Decoupling from Volatility

What You Need to Know

Our analysis of recent performance struggles in variable annuity (VA) risk-managed platforms reveals an overwhelming concentration in volatility-targeting solutions. But the challenge also highlights a path to enhancing diversification in risk-managed platforms—with a solution that decouples from volatility targeting.

Executive Summary

Risk-managed solutions are a compelling proposition for VA providers’ investment platforms, offering the potential to control volatility and improve policyholders’ long-run wealth accumulation while also enabling insurers to better hedge long-term liabilities. Given this appeal, the dramatic growth in this category since the global financial crisis (GFC) comes as no surprise.

However, many risk-managed solutions have struggled in recent years, posting disappointing returns. To understand what happened, and how insurers might be able to further enhance risk-managed platforms, we conducted a proprietary analysis of a large sample of risk-managed solutions. It’s a cohort that spans nearly 160 unique strategies with nearly $260 billion in assets under management.

Our work identified a widespread reliance on recent realized or implied volatility levels as inputs to determine the equity allocation. This has caused many risk-managed solutions to be sluggish when re-risking in a new market regime that features rapid sell-offs and fast recoveries—often with still-elevated volatility.

Identifying the source of the issue also points to a solution: designing a risk-managed solution that decouples risk management from volatility management. Incorporating underlying asset prices as an allocation input instead of volatility enables more dynamic equity-allocation responses that can capture a greater share of equity market rebounds. Cost-effective option exposure and fixed-income duration extension can also help reduce the impact of large drawdowns.

This new approach aligns with insurers’ approach to hedging long-term liabilities, effectively acting as a synthetic hedge. It also happens to possess the attributes of an effective investment strategy that won’t impair policyholders’ wealth-accumulation plans and that demonstrates attractive risk/return characteristics. Because no risk-managed solution wins all the time, incorporating this solution can further diversify VA risk-managed platforms, improving outcomes for VA providers as well as policyholders.