annual environments such as 2000 carry greater interest rate
return during the accumulation phase). Varying these risk than VA kernels initiated in lower equity
choices did not materially alter our empirical results, environments such as 2003
Partial delta* of VA kernels associated with origination years 2000 and 2003; $
and therefore we fix all of these parameters.
-0.00
2000
Thus, each VA kernel is specified by its start date, and -0.02 2003
we include one VA kernel for each calendar year (with
-0.04
the start date assumed to be at the beginning of the
year). This simplification also makes it easier to -0.06
develop intuition regarding the results. Notably, VA -0.08
kernels initiated in 2000 (at the peak of the stock -0.10
market, and with much less time remaining in the
-0.12
accumulation phase currently) carry greater interest
rate risk than VA kernels initiated in lower equity -0.14

environments (such as in 2003see Exhibit 3). -0.16

Similarly, for VA kernels originated in similar equity 2007 2009 2011
environments, kernels originated in higher yield * Defined as the change in price of each VA kernel for a 1-bp tweak in long-term rates. Each
environments carry greater interest rate risk than VA kernel is sized to a $1 lump-sum premium at inception.
kernels originated in lower yield environments; this is
seen in comparing the partial interest rate deltas of the Exhibit 4: while kernels originated in higher yield
kernels corresponding to origination in 2002 and 2004 environments carry greater interest rate risk than
kernels originated in lower yield environments
(Exhibit 4). Taken together, VA kernels originated in Partial delta* of VA kernels associated with origination years 2002 and 2004; $
the late nineties (such as 1997, a higher yield, lower
-0.00
equity environment) and (say) 2007 (which represents a 2002
-0.02 2004
higher equity, lower yield period) arguably represent
the two extremes in terms of VA kernels. Perhaps -0.04
unsurprisingly, as a result, our calibration approach -0.06
suggests that these two kernels suffice in order to
-0.08
adequately model the duration risk of the VA universe.
-0.10
Our calibration involves solving for the non-negative -0.12
weights on each kernel, such that the weighted sum of -0.14
kernel durations (i.e., the estimated duration of the VA
-0.16
universe, within a scale factor) maximally explains
2007 2009 2011
movements in 30-year swap spreads (together with the
10s/30s Treasury curve and 10-year swap spreads as * Defined as the change in price of each VA kernel for a 1-bp tweak in long-term rates. Each
VA kernel is sized to a $1 lump-sum premium at inception.
other factors) in selected periods of time. In other
words, we seek to find those non-negative weights that universe duration for our purposes. Last, such a
best explain the portion of movements in long-end calibration approach can only produce relative
swap spreads that are not accounted for by other drivers estimates; we separately estimate a suitable scaling that
(i.e., the general level of swap spreads and the slope of results in a true estimate for the aggregate duration of
the long end of the Treasury curve), in periods where the VA universe.
VA hedging flows are anecdotally known to have
played a significant role in driving long end swap Impact on long end spreads
spreads. As it turns out such a calibration suggests that
a weighted combination of VA kernels corresponding With respect to the impact on long-end swap spreads,
to the origination years 1997 and 2007 (16:84 three conclusions are worth highlighting currently.
weighted) produces the best estimate of the VA

4
 Derivatives Strategy
September 28, 2011

Srini RamaswamyAC (1-212) 834-4573

Terry Belton (1-312) 325-4650
J.P. Morgan Securities LLC

Exhibit 5: The aggregate duration exposure of the Exhibit 6: The sensitivity of long end swap spreads to
VA universe is now at an all-time high the duration of the VA universe has been declining
Estimated duration of the VA universe*; $bn of 20-year equivalents steadily in magnitude
Partial beta of maturity matched 30-year swap spreads with respect to VA
280 universe duration*; bp per $bn of 20-year equivalents
260 0.0
240
220 -0.2
200
180 -0.4
160
140 -0.6
120
100 -0.8

Jan 07 Dec 07 Nov 08 Nov 09 Oct 10 Sep 11

-1.0
* Estimated from a weighted combination of the deltas of all the VA kernels, which is Sep 09 Feb 10 Jul 10 Dec 10 Apr 11 Sep 11
then scaled to represent the aggregate VA universes duration in billions of 20-year
swap equivalents
* Based on rolling 2-year regressions, with the 10s/30s Treasury curve and the stock of
outstanding long end Treasuries (ex Fed purchases) as other factors.
First, as seen in Exhibit 5, the aggregate duration
exposure of the VA universe is now at an all-time high, Exhibit 7: but could modestly increase as Operation
even higher than in 4Q08. Second, the sensitivity of Twist commences, likely due to a crowding-out effect
long-end swap spreads to VA hedging needs has at the long end due to Fed purchases
De-trended partial beta* with respect to VA duration;
steadily lessened (in magnitude) over time (Exhibit 6), bp per $bn of 20-year equivalents; highlighted areas indicate QE periods
but VA duration remains an important driver of the
long end of the yield curve; this might reflect the fact -0.8
that hedgers have been steadily increasing Treasury
market allocations (whether via cash instruments, -0.9
futures, or other derivatives). Last, this broad declining
trend in the sensitivity of long-end spreads to VA
duration needs masks a more nuanced picture that -1

