Since the start of 2023, we have noticed an increased level of client engagement around hedging risks associated with embedded insurance guarantees. 

Many insurance policies with embedded guarantees were sold before the global financial crisis, during periods of favourable market conditions and high interest rates. Back then, guarantees could be met fairly easily.

However, in the low-yield environment experienced since the 2007 crisis, meeting guarantees became particularly challenging as fixed income assets offered less margin. 

Setting up the right investment structure with adequate risk control is vital.

The last few years of volatility, distorted asset class correlations and extreme market moves have made such guarantee structures even more complex to manage. As a result, setting up the right investment structure with adequate risk control is vital. Risk control frameworks and hedge structuring are fundamental from an economic hedging standpoint and also from the perspective of balance sheet stability under Solvency II (SII).

Asset and liability mismatch under the SII rates and equity stresses can result in significant regulatory capital requirements, so it is in insurers’ interests to minimise these mismatches through effective and efficient economic hedging frameworks.

For insurers who feel there is more they could do to hedge market risks, this article outlines different guarantee hedging strategies – with a focus on liquidity and simplicity to ensure successful tracking and rebalancing under ever-changing market conditions.

Guaranteed return products

Guaranteed return products provide a greater certainty of investment outcomes to policyholders. There is a wide range of product structures offering a certain degree of guaranteed income through minimum annuity payments or minimum investment returns. In both cases, the insurers bear the risk that adverse market conditions result in the investment return or asset value falling short of the guaranteed minimum amount.

The guarantee provided by the insurer to the policyholder is similar to the protection offered by a financial option, which in relation to the equity market offers upside in the case of strong equity market performance but protection against poor equity market performance.

This asymmetry means that hedging is a challenging process using plain vanilla instruments, given their linear implied returns. In addition, the ever-changing regulatory backdrop that applies to both insurers and derivatives markets provides a further layer of complexity.

Where guarantees associated with future premiums are to be hedged, it is unlikely that funded asset strategies alone will be sufficient, and therefore insurers tend to use derivatives hedging strategies alongside invested assets. Let’s take a look at three aspects of derivatives hedging strategies.

Exposure to be hedged

Guaranteed return products offer a guarantee on the performance of an underlying investment portfolio. The investment portfolio may hold a wide variety of asset classes, but for this exercise we will limit our considerations to fixed income and equity assets.

The value of the guarantee is a function of time and underlying market movements. If market returns are lower than the guaranteed amount, the insurer needs to make up the difference and this is the exposure they aim to hedge. Should market return exceed minimum guaranteed return, the value of the guarantee will fall to zero.

We will also make the further simplification that fixed income and equity exposures are independent. This assumption better aligns the hedge with the most liquid derivatives products and helps avoid bespoke products that can prove costly to enter and extremely difficult to adjust or close prior to maturity. Segregation of equity and fixed income hedges is a strategy employed by a number of insurers.

In order to calibrate the appropriate hedge, the insurer would typically assess the future value of the guarantee under different possible market scenarios and then identify the relevant instruments in the market with a similar return profile. This can minimise the mismatch between the insurer’s liability and asset return.

Due to the asymmetries involved, the likely best candidate is an options-based strategy. Hedging such guarantee returns with plain vanilla instruments (e.g., swaps and futures) is feasible but can require frequent rebalancing and monitoring.

Hedge construction

For this example, we will focus on the construction of a ‘buy-and-hold’ hedge using derivatives contracts that closely replicate the non-linearity of the guarantees. This strategy is expected to provide a more stable hedge and perform better under extreme market moves. The resilience under extreme market moves limits trading requirements during periods of heightened market volatility, which is often accompanied by reduced liquidity and higher transactions costs. It’s useful to consider the equity and fixed income hedges separately.

Equity hedge

Broadly speaking, the assets that hedge the cost of the guarantee must provide a return that offsets the negative impact of a sell-off in equity indices on liabilities – but, crucially, without creating a loss when markets rally.

Equity index options provide a useful tool for hedging such non-linear equity guarantee exposures, with downside protection provided by a put option payoff pattern (see Figure 1).

