be thought of as constructing insurance in the market for the provider, and our techniques can assist in determining if hedging is appropriate. In particular, we focus on two main questions: how effective is the hedging strategy at removing downside risk, and what is the return on the regulatory capital investment? We found that even a simple delta-neutral hedging strategy was very effective at reducing the downside risk if it was possible to set up a hedging position using the underlying mutual fund, or a perfectly correlated asset (such as hedging an index tracking mutual fund using index participation units). However, in many cases it is not possible to use the underlying mutual fund itself when constructing the hedging portfolio. When hedging with an asset, which is not perfectly correlated with the underlying, the majority of the residual risk is due to basis risk between the hedging and underlying instruments. As a result, very frequent re-balancing and more complex gamma-neutral strategies may not be effective at further reducing the variability of the partially hedged position.
The other main reason why an insurer would consider implementing a hedging strategy is to reduce the regulatory capital requirements for these contracts. Our results indicate that some of the risks involved with offering these contracts, and hence the capital requirements, can be reduced dramatically using simple dynamic hedging strategies. Current regulatory policy in Canada has taken a conservative position and by implementing a hedging strategy, the provider is allowed a maximum 50 percent reduction in the required capital. In this case, the return on the initial capital investment made by the insurer decreases when hedging is implemented. As a result, many institutions offering these products back these guarantees with capital reserves and do not actively hedge their risk exposures to these contracts. There are indications that a full credit for hedging may be granted in the future. In this case, hedging can dramatically reduce the required capital, thereby increasing the return on this initial capital outlay, so more institutions may be inclined to take advantage of this credit.
For expositional simplicity, we develop the model for hedging with a partially correlated asset in the context of a simple vanilla put option. In particular, we ignore exotic features associated with segregated fund guarantees such as mortality benefits, the deferred payment of these contracts through proportional fees, the reset feature, and lapsing. Yet, the numerical results provided in this chapter are based on a generalized model that incorporates these effects.