Wenchu Li's Abstract
Variable annuities (VAs) are personal savings and investment products with long-term
financial guarantees. U.S. life insurers who offer VAs have benefitted from their popularity, but also face significant challenges in managing the risks from these guarantees, such as financial risk, longevity risk, and policyholder behavior. We show that VA providers should additionally be concerned about basis risk, that is the discrepancy in returns between the policyholders’ chosen investment funds and the insurers’ hedging instruments. Basis risk arises because the insurer’s hedging strategy entails a short position in the assets underlying the guarantees, but the mutual funds cannot be shorted. This paper presents the first comprehensive empirical study on basis risk for VA underlying mutual funds. Using standard fund mapping techniques, LASSO regression, and a variety of instrument sets, we identify suitable instruments for each mutual fund. Even so, we find that basis risk is substantial and pervasive across different Lipper Objective classes, asset classes, and fund types. Our findings are independent of asset return models and hedging strategies, and offer practical insights to VA providers and insurance regulators.