Option prices determine the primary cost of manufacturing equity-indexed annuities (also called as fixed indexed annuities). Since insurers hedge equity-indexed annuities mainly using equity options (call options), high-precision models of option valuation have become key to success in hedging, product pricing and management.

Dealer Pricing

Derivative OTC dealers always add a markup as compensation for providing liquidity in the OTC derivatives market. The mark-up may vary from 0-20 bps for OTC options on S&P 500 Index, to over 100 bps on options on Smart Beta indices. The markup is determined primarily by the bargaining power of the buyer. This dealer markup inversely correlates with the size of purchases and liquidity in the relevant exchange traded options market. Insurers must know both the fair value of the option, as well as the dealer markup, to manage their own pricing and hedging operations effectively.

Smart Beta Indices

Smart Beta Indices have gained significance in the equity-indexed annuity market because they offer diversification relative to market-cap-weighted indices. While the traditional market-cap weighted indices (such as S&P 500 and Nasdaq 100 indices) have a highly liquid derivatives market, Smart Beta indices being custom-designed indices, do not have any associated OTC derivatives market. Often the case is that only the designer (or manufacturer) of the smart beta index offers OTC derivatives on the index, which leaves insurers with no bargaining power. 


Interest Rate Hedging

 Insurers are exposed to interest rates in multiple ways. For purchasing options, insurers are exposed to interest rates at 1-2 year duration. For asset yields, insurers use tenors as per their surrender charge schedules (typically 5 or 7 years). So, issuers are exposed to multiple tenors within a 0 to 7-year curve. Moreover, hedging for multi-year guaranteed annuities requires purchasing either caps-floor spreads or interest rate swaps, both of which are exposed to interest rate volatilities.

Collateral Management

Derivative counterparties post collateral with insurers, which fluctuates with mark-to-market option values. In a rising rate environment, as the asset book bleeds cash, collateral management can turn into a significant drain on an investment manager’s attention and productivity. 

Accurate option prices are essential for effective hedging, pricing, product design and management. Annuity Risk offers a vast library of pricing models covering both vanilla and exotic option models on traditional indices, as well as smart beta indices, in addition to pricing and support for interest rate hedging.

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