Session 5a – Downside Risk Management in Investment

Andrew D. Rallis, FSA, MAAA

9/7/2016

Downside Risk Management in Investment

Andy Rallis (罗安迪) , FSA, MAAA Executive Vice President & Global Chief Actuary, MetLife Inc.2016.9.1

Agenda

§ Global Market§ Regulatory Environment§ General Account Risk Management§ Risk Management In Low/Negative Interest Rate

Environment § Separate Account Risk Management

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Global Market

l Slow Global Growthl Deleveraging After Financial Crisis

l Aging Population

l Shrinking World Trade

l Global Deflationary Pressure

Data Source: World Bank

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Global Marketl Low Interest Rates

l Central Bank Monetary Policies

l Persistent Period Of Low/Negative Rates

l Negative Rates in Japan and Europe

l BOJ Proved Policy No Longer Effective

l Currency War – Race To The Bottom

l Still In The Downward Channel

l Except for China, which also face downward pressure

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Global Market

Data Source: World Bank

l Volatile Equity Marketl U.S. Market At All-time High

l Strong Global Rally After Brexit Vote

l Late In The Cycle?

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Agenda

üGlobal Market§ Regulatory Environment§ General Account Risk Management§ Risk Management in Low/Negative Interest Rate

Environment § Separate account risk management

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Systemic Importance of Insurers in the US• FSOC (Financial Stability Oversight Council)

• Authority Under Dodd-frank• Bank SIFIs(Systemically Important Financial Institutions)• AIG, Prudential(U.S.)• Metlife’s SIFI Designation Was Temporarily Rescinded, FSOC Appealing

• Assessment Based On :• Existing Regulatory Scrutiny• Size• Interconnectedness• Substitutability• Leverage• Liquidity Risk And Maturity Mismatch

• Implications :• Supervision By Federal Reserve; Stress Tests; Early Remediation; Counterparty Credit Limits• Resolution Plans• Higher Capital (TBD)

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Systemic Importance of Insurers Globally• Financial Stability Board (FSB) And International Association Of Insurance Supervisors (IAIS)

• Nov 2010 : G20 Leaders Endorse FSB Report On G- sifis• May 2012 : IAIS Develops Assessment Methodology For G- siis• July 2013 : First Designations Of G- siis• 2014 : Backstop Capital Requirement To Be Developed By IAIS

• Assessment Based On :• Size• Global Activity• Interconnectedness• Non-traditional Insurance And Non-insurance Activities• Substitutability

• Implications :• Enhanced Supervision• Effective Resolution• Loss Absorption• Higher Loss Absorption Capacity

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Systemic Risk• Systemic Risks: The Risk Of Collapse For An Entire Financial System Or Market. • Separate Account Products Themselves Do Not Pose Systemic Risk To Market:

• Policyholder Interest Not Affected By Losses In Insurer’s General Account Or Regulatory Action

• No Liquidity/Credit Pressure From Policyholder Redemption For Insurers In Stress Market• Insurers Experience Lower Lapse When Guarantees Become More Valuable In Stressed Markets

• Downside Risk Management Brings Downward Pressure In Stressed Market• Risk Managed Funds And Downside Protected Funds Have Built-in Mechanism Of Rebalancing Out Of Risky

Assets When Market Drops

• Hedging Needs To Add More Shorts (Through Derivatives) When Market Slumps

• Annual National Association Of Insurance Commissioners’ (NAIC) Surveys And Various Investment Bank Derivative Market Reports Show That The Total U.S. Insurance Industry Derivative Positions Represent Less Than 1% Of Total Volumes Worldwide.

• Systemic Risk Management• Prudent Use Of Derivatives In Hedging: Hedging Using The Most Liquid Exchange-traded (Cleared) And Over

The Counter (OTC) Derivative Instruments

• Corporate Risk Management Framework – Trading With Only Strong And Credible Counterparties

• Monitoring: NAIC And Investment Banks Monitor The Volumes Of Various Non-traditional Funds And Derivatives And Their Potential Impact To The Global Market

• Macro Hedging: Using Short Dated Options For Gap Risk Management

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Risk Based Capital C3 Phase 1 Calculation• Using CFT Models, Capture The Present Value Of Statutory Surplus Result For Every

Scenario For Each Calendar Year-end Of The Testing Period.

