Write Down What You Are Not Hedging
Nine of the ten required headings describe what your hedging program does. The tenth describes what you have decided to let happen — and it is the one that tells you whether the program is real.
A Clearly Defined Hedging Strategy under AG 43 and C3 Phase II has to answer ten questions, lettered a) through j). Objectives. Risks hedged. Risks not hedged. Instruments. Trading rules and tolerances. How effectiveness is measured, against what criteria, how often. When hedging will not take place. Who is responsible.
Nine of those are about activity. One is about acceptance.
Section c) is the one I read first, and it is almost always the weakest thing in the document.
Why it gets written badly
The reason is not laziness. It is that naming an unhedged risk is a commitment, in writing, approved by senior management, to absorb that risk when it shows up. Everything else in the document describes protection you are buying. This section describes losses you have agreed in advance to take.
So it gets written defensively. "All other risks are considered immaterial." "Risks not hedged are monitored through the normal risk management process." Sentences that survive any outcome, which is exactly what makes them worthless.
The problem with that isn't regulatory. It's that a program whose unhedged risks were never named cannot tell you, on the day something moves, whether what just happened was inside the plan or outside it. If everything unhedged is "immaterial," then any loss from an unhedged source is a surprise — and surprises get escalated, investigated, and explained after the fact rather than pointed at a document that said this could happen.
What an honest version contains
A real Risks Not Hedged section for an indexed or variable annuity program tends to name four clusters, and each one is an admission worth making.
Policyholder behavior. Mortality, lapse, rider utilization, transfers between funds or crediting strategies. These are actuarial assumptions, not market variables, and no option position hedges them. If experience diverges from assumption, the hedge does exactly what it was built to do and the program still loses money.
Basis risk. The gap between what the liability actually tracks and what the hedge instrument tracks. Fund lineups do not move like the indices you can buy options on. You can narrow the gap by choosing instruments with higher correlation to the item being hedged; you cannot close it, and pretending otherwise is how a program that tests effective quarter after quarter still underperforms.
Model risk. The valuations driving every rebalancing decision come out of models. Naming model risk as unhedged is an acknowledgment that the numbers steering the program carry their own error, and that the error does not disappear because the process ran on schedule.
Regulatory and other external forces. Reserve methodology changes, capital treatment changes, accounting changes. A hedge protects an economic position. It does not protect the framework that measures the position, and that framework moves.
The phrase that gives the game away
There is a fifth entry that separates a program written by an operator from one written from a form. Stated plainly, it reads something like: subtle and moderate market events are not hedged.
Read that again, because it is a much larger statement than it looks.
A guaranteed-benefit hedging program built around downside protection is, by construction, aimed at the tail. The instruments are struck away from the money. The shock grid the program is tested against runs to severe levels because those are the levels that threaten statutory surplus. That is a rational design — surplus is what you are protecting.
But it means the ordinary case is uncovered. A market that grinds down slowly, or chops sideways, or falls a modest amount and stays there, produces liability movement with very little offsetting hedge payoff. The program is not failing when that happens. It is doing precisely what it was designed to do, and the design has a hole in the middle of it that somebody chose.
Writing that sentence down converts a future argument into a prior decision. Without it, the first moderate drawdown produces a meeting about why the hedges did not work. With it, the meeting is about whether the accepted exposure is still the right one — a completely different conversation, and one the board is equipped to have.
The second place: when you decline to act
Section i), conditions under which hedging will not take place, is the operational twin of section c