Decomposing and Managing Multivariate Risks: The Case of Variable Annuities

Thomas S. Y. Ho and Blessing Mudavanhu

Volume 3, Number 4, Fourth Quarter 2005

The market of variable annuities has grown tremendously in recent years and has become a significant part of our capital markets. These equity and interest rate structured products offer a broad range of guarantees, whose risks are typically borne by the insurers’ balance sheets. The limited risk capital of the life insurance industry may constrain the future growth of the market, and therefore the management of the risk of these guarantees is an urgent problem to address. In this paper, we apply a decomposition methodology to identify the risks of these guarantees. We then discuss the hedging strategies in managing them within the context of an investment process. Finally, we discuss the broad applications of the methodology.