• The Goal Is To Obtain The 95 th Percentile Of C3 Risk Approximated By Running A Set Of 50 Scenarios That Represent The Tail Scenarios Of A Set Of 200

• For Each Scenario, The C-3 Measure Is The Greatest Negative Of The Series Of Present Values

• 13 Of The Worst Scenarios Are Weighted Accordingly To Obtain The 95 th Percentile

• Discount Rate Is Set Equal To 65% Of 105% Of The Scenario Specific 1 Year Treasury.

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RBC C3 Phase I Interest Rate Scenarios

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Weights of the 13 scenarios

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RBC C3 Phase I Interest Rate Scenarios

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Segmented Regulation in Chinal The Exchange Bond Market And The Inter-bank Market Are Primarily Regulated By CSRC And Pboc

l Enterprise Bonds Are Mainly Subject To The Approval And Regulation By NDRC

l In Addition, China's Bond Market Is Also Regulated By CBRC, CIRC, The Ministry Of Finance ( Mof) And SAFE, That Are Responsible For Regulating Their Affiliates And Related Business Sectors

l The Same Type Of Bond Products May Be Subject To The Regulation Of Multiple Government Regulators

Regulatory framework of the domestic bond market

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Agenda

üGlobal MarketüRegulatory Environment§ General Account Risk Management§ Risk Management In Low/Negative Interest Rate

Environment § Separate Account Risk Management

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General Account Liabilities

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How Do We Value Liabilities?

• Statutory

• Emphasis Is On Solvency

• GAAP

• Emphasis Is On Comparability

• Economic

• Emphasis On Market Value Of Risk

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Hedging Needs Vary by Product• Minimum Interest Rate Guarantees and Book Value Surrender Option

• indeterminate elements• implicit guarantees : Whole Life, Long Term Care • explicit guarantees : Deferred Annuities, Universal Life

• Variable Annuity Guarantees• GMxBs : Death, Accumulation, Income, Withdrawal

• Long Duration Liabilities• Payout Annuities• Universal Life with Secondary Guarantees

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Hedging Minimum Interest Rate Guarantees and Book Value

Surrender Option

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Minimum Interest Guarantees

The Risk Of A Long Term Decline In Interest Rates To A Level Near Or Below The Minimum Contractual Guaranteed Credited Rate

• Explicit Contractual Minimum Interest Guarantee

• Statutory Nonforfeiture Requirements

• Potential Earnings Impairment

• Potential High Level Of Economic Capital

• Examples

• Deferred Annuity

• Universal Life

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Minimum Interest Guarantees : Approaches

• Update Guarantees For New Products

• Limit Deposits

• Extend Duration

• Purchase Interest Rate Floors

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Book Value Surrender

The Risk Of Rapidly Increasing Interest Rates And Resulting Impact On Policyholder Behavior

• Examples:• Deferred Annuities• Retained Asset Accounts• Universal Life• Traditional Whole Life

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Book Value Surrender : Approaches

• Impose Surrender Penalties• Reduce Duration

• Purchase Interest Rate Caps

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Long Tailed Liabilities• Liability Cash Flows Extend To Maturities Greater Than Available Asset Cash Flows

• Reinvestment Risk Depends On Receipt Of Future Premiums And/Or Asset Availability

• No Or Limited Ability To Reset Rates

• Examples:• Structured Settlements• Long-term Care• Universal Life With Secondary Guarantees

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• Adjust Premiums• Extend Duration• Limit Pre-payable Assets• Consider Funding With Equity

• Engage In Interest Rate Swaps

Long Tailed Liabilities : Approaches

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MetLife Derivative Usage

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Agenda

üGlobal MarketüRegulatory EnvironmentüGeneral Account Risk Management§ Risk Management In Low/Negative Interest Rate

