The Geneva Association just published on its website an interesting report on variable annuities and systemic risk (online here). Based on a definition of potentially systemically risky activities, on interconnectedness or substitutability, the report claims that since “none of the criteria is triggered”, variables annuities is “not a potentially systemically risk activity”. Even if “short-term effects are conceivable”. I guess it is a diplomatic way to say it…
Note that a series of slides can also be downloaded (there) on insurance and systemic risk. But that deserves a more detailed post.
2 thoughts on “Variable annuities is not a systemic risk ?”
Nice blog. This publication indeed overlooks negative feedback effect (fallacy of composition). Additionnally given the mammoth size of some insurers, a disorderly liquidation of big chunks of their equity portfolio could definitely impact prices. That being said, prices movements are definitely not independent of their past behavior !
Note that regulation, which i am not opposed to, can increase negative feedback since most regulatory capital measures are increasing function of volatility. The more markets crash, ther more you have to sell. Solvency II has a dampener effect in order to diminish this feature.
Many companies now uses put spread equity options to manage their reg cap requirements. As such it may diminish the amount of rebalancing they’ll have to do (unless crash is big to a point the furthest strike is hit. Note also that by doing so insurers, in terms of PL are shorting the volatility skew which is not so good in times of crises). But at the end of the day someone has to short i.e. the put option seller.
I think there is a component that is overlooked in that report and it is correlation. They do mention interconnectedness but they do not put any emphasis on the fact that results of all companies will be affected in the same way when the market declines. If VAs represent a large chunk of the business for all insurance companies, then if one company fails it is very likely that others will as well since all companies carry the same risk.
Moreover, on the hedging issue, they state “it is unlikely that a single insurer’s hedging programme could move a market”. Yes, but if all insurers use similar strategies then they will react in the same way and together they may be able to move the market!
Maybe their criteria are not triggered for systemic risk, but when businesses in the same industry all carry systematic (market) risk then it just makes sense to say that there is systemic risk in that industry. How do we avoid systemic risk? Well, a simple answer would be not to carry large chunks of systematic risks. VAs are products with systematic risk so that, in my opinion, it is a potentially systemically risk activity (abbreviated by pSRA in the report if you want to be fancy).
That makes me realize that sometimes it is better to look at the big picture instead of establishing criteria and following a “scientific” analysis like in the report to arrive at a conclusion that doesn’t sound right (i.e., VA is not a systemic risk). So if it is not a systemic risk, let’s all together sell those products!
REPONSE: I completely agree with you ! there is a huge problem of comonotonicity when all the players on the market behave with the same models, and move all together…