emerges due to Fed purchases. This is highlighted in

Exhibit 7, which looks at the same partial beta shown -1.1 QE1 QE2
in Exhibit 6 on a de-trended basis, with special focus
on the periods corresponding to the Feds Treasury
-1.2
purchases under QE1 and QE2. As can be seen, periods
when the Fed has been purchasing Treasuries have Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11
resulted in increased sensitivity of long-end spreads to * Based on rolling 2-year regressions, with the 10s/30s Treasury curve and the stock of
VA duration needs (adjusted for the broader declining outstanding long end Treasuries (ex Fed purchases) as other factors. Beta has been de-
trended over the period shown.
trend); this most likely reflects a crowding-out effect in
the Treasury market, forcing duration buyers into the cause long-end spreads to exhibit greater vulnerability
swaps market. Looking forward, although the Fed is to VA hedging needs.
not embarking upon more quantitative easing,
Operation Twist is likely to resemble prior QE periods Impact on the 10s/30s curve
in terms of its net impact on the long end, which is the
sector of most interest for insurance companies hedging Variable annuity hedging flows impact the very long
VA exposure. Thus, we would expect a crowding-out end of the Treasury curve as well. Exhibit 8 presents
effect again over the next nine months, which should our fair value model of the 10s/30s Treasury yield
curve, estimated over five years of data. As can be

5
Derivatives Strategy
September 28, 2011

Srini RamaswamyAC (1-212) 834-4573

Terry Belton (1-312) 325-4650
J.P. Morgan Securities LLC

seen, VA duration is a significant driver of the curve, in Exhibit 8: A fair value model of the 10s/30s Treasury
addition to other factors (the level of short-term curve
Treasury yields, 5Yx5Y forward inflation expectations 10s/30s Treasury yield curve (bp) fair value model
from the inflation swap market and the total amount of Variable Coefficient T-statistics
outstanding Treasury debt in the 17- to 30-year sector Intercept 114.2 17.2
of the curve). Specifically, the model suggests that a 3-year yields; % -24.2 -48.7
$50bn 20-year equivalents increase in VA duration 5yx5y inflation swap rates; % 10.8 7.3
would flatten the 10s/30s curve by around 16bp (-0.32 JPM index of variable annuity hedging
-0.32 -18.3
x 50). flows; $bn of 20-year equivalents
Treasuries outstanding with maturities
It is also worth noting that the slope of the 10s/30s 0.11 28.7
greater than 17-years; $bn
curve shows no declining sensitivity to VA duration. 5-year regression; R2 = 93.4%
Exhibit 9 shows the evolution of the partial beta of the
10s/30s curve with respect to VA duration over time. Exhibit 9: Unlike with long end swap spreads, the
As can be seen, the slope of the long end of the curve sensitivity of the slope of the 10s/30s curve to the
remains vulnerable to swings in VA duration, with no duration of the VA universe shows no declining trend
Partial beta of the 10s/30s Treasury curve with respect to VA universe duration*;
diminishing sensitivity evident (as was the case for bp per $bn of 20-year equivalents
long-end swap spreads). This is likely the result of
-0.25
growing allocations by insurance companies to
-0.30
Treasury-based hedges, whether via cash instruments
-0.35
such as bonds and long-end STRIPS or via Treasury
-0.40
futures or other derivatives.
-0.45
-0.50
Conclusions
-0.55
-0.60
In this paper, we have devised a relatively simple way
-0.65
of estimating the duration exposure of the highly
-0.70
complex variable annuity market. This is significant
-0.75
since VA duration remains a significant influence on
Mar 10 Sep 10 Mar 11 Sep 11
the slope of the long end of the curve. In addition,
although long-end swap spreads have steadily become * Based on rolling 2-year regressions, with front end yields, 5Yx5Y inflation expectations
and the outstanding stock of long-end Treasuries as other factors.
less sensitive to VA duration, the crowding-out effect
from the Feds Operation Twist is likely to cause swap
spreads to exhibit increased sensitivity to VA duration
as well, albeit not to the extent seen in 4Q08.

6
Derivatives Strategy

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