Environment § Separate Account Risk Management

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Low/Negative Rate Environment• Artificially Sustained Low Interest Rate Environment After 2008 Financial Crisis

• Central Bank Policies To Stimulate The Economy, Improve Employment, And Increase Inflation• Put Unusual Pressure On Insurers’ Financial Condition, Straining Their Ability To Be Profitable

• Impacts Life Company’s Earnings, Liquidity, Strategy, And Operation• A Major Threat To Life Companies’ Rate-sensitive Products And Investments

• Lower Earnings: • Lower Investment Returns, Higher Capital And Reserves• Asset & Liability Mismatch• May Be Insufficient To Meet Guarantees

• May Tighten Liquidity • Cash Flow Mismatch – Loss From Asset Sale To Meet Liability Cash Flow Needs• Low Lapse Reduce This Risk

• Change Strategies• Product And Crediting Strategies – Reduce Sales, Premium Income• Investment And Hedging Strategies – Higher Cost, Potential Risk Profile Change

• Operation• Risk Models Fail With Negative Rates

High Low

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Interest Rate Risk Management• Product And Crediting Strategies

• Diversify Product Portfolio To Reduce Interest Rate Sensitivity• Offering Rate-sensitive And Non-rate-sensitive Products

• Discontinue Interest Rate Sensitive Products

• Raise Price/Fee Rates For New Products

• Reduce Crediting And Guarantee Rate

• All Will Reduce Sales And Premium Income

• Investment And Hedging Strategies• Investing In Higher Yield Instruments?

• Could Mean Higher Risks, From Other Markets (E.G. Foreign, High Yield, Equity, Housing, Commodity)

• Increasing The Duration Of Assets• Better Asset And Liability Matching

• Reduce Future Reinvestment Risk

• Could cause liquidity risk

• Hedging Using Derivatives• Locking In Higher Rates

• Swaps, Futures, Floors, Swaptions

• Higher Cost of Running Business

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Agenda

üGlobal MarketüRegulatory EnvironmentüGeneral Account Risk ManagementüRisk Management In Low/Negative Interest Rate

Environment § Separate Account Risk Management

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Separate Account Liabilitiesl Products

Variable Annuities And Variable Life Contracts, Often With Guaranteed Minimum Benefits

l Guaranteed Benefit Types And Featureso Guaranteed Benefit Types:

o Living Benefits:

o Guaranteed Minimum Withdrawal Benefit (GMWB, GMWBL)

o Guaranteed Minimum Income Benefit (GMIB)

o Guaranteed Minimum Accumulation Benefit (GMAB)

o Death Benefit: Guaranteed Minimum Death Benefit (GMDB)

o Guaranteed Benefit Features:o Return Of Premium

o Ratchet

o Roll-up

o Combinations Of Above

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Risk Management Considerationsl Statutory Solvencyl Economic Value And Profit & Lossl GAAP Reserve And Income Volatilityl Risk Profile Matters:

• Diversification Offsets• Managing Total Company Interest Rate Risk • C3 Phase II -> C1 Equity Component For Covariance Offset

• Impact Various By Legal Entity• Internal Economic Capital Formulas

l Risks: l Market Riskl Actuarial Riskl Credit Riskl Operational Riskl Systemic Risk

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Market Risk Factors• Delta: Sensitivity Of Economic Value To Equity Or Exchange Rate Level Movements ( Fx)

• Rho: Sensitivity Of Economic Value To Interest Rate Movements

• Vega: Sensitivity Of Economic Value To Equity, Interest Rate, Or Fx Volatility Movements

• Gamma: Sensitivity Of Delta To Equity Or Exchange Rate Level Movements ( Fx)

• Convexity: Sensitivity Of Rho To Interest Rate Movements

• Cross Greeks: Sensitivity Of Economic Value To Simultaneous Movements In Equity, And/Or Interest Rate, And/or Volatility

• Higher Correlation In Stressed Market

• Can Have Significant Impacts On Liability Value And Greeks In Stressed Market

• Liquidity: The Degree A Security Can Be Quickly Bought Or Sold In The Market Without Affecting The Asset's Price.

