“When we do research, which we do, and go out and talk to investors and advisers, they’re always asking for more benefits and lower price – in a general sense, but then you look at specific attributes, and what you can do in terms of meeting those specific needs.”
Adrian Emery, general manager of sales and marketing for AXA, says product providers can make the cost and outcomes of capital- and income-protected products simpler by being very careful about what rules they build around the product.
In the case of its North product, AXA has “designed the product to have certain rules and features around it, which help us to manage risk”.
“So we start by managing our risk, by being very clear about what [clients] can and cannot do. We make that as flexible as we can, but we’ve thought about what client behaviour we would expect, and that has gone to help in modelling [product] features.”
Emery says the nature of the underlying investment funds is critical; and a fund – or individual manager – whose performance is likely to be outside a certain index tracking error is generally excluded, because hedging that level of investment risk is very difficult, and very expensive.
But once parameters for the underlying investments have been determined, the cost of protection can be calculated. The cost is greater for underlying investment options with a high proportion of growth assets than it is for underlying investments with a lower level of growth assets; and it’s more expensive to provide protection over short periods of time than it is to provide it over longer periods of time.
The fee paid by investors to cover the cost of protection can be thought of like an insurance premium.
“We collect the premium and that’s what buys the futures and options, or we put in cash,” Emery says.
On the one hand, the product has a liability to pay investors a given sum of money, at some point in future. On the other hand, it has an asset – the premium collected for protection.
Emery says the liabilities are treated as a pool; approaching it this way provides a higher degree of predictability (and hence reduces costs) than individually protecting each investor.
“We’re pooling all of this; we get a lower risk profile that what your risk profile would be as an individual, and we manage it as a pool,” Emery says.
“We know on any day exactly what our exposures are.
“It’s a very sophisticated computer program. At any point in time we know what our exposures are, and we trade futures and options to match our exposures.”
Emery says that if the trading strategy goes perfectly right, “then it exactly matches our liabilities”.
But in practice, because clients’ behaviour is not 100 per cent predictable, some minor mismatching can occasionally occur. When this happens, the capital set aside by the life company comes into play, to potentially make good any losses. (It should be noted that the mismatch between assets and liabilities is generally short lived, and often usually only on paper.)
While liabilities and assets are monitored and measured daily, Emery says it’s not always necessary to execute trades, especially when market volatility is low.
When markets are rising, of course, the value of the investors’ underlying funds also rises. If markets fall, however, then the hedging instruments put in place pay off “and that matches our liability for what we pay to investors”, Emery says.
“The theory is simple,” he says, although in practice it is a little more complicated.
“Large, sophisticated investors, with large amounts of money, do this individually,” he says.
Investors see little of this complexity, Emery says.
“That’s the duck analogy,” he says. “For the client it’s set-and-forget, whereas we [potentially] rebalance on a daily basis. At the moment we’re doing it weekly, but when markets are more volatile we rebalance more frequently.”
Kan says capital protection or income protection inevitably comes at a cost. Generally speaking, the cost of protection rises when market volatility rises, and declines when markets are less volatile.
“If you look at the way the fees are divided – and this is all disclosed when you look at the PDS – there are different fees for different purposes,” Kan says.
“There’s a fee that relates specifically to the guarantee component; there’s fees for the underlying investment funds; and then there’s broadly speaking, I suppose, what you would call an administration-type fee.
“In providing a product with a guarantee – say, a guaranteed income for life – there’s an obligation to pay an investor, depending on what the level of that guarantee is. Let’s say they’re a person who has a 5 per cent guarantee for life on a protected income basis at a particular point in time.
“There are risks associated, from a provider perspective, or issues associated with providing that guarantee. That’s the role, what the provider does, managing those risks collectively on behalf of the investor. Principally, there’s longevity risk, there’s market risk, and there are other risks.
“The markets move up and down. In terms of the underlying investments, the value of those underlying investments will move up and down.
“What we do is have a program in place to neutralise the effect of the market movements. So we actively hedge – and I mean ‘hedge’ in the true sense of the word; we’re not a hedge fund, I want to make that quite clear. We’re not a hedge fund where we’re trying to make money out of market movements. We’re trying to neutralise the effect of those movements, which then puts us in a position to manage the payout to clients down the line. That’s one level.
“There are other levels. There are certain things we can manage actively in capital markets, like, for example, market movements, and we can hedge those. There are other risks, like, for example, longevity risk, that are not actively hedged but you have to take a collective view on risk. You need to make provision for that.”
