What effect can variable annuity hedging have on the value of a company?

Life insurers’ price-to-earnings (P/E) ratios have historically been significantly lower than the average S&P P/E of 15.7. Variable annuity (VA) writers, in particular, have experienced high betas and have typically traded below their book values in recent years. The average beta and P/E ratio of some of the largest VA writers is 1.5 and 8, respectively.

Variable annuity guarantees are generally perceived by market participants (and rightly so) as extremely risky products with significant market exposure. While companies have had tremendous success in managing this risk primarily via hedging, market participants have not fully appreciated the value of such risk management techniques. Decreased confidence in VA writers leads to excessive trading and volatility, which translates into high betas and low P/E ratios.

This article by Milliman’s Ken Mungan and Poojan Shah attempts to illustrate, through an example, that hedging VA guarantees can smooth company earnings. Even though the majority of VA writers have implemented hedge programs to manage the market risk, P/E ratios continue to be low.

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