• Higher Transaction Cost In Stressed Market

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Economic Value of GMxB (illustrative only)

PV Fees = $294.4m-

PV Claims = $243.8m

Economic Value = $50.6m

“Risk-neutral” capital market assumptions

Equivalent to 41bp out of 50bp

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Sensitivity of Economic Value to Shock to Equity Level

+20% 128.3

+10% 91.1

+5% 71.3

+1% 54.8

0% $50.6m $4.2m $420m

-1% 46.4

-5% 29.1

-10% 6.7

-20% -41.2

A $420m short equity position will offset the sensitivity of the Economic Value of the GMxB

$4.2m is the “dollar delta”

Equity EV

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Risk Management – Product Managementl Product Design

o Design Less Risky Products And Charge Appropriate Fees

o Conservative Roll-up Rates, Withdrawal Rates, And Annuitization Rates

o Guarantees Link To Interest Rate, Withdrawal Rates Link To Account Value

o Fees Link To Risks

o Offer Offsetting Features And Offsetting Products

o Living Benefit + Death Benefit

o Variable Annuity (Downside Risks) + Fixed/Structured Indexed Annuity (Upside Risks)

o Provide Easy To Hedge Product Features

o No Exotic Optionality

l Product Managemento Tender Offer To Buy Back Old/Risky Riders

o Revise The Products With Less Risky Features

o Stop Selling Block Of Business

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Risk Management – Underlying Fundl Asset Allocation Restrictions To Equity

l Fund Offering:o Index Funds: Easy To Hedge, Reduce Basis Risk In Hedging

o Risk Controlled Funds:

o Volatility Controlled Funds, Risk Parity Funds, Etc

o Reduce The Need Of Hedging For Certain Risk Factors

o Downside Protected Funds:

o CPPI Funds

o Reduce The Need Of Hedging For Most Risk Factors

o Limited Upside Performance In Low Interest Rate Environment

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Risk Management – Reinsurancel Full Reinsurance That Covers Market And Actuarial Risks

o The Best Risk Management Method - No Basis Risks

o Limited Availability In Market

o Expensive

l Financial Reinsurance That Covers Market Risks Only:o Alternative To Internal Hedging, Still Need To Manage Actuarial Risks

o Benefit In GAAP Accounting

o May Hurt In Statutory Accounting

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Risk Management – Hedgingl Dynamic Hedging

o Purpose Is Usually To Cover Future Economic Claims And Reduce Earnings Volatility

o Hedge Market Risk Factors Explicitly: Delta, Vega, Rho, Etc

o Need To Quantify The Liabilities, Trade The Capital Market, And Measure The Performance Relatively Frequently

o Need Complex Structures, Procedures And Tight Controls

l Tail Hedging:o Solvency, Macro Economic, Event

o Usually Engage Short Options For Gap Protection

o Market Slump, Systemic Risks

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Hedging: Hedge InstrumentsProduct Covered Risk Covered Cost Advantages Disadvantages

Equity Futures • Equity• Negligible Upfront,

Embedded carry cost, Quarter roll cost

• Low Upfront Cost, Liquid, Exchange traded

• No counterparty risk

• Frequent Rebalancing, High market volatility results in high cost and breakage

Treasury Futures • Interest Rate

• Negligible Upfront, Embedded carry cost, Quarter roll cost

• Low Upfront Cost, Liquid, Exchange traded

• No counterparty risk

• Same, plus basis risk with liability which is valued using swap rates

EquityInterest Rate

Options

• Equity & Interest Rate, Equity & IR Volatility

• High upfront or over time

• No frequent rebalancing needed, better liability match in high volatility environment

• High upfront cost, may change in future, counterparty risk

Interest RateEquity Variance

Swaps• Equity&

IR Volatility• No upfront• Carry emerges over

time

• Unbundled Vega exposure, usually better value than equity options, liquid

• High cost, counterparty risk

Interest RateTotal Rate of

Return Swaps• Interest Rate &

Equity

• Bid/ask per tenor and type

• Carry emerges over time

• Liquid, Low cost, IRS matches liability valuation

• using swap rates

• Rho exposure on TROR

• Counterparty risk

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Hedging: Frameworkl Define Objective Of Hedging – Accounting Matters

l Economic? Statutory Solvency? Gaap?

l Define Hedge Guideline:• Strategy:

• Delta, Rho, Vega, Gamma, Convexity…• Dynamic, Dynamic + Static, Dynamic + Static + Tail…

• Risk Appetite• Tolerance Range• Rebalancing Frequency• Cost Considerations

• Allowable Instruments: • Depends On Strategy• Availability In Market• Consider Liquidity

l Get Approval From Corporate Risk Committee

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Hedging: Framework (2)l Build Hedging Infrastructure:

• Software, Model • Hardware

l Build Routines For Hedging :• Quantification Of Liability Value And Risk Greeks, Provide To Trading Team• Trading Team Monitors The Markets, Evaluates The Need For Rebalancing, And Take Action

When Necessary• Performance Measurement, Monitoring, And Reporting• Clear Cut Of Roles And Responsibilities• Transparency• Controls And Communications

l Periodic Review And Feedback, And Possible Guideline Change• Periodic Performance Review, Cost/Benefit Review, Internal/External Environment Review And

Feedback• Possibly Revise Hedge Objective Or Hedge Guideline Based On The Reviews And Changing

Environment

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Managing Market Risks Through Hedge Programs

• Statutory– Minimization Of Capital

Requirements– Capital Call Probability

• Gaap– SOP 03-1 (Actuarial)– FAS 157 (Mark-to-market)

• Economic

• Tolerances Around Hedged Risk Factors

• Rebalancing Frequency

• Basis Risk

• Selection Of Risk Factors– Delta (Equity Level)– Rho (Interest Rates)– Vega (Equity Volatility)

• Selection Of Instruments– Liquid: Futures And Swaps– Less Liquid: Options And

Swaptions

Primary Importance

Sets Overall Targets For Risk Reduction

Secondary Importance

Affects Cost Efficiency And Effectiveness In Optimizing Regulatory Calculations

Tertiary Importance (Assumes Basis Risk In Nominal Amounts)

Mostly For “Beauty Pageants”

Tactics Of The HedgeInstruments And Risk Factors

Quality Of The HedgeTolerances And Basis Risk

Objectives Of The HedgeAccounting Trade-offs

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Software and Hardware• Scale Matters

• Sophisticated Hardware And Software

• Key Personnel

• Model Calibration

• Software• Model: Risk Free Vs. Real World, Depending On The Hedge Objective

• Consistency Of Hedge And Reserve Calculations

• Nested Stochastics

• Hardware• Test Vs Production Environment

• Cloud Computing

• Speed Of Execution• Distributed Processing

• GPU Technology

• Connectivity

• Security

• Support

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Communication and Transparency• Communication Matters

• Internal Constituents• Boards Of Directors• Executive Group• Risk Management• Treasury And Valuation• Auditing

• External Constituents• Regulators• Rating Agencies

• Transparency Matters• Stakeholders’ Sophistication• Continuity• Complexity

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Hedging Program – Roles and Responsibilities

A/LM Unit : Project Management

Scope, Implementation, Monitoring

Investments

Hedging, VA General Account

Product Management

Product / Business Specifications

New Funds, Monitor Policyholder Experience

Reinsurance

State Filings, Impact on Captive

Accounting

Overall Accounting Treatment

Operational Accounting

Margin Account Maintenance

Information Technology

Project Management

Software Maintenance (third party)

Hardware

Treasury

Cash & Capital Management

Corporate Risk Management/Auditing

Program Oversight

Enterprise Risk Management Impact

Internal and External Auditing

Line of Business Finance

GAAP & STAT Financials

Corporate Actuarial

Statutory. & GAAP Reserves, DAC, Statutory RBC

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