Part III

Hedging Programs
in a Turbulent Market
May 21 2008
Peter Sun, CFA, FSA, MAAA
Milliman, Inc

Agenda
1. Overview of Capital Market Conditions
2. Analysis of Hedging Program Performances
3. Illustrative Hedging Effectiveness Example
4. Conclusion and Discussion
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3
Overview of Capital Market Conditions

We Have Experienced a Tough Time!
• “Subprime” was the word of the year for 2007!
High profile write-downs at well known financial institutions
The crisis is global in nature – US, Europe, Asia
The crisis of confidence started with subprime and expanded to credit
products and their liquidity
The crisis is characterized by
- Equity market drop
- Reduction of interest rates
- Sudden increase of both realized and implied volatility
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Volatility is the Key
15 separate days since July of 2007 when the daily volatility falls in
the 2% tail of the highest volatility days the U.S. has experienced
since going off of the gold standard
Weekly realized volatility is not extreme
US government intervention and foreign infusion of capital has
prevented the market from a melt down
The past several months is far from dooms-day scenarios
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S&P 500 Volatility
S&P Weekly Realized Volatility
Annualized Realized Volatility
40.00%
35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
Experienced volatility has been low in the past 5 years.
0.00%
4/1998 4/1999 4/2000 4/2001 4/2002 4/2003 4/2004 4/2005 4/2006 4/2007 4/2008
The low volatilities experienced in the past 5 years make the recent market conditions appear
severe
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7
Analysis of Hedging Program Performances

Good News: Hedging Programs have Generally
Performed as Anticipated
Most well designed hedging programs have to withstand much more
severe scenarios
– September 11 th
– Black Monday
– Japan bubble burst
– Other stress scenarios
The turbulence experienced in the past several months is severe, but
not nearly as extreme as the stress scenarios
Hedging will never be perfect, but they have been generally effective
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Profile of Survey Participants
16 respondents in the US, Europe and Asia
Direct writers and reinsurers
Over $468 billion of asset under management
Most have foreign exposure
Respondent Size
Under $1 billion
18%
$1 to 10 billion
12%
Above $10 billion
68%
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Hedge Program Objective
Hedge programs could have conflicting objectives
Selection of hedge program objectives reflects management risk
preference and appetite
Trade-off of objectives are often needed
Most respondents do not plan to change hedge objectives
There is a movement towards fair value hedge objectives
Distrubtion of Hedge Objectives
source: Milliman survey
Combination
25%
Statutory cash
value 6.25%
Economical
37.5%
IFRS 6.25%
US GAAP 25%
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Hedge Strategies
Almost all use a dynamic hedging strategy
More sophisticated companies opportunistically use a combination of
strategies
Almost all companies incorporate a delta hedging strategy.
Some also layer on rho and vega hedging strategies
69% of respondents do not hedge all exposures
Combination 25%
Distribution of Hedge Strategies
source: Milliman survery
VAR 6.25%
Static 6.25%
Dynamic 62.5%
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Hedge Performance
Most hedge programs performed as expected
88% of respondents experiencing gains or unanticipated losses of
less than 10 basis points (bps) of account value
Only 2 respondents have unanticipated loss of over 30bps of AV
Results are comforting and not surprising given the capital market
experience
Loss between 30
and 40bps of AV
6%
Loss less than
10bps of AV 18%
Loss more than
50bps of AV 6%
Gain 12%
No gain or loss 56%
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Hedge Performance
Reasons for positive deviation are mostly due to positive basis
mismatch
Reasons for negative deviation are varied
– Basis mismatch
– Realized volatility
– Cross-Greek movements
– Operational hedging issues due to increased cost of OTC hedging
instruments or lack of capacity
Most hedge programs did not experience operational issues
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– There is report of structured derivatives becoming less available

Future Directions
Most respondents expect the recent market down turn to negatively
impact VA sale
– The availability of guarantees are expected to reduce the impact
– Some respondents even expect increased sales due to the guarantees
Operational efficiency improvement
– Enhanced vega/rho hedging
– Increased frequency of in-force updates
– Expansion of hedging coverage
– Reductions in derivative execution costs through increased use of
exchange-traded instruments
– Better fund selection process
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Illustrative Hedging Effectiveness Example
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Description of Block
$ 1 billion of GMWB
Projected over the past 8-month market conditions
Fair value accounting under US FAS133
Hedging strategies tested
– No hedging
– Delta
– Delta, rho
– Delta, rho, and vega
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Delta Only Hedging
$15,000,000
Hedge Program Net P&L - No Hedging vs. Delta Hedging
$10,000,000
$5,000,000
$-
7/13/07
7/27/07
8/10/07
8/24/07
9/7/07
9/21/07
10/5/07
10/19/07
11/2/07
11/16/07
11/30/07
12/14/07
12/28/07
1/11/08
1/25/08
2/8/08
2/22/08
3/7/08
P&L
$(5,000,000)
$(10,000,000)
$(15,000,000)
No Hedging Delta
It is clear the reduction in P&L volatility is quite limited.
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3/7/08
2/22/08
Delta/Rho Hedging
$15,000,000
Hedge Program Net P&L - No Hedging vs. Delta-Rho Hedging
$10,000,000
$5,000,000
$-
7/13/07
7/27/07
8/10/07
8/24/07
9/7/07
9/21/07
10/5/07
10/19/07
11/2/07
11/16/07
11/30/07
12/14/07
12/28/07
1/11/08
1/25/08
2/8/08
P&L
$(5,000,000)
$(10,000,000)
$(15,000,000)
No Hedging Delta-Rho
This is an improvement over delta only strategy.
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3/7/08
Delta/Vega/Rho Strategy
$15,000,000
Hedge Program Net P&L - No Hedging vs. Delta-Rho-Vega Hedging
$10,000,000
$5,000,000
$-
7/13/07
7/27/07
8/10/07
8/24/07
9/7/07
9/21/07
10/5/07
10/19/07
11/2/07
11/16/07
11/30/07
12/14/07
12/28/07
1/11/08
1/25/08
2/8/08
P&L
2/22/08
$(5,000,000)
$(10,000,000)
$(15,000,000)
No Hedging Delta-Rho-Vega
Significant reduction in P&L volatility
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Comparison of Results
Weekly P&L 2007-07-13 to 2008-03-14
Total Standard Deviation
No Hedging $ (49,385,593) $
4,578,505
Delta $ (37,317,437) $
3,957,001
Delta-Rho $ (13,828,580) $
2,015,162
Delta-Rho-Vega $ (9,177,679) $
1,122,716
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Selection of a Hedging Strategy
More sophisticated strategies can offer improved protection
More sophisticated strategies also tends to be more expensive
Cost/benefit analysis is needed
– Portfolio size
– Accounting practice
Must withstand stress scenarios with tolerable deviations
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Contacts
Milliman Ltd.
Unit 3904 AIA Tower,
North Point, Hong Kong
Tel. 852-2147-9678
wing.wong@milliman.com
peter.sun@milliman.com
david.wang@milliman.com
www.milliman.com
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