Head of structuring within equities Wojciech Nabialek says the products are extremely challenging to hedge and he believes that creat- ing derivatives of this complexity is outside the core expertise of insurers.
Risks include longevity, the performance of the equ- ity markets and the inter- action between these two factors. There is also the lapse risk of clients leaving pol- icies before they have effectively paid for the guarantee.
Nabialek says: “Some of the risks are really tricky to price and hedge out so ins- urers are increasingly call- ing on investment banks before launching the product to help them in design- ing and pricing the guarantees. When it comes to hedging, the insurers are basically left with three options.”
He says that life companies could create their own derivatives trading unit but suggests “this is not exactly within their core business or experience”.
An alternative approach is to transfer the risks to a reinsurer but Nabialek says life offices would have to sacrifice most of the revenue by doing this.
Finally, he says they can partner with an investment bank to hedge the financial risks and keep some of the actuarial risk.
He says: “This last app-roach offers potentially both great flexibility and good value when implemented correctly. It makes sense for insurers to outsource the risks to investment banks.”
Aegon says it can hedge guarantees on third-way products in house due to its expertise in the US market.
Standard Life head of pension policy John Lawson says: “Insurers with exper- ience in other mature markets such as the US might be willing to create the derivatives in house. We will rely on some outside expertise as it is a new activity for us.”