Hedging is a risk management strategy that investors use to reduce risk. It involves taking an offsetting position in a related asset, such as a futures contract or an option to offset the risk of price movements in the underlying assets.
It can be helpful to think about it as a form of insurance. When someone decides to purchase homeowners’ insurance, they are protecting themselves against the negative financial impact of an unforeseen event, such as a fire or break-in. Similarly, hedging strategies are used to reduce exposure to various investment risks, such as market risk and interest rate risk.
Using hedging to manage annuity risk
When it comes to providing guaranteed lifetime income, a strong risk management framework is essential to ensuring insurance companies are able to stay true to their promises. The insurer must manage both market and longevity risks as they are responsible for funding the guaranteed income levels if the underlying portfolio is depleted.
That is why hedging is so important. The purpose of these strategies is to provide a return to customer policies and ensure contract guarantees are met. Index-linked annuity customers do not receive investment results as returns; because their premium is not actually invested in the market, but instead they receive interest based on market indexed returns, hedging is used to provide that return. Note there are two types of hedging strategies that can be employed to protect against risks facing an investment:
- Static hedging – only rebalanced or adjusted at the contract anniversary.
- Dynamic hedging – frequent adjustments (daily or more often) as time passes and market conditions evolve.
Such strategies may either be done in-house or outsourced by purchasing an over-the-counter solution from an investment bank. Most insurance companies utilize the latter, outsourcing, approach.
At Allianz, however, we employ a dynamic hedging strategy performed in-house through Allianz Investment Management U.S. LLC (AIM US), a wholly owned subsidiary of Allianz Life Insurance Company of North America (Allianz) with a long track record of developing and executing risk management strategies across the globe. By hedging in-house, we are able to drive cost efficiency, inspire product innovation, and contribute to thought leadership strategies.
As mentioned, when an insurer uses a hedging arrangement to manage risk, it typically purchases an option strategy, or “hedge” from an investment bank. However, outsourcing hedging comes with an additional cost, which could be upwards of 30 bps. By hedging in-house, Allianz is able to avoid paying that additional cost to the investment bank, and we can then pass the savings back to our policyholders in the form of higher rates and a higher-quality bond portfolio.
With this approach, we are able to deliver higher caps (the maximum interest an annuity can earn, regardless of the change in an index) and higher participation rates (the portion of the increase in an index’s value that the insurance company credits to an annuity). And we’re able to do so without taking on more risk. In order to afford the additional cost paid to an investment bank, other insurance companies need to take on more risk in their general account. Because we don’t have that additional cost, we are able to be more conservative with our general account investments.
Inspiring product innovation
By hedging in-house, we’re also able to innovate through collaboration with other core business areas. Being under the same ownership enables us to build relationships cross-functionally with colleagues in Actuarial, Corporate Risk Management, Back Office and Accounting, and Product Innovation.
The Hedging team sits a floor away from the actuaries. That proximity leads to spontaneous interactions, which help spark new ideas and fuel innovation. It gives us a different perspective and helps us find new ways to deliver value to contract holders.
This cross-functional collaboration has led to a number of pioneering features, such as Index Lock and Increasing Income Potential. The latter is available on the Allianz Lifetime Income+® Annuity with Lifetime Income Benefit and provides contract holders with an opportunity for income increases based on market performance even after annuity accumulation value drops to $0. This increasing income feature may be provided by either built-in or optional riders at an additional cost.
Driving thought leadership strategies
The Portfolio Impact Report (PIR) engine is a tool developed by AIM US to demonstrate the probability of achieving retirement goals by using model hypothetical portfolios and 20,000 Monte Carlo simulations.
This robust analysis allows us to demonstrate the impact of an annuity on a portfolio when things go to plan and when things don’t go to plan. We can compare the performance of a hypothetical portfolio with an annuity to one without and see how these play out in a number of scenarios.
While not intended to be a financial planning tool, the PIR engine can improve understanding of annuities and the value they offer by illustrating the quantitative impact one may have on a retirement portfolio. It’s also assumption agnostic, so when starting a new report, we don’t need to use the assumptions that Allianz uses – we can use your assumptions.
Using reasonable assumptions, we generally see that an annuity has a positive effect on portfolio outcomes. For instance, the latest white paper from our Employer Markets team displays how the Allianz Lifetime Income+® Annuity can quantitatively improve outcomes in a number of scenarios for a diverse range of plan participants.
What makes our hedging activities unique?
While hedging in-house helps power the benefits outlined above, what makes our approach unique is our experienced team, the ecosystem we have built, volatility control indices, and our liability absorption.
Our highly skilled team is composed of 30 employees, including 21 with advanced degrees, and is structured like an investment bank with a strategy team of high-powered mathematicians, a systems team to implement mathematical models, portfolio managers who use models to identify trades, and traders who execute the derivate trades.
Members of the AIM US team are not only experienced risk professionals, but they also bring a range of transversal skill sets – they’re also computer programmers and software developers. These cross-functional skill sets are key, as all of the software used by the team is created in-house.
Because no one can predict the future, the ability to quickly react to changes in the market can be important. The experienced team and robust technology behind our hedging strategies enables us to evaluate the impact of market movements and manage assets in a way that helps us guarantee our promises to our contract holders.
Request a custom portfolio impact report.