The put option provides downside protection without impacting upside participation. When calibrating the options-based strategy, an insurer can change the value at which the equity protection will kick-in (i.e., the strike), the time-period of protection (i.e., expiry) and the specific underlying equity index.

The strike can be calibrated to the required level of protection, with less protection equating to a lower cost for the protection. Buying a put option that is significantly out-of-the-money (i.e., where the current price of the underlying asset is above the strike price) can mean substantially lower costs for the protection while still providing downside protection against large equity market selloffs.

If the guarantees an insurer has given to policyholders are struck at different levels and across a variety of dates, a diversified portfolio of options at appropriate strikes/expiries should be held within the hedging portfolio.

Payoff Diagram At Expiry

Source: abrdn, August 2023

Fixed income hedge

Where a guarantee locks in a minimum future investment yield, the value of this guarantee increases as yields fall. Therefore, the fixed income hedge should offset the increase in the guarantee’s value if yields fall. While providing protection against falls in rates, the hedge should not negatively impact returns as yields rise.

In the fixed income market, the most liquid asset to meet this requirement is a receiver swaption (option to enter a receiver swap in the future). This is an instrument that locks in a minimum yield (the strike) from a specified date in the future (expiry) to the end of the protection period (maturity).

Where guarantees have been written at a number of return levels over a range of protection periods, a portfolio of swaptions with varying strikes, expiries and maturities should be considered.


Where hedging activities are carried out through derivatives contracts, it is important to consider efficient implementation. Hedging strategies can be implemented through exchange traded derivatives (ETD) or bilateral/cleared over the counter (OTC) derivatives. The margin requirements of these instruments are a key consideration for implementation and sustaining hedging strategies.

Historically, insurers tried to trade bilaterally as much as possible in order to minimise the initial margin of OTC contracts. Changes to derivatives market regulation through the Uncleared Margin Rules (UMR) means many more insurers are required to post initial margin under bilateral contracts, reducing benefits from trading bilaterally rather than cleared contracts.

There is a balance to be struck between providing the best liability match and implementation through liquid contracts.  

Creating an efficient hedging strategy also involves trading derivatives contracts with sufficient market liquidity. There is a balance to be struck between providing the best liability match and implementation through liquid contracts.

For example, equity index options with a December expiry provide the greatest liquidity, while swaptions market liquidity can be particularly poor for long-dated expiries beyond 20 years and swap maturities in excess of 30 years. For both equity options and swaptions, the greatest liquidity is seen for strikes at the current market level.

Consideration should be given to the timing of hedge implementation and rebalancing to ensure appropriate levels of liquidity are achieved. For example, trading equity options between the December expiry and year-end can be very challenging and costly.

It should be noted that alternative hedging structures based around these most liquid equity and interest-rate options can be beneficial depending on market conditions and characteristics of the guarantee to be hedged.

In conclusion

Guarantees written by insurers during times of high interest rates have become particularly onerous to meet/hedge during the low-yield environment of the last 10 years. We have outlined a number of buy-and-hold hedging strategies that could be employed by insurers to help mitigate the risks associated with these guarantees.

Although insurers have typically stopped offering these minimum guarantee products to new customers, they still retain significant back books in many cases. Given the long-term nature of these products, the requirement for guarantee hedging will remain for many years to come.

Whilst we have outlined buy-and-hold hedging strategies, it is recognised that rebalancing will be required in practice. Rebalancing may be driven by a number of factors, including, for example, changes in actuarial assumptions embedded in guarantee modelling. For this reason, hedging strategies are focused on the most liquid hedging instruments to allow rebalancing when required.

Given the ever-changing regulatory environment for both insurers and derivatives markets, hedging strategies will be required to evolve continually.

Final thoughts

Finally, 2022 saw a dramatic rise in yields across developed economies, leaving behind 10 years of ultra-low interest rates. As such, we may be moving to an environment where writing minimum guarantee products becomes appealing to insurers once again. Lessons from the last 10 years must be learned: volatile markets and restrictive regulation leave no room for complacency.