By Chuck Fang

Despite its importance implied in asset pricing and macroeconomic models, insurance against long-run volatility risk has received little empirical documentation regarding its demand, supply, or pricing. This paper bridges the gap. First, I show that households have directly purchased large quantities of insurance against long- run volatility risk through the minimum return guarantees available in variable annuities, a form of retail retirement and savings product offered by life insurance companies. Total net assets with such insurance grew from zero when the guarantees were first introduced in the early 2000s to close to $1 trillion in 2015. To supply the guarantees to households, life insurance companies hedged themselves with large quantities of long-maturity (> 5Y) options and variance swaps, which led to a sharp increase in the prices of these long-term volatility assets: the ten- year implied volatility increased from 20.0% before 2000 to 27.3% afterwards while the short-term counterpart (VIX) has remained unchanged (from 19.2% to 19.7%). Insurers’ hedging activities therefore explain the significant steepening of volatility term structure in the early 2000s. Relative to the price they paid on hedging, how- ever, the price that life insurance companies charged on the guarantees was much lower, at 15.2% implied volatility prior to the Great Recession. I show evidence of extensive product-cross subsidization – under-pricing of guarantees was used to induce sales and lock in customers that would be subject to over-priced base fees and mutual fund expenses.

Source: SSRN