1. 2009 General Meeting ● Assemblée générale 2009 Ottawa, Ontario ● Ottawa (Ontario) 2009 General Meeting ● Assemblée générale 2009 Ottawa, Ontario ● Ottawa (Ontario) Canadian Institute of Actuaries Canadian Institute of Actuaries L’Institut canadien des actuaires L’Institut canadien des actuaires Session/séance : Hedging Variable Annuities/ Segregated Fund Products Speaker(s)/conférencier(s) : Pierre Le Pape, Société Générale

2. Agenda Standard VA Products in Canada Standard Dynamic Hedging Program Most Common Practices Focus on Variance Swaps Focus on Put Spread Collars Beyond the Standard Dynamic Hedging Delegate Risks Management Static Hedges Partner with an expert in Risk Management 2009 General Meeting Assemblée générale 2009 2009 General Meeting Assemblée générale 2009

3. Standard VA Products in Canada Widespread VA product: GMWB for Life with Annual reset Withdrawal rate at 5% p.a. (after 60) Very significant sensitivity to actuarial assumption Insurance liabilities models include a dynamic lapse rate and utilization rates 2009 General Meeting Assemblée générale 2009 2009 General Meeting Assemblée générale 2009

4. Standard VA Products in Canada These exotic liabilities have: Very significant actuarial assumption lapse and utilization rate 2009 General Meeting Assemblée générale 2009 2009 General Meeting Assemblée générale 2009 Observations: –Vega will depend on the interest rate level –As interest rates decline, a dynamic hedger has to buy more Vega to stay neutral Source: SG Analytics Large market sensitivities and exotic cross-greek impact If spot drops adjust interest rate hedge If interest rate drops adjust vega hedge Vega of a GMWB vs. Changes on the Interest Rate and Spot

5. Standard Dynamic Hedging Program Requirements Experienced team Traders Analysts Back-Office Risk managers IT infrastructure Booking, P&L analysis and trading systems Risk analysis systems (stress-tests, etc) Computation power 2009 General Meeting Assemblée générale 2009 2009 General Meeting Assemblée générale 2009

6. Standard Dynamic Hedging Program Most Common Practices Delta/ Rho Hedging Equity futures or swaps, adjusted periodically Interest rate futures or IRS Cost of hedging hard to forecast Hedging cost not comparable to market price of liabilities on any specific year 3- Greek Dynamic Hedging Hedge interest rate exposure with interest rate swaps and swaptions Purchase up to15-year put options Variance Swaps on major indices to hedge vega exposure Put spread collars to hedge stress test scenario 2009 General Meeting Assemblée générale 2009 2009 General Meeting Assemblée générale 2009 CURRENTLY MASSIVELY TRADED

7. Standard Dynamic Hedging Program Most Common Practices Advanced Dynamic Hedging Use of additional derivatives instruments such as lookback, options on basket, hybrid options, Future development: options linked to variance 2009 General Meeting Assemblée générale 2009 2009 General Meeting Assemblée générale 2009 FAIRLY NEWLY TRADED

8. Standard Dynamic Hedging Program Most Common Practices – Focus on Variance Swaps Policyholders have struck their riders at different time/spot and with different notionals Actuarial assumptions tend to accentuate and flatten the distribution of Vega over all spots Variance Swaps can be added to Puts to better match VA riders’ vega profile 2009 General Meeting Assemblée générale 2009 2009 General Meeting Assemblée générale 2009 No specific strike Vega hedging (flat profile) No rho component VAR SWAPS Fixed strike Vega hedging (convex profile) Rho component PUTS

9. Standard Dynamic Hedging Program Most Common Practices – Focus on Put Spread Collar Rationale: Zero-cost solution: limited downside protection vs. limited upside Perfect hedging solution if you expect the underlying to stay within a range Advantages: STAT/ capital constraints in an environment of high volatility 2009 General Meeting Assemblée générale 2009 2009 General Meeting Assemblée générale 2009 10070130 Massive trading flattens the ST skew (trades of 1 or 2 years) Puts ITM = benefits capped at 30% of underlying 1 1 Put ITM = benefits from protection 2 Puts and Call OTM = no payout 3 Call ITM = loss above 130% of underlying 4 23 4

10. Standard Dynamic Hedging Program Most Common Practices – Focus on Advanced Dynamic Hedging Because of features such as Ratchet and cross greek sensitivities, insurance companies have traded more comprehensive options: Lookback options Correlation vega/ interest rates Correlation equity/ interest rates 2009 General Meeting Assemblée générale 2009 2009 General Meeting Assemblée générale 2009 Max [ Equity Max on observations - Equity Final, 0 ] Equity Put x Interest Rate Put Spread Max [ Constant - Interest Rate – Equity, 0 ]

11. Standard Dynamic Hedging Program Most Common Practices – Pros & Cons 2009 General Meeting Assemblée générale 2009 2009 General Meeting Assemblée générale 2009 PROs  Flexibility  Rebalancing  Adjustment stress test consumption  Tracking error  Liquidity  Tight quotes under normal market conditions  No market lock  Listed Options allow for no counterparty risks CONs  Rebalancing Options, Future Costs  Model risk  Infrastructure needed  Not possible to Hedge in advance (pre hedge a block )  Expensive in volatile markets How to improve this? Beyond the Standard Dynamic Hedging Program Vs

12. Beyond the Standard Dynamic Hedging Delegate Risk Management 2009 General Meeting Assemblée générale 2009 2009 General Meeting Assemblée générale 2009 For insurance companies whose core business is not to manage the market risk of the VA books Delegate risk management to an asset manager Experienced team IT infrastructure Model Valuation etc ISSUES Need for experts in Risk Management to handle liabilities risks Alternative 1 COST RISK However some residual risks remain Policyholder Behavior Mortality Improvement Evolution of transaction costs

13. Beyond the Standard Dynamic Hedging Get rid of the Risks – Static Hedge 2009 General Meeting Assemblée générale 2009 2009 General Meeting Assemblée générale 2009 Full Reinsurance (when available) To outsource all risks (only counterparty risk remains) To clean your Balance Sheet Macro Hedge To diversify your risk management scheme To clean your Balance Sheet Alternative 2 MACRO HEDGE: a capital market swap matching the liabilities cash-flows Based on the insurance company’s liability model Incorporating dynamic policy holders’ behaviors Usually grouped by cells Risk transfer can be customized to exclude some sensitivities, such as long-term equity volatility The BEST Static Hedge

14. Beyond the Standard Dynamic Hedging Get rid of the Risks – Static Hedge 2009 General Meeting Assemblée générale 2009 2009 General Meeting Assemblée générale 2009 PROs  Market risk Allows to get rid of market model and Operational risks  Greeks Main and second order Greeks Can customize the Greeks hedged and the risk retained by the insurance company  Less IT development needed CONs  Difficulty to adjust for changes in the asset portfolio  Initial Transaction Cost A real improvement from the Standard Dynamic Hedging Programs when combined with an Overlay Hedge Vs Alternative 2

15. Beyond the Standard Dynamic Hedging Partner with a Product Designer 2009 General Meeting Assemblée générale 2009 2009 General Meeting Assemblée générale 2009 Design of the VA product can: Reduce the embedded market sensitivity Reduce the embedded actuarial sensitivity Source some illiquid assets Reduced guarantees strength Increased fees Recent trends in the industry : Decreasing product attractiveness Do no remove main inefficiencies Result: Alternative 3 VARIABLES Fee structure Underlying fund Guarantee definition

16. Beyond the Standard Dynamic Hedging Partner with a Product Designer - Features 2009 General Meeting Assemblée générale 2009 2009 General Meeting Assemblée générale 2009 Volatility Target Mechanism on the Asset Allocation This solution has been used for years to write options on esoteric assets Allows for flexibility for the manager of the portfolio Acts as an efficient risk management tool during crises Concept: the leverage to the Asset Allocation is determined to keep a constant volatility model This mechanism benefits the client as well as a way of mitigating volatility risk < Volatility Target = Volatility Target > Volatility Target Leveraged exposure (Up to 150%) to the Asset Allocation Less than 100% exposure to the Asset Allocation 100% exposure to the Asset Allocation 100% If Historical Volatility is: Alternative 3 Investment in money- market

17. Beyond the Standard Dynamic Hedging Partner with a Product Designer - Features 2009 General Meeting Assemblée générale 2009 2009 General Meeting Assemblée générale 2009 The Volatility Target Mechanism can include a transition from equity to bond and money-market Transition can be customized depending on marketing needs Local volatility almost predictable (the vol of the vol is quite low) Liabilities are sensitive to the volatility of long- term forward rather than spot Basis risk can be increased or the management of the policies can be made more complex Depending on the local regulation, this risk can be eliminated Alternative 3 HOWEVER

18. Beyond the Standard Dynamic Hedging Partner with a Product Designer - Features 2009 General Meeting Assemblée générale 2009 2009 General Meeting Assemblée générale 2009 Other features to improve risk management while keeping the marketing power of the product include: Important factors to keep in mind while designing a VA product Alternative 3 May depend on the volatility May have an interest rate or equity component Fees Guarantees Cost control Market Risk Management Marketing

19. OVERVIEW Insurance Companies Today Demographic trends ensure a continuous VA market Only insurance companies have the ability to offer such products To maintain a sustainable activity in this market, insurance companies should adjust the design of the product to be: Manageable Marketable 2009 General Meeting Assemblée générale 2009