Does Hedging really work?
A number of large VA providers have active Equity Hedge programs in place for risk management against adverse effects of stock market fluctuations. after the last 18 months of craziness in the stock market, maybe this is the perfect time to examine the cost and effectiveness of hedging programs?
One of the best know practitioner of hedging theory is Ken Mungan of the Milliman Financial Risk management practice based in Chicago. Ken estimates the Insurance industry was able to conserve tens of billions of dollars in capital through the effective use of Hedges in support of guaranteed minimum payments incorporated in Variable Annuities. For the direct quote from Ken, see my upcoming article in the spring issue of Windows in Financial Services.for more info see:
On the other hand, Chris Brown, at that time, director of advanced technology at the Hartford has been quoted in the press stating that the cost of a Effective Hedging program was 23 basis points. I can only assume this includes the instruments and the computer infrastructure required to implement the program.
These two numbers are far from correlated, but give us the basis ( pardon the pun ) to estimate the worth of hedging programs.
From 2002 - 2006 almost 680 billion dollars in variable annuities were sold worldwide (1). 23 basis points on these funds over the past year was approximately 1.55 Billion dollars. If this investment produced a capital savings in excess of 10's of billions of dollars it seems like a pretty good investment to me, even in the case where returns ( for correspondingly lower costs ) in the preceding 5 years were zero.
(1) The ITT Insurance Fact Book, P 20 , Individual Annuity consideration 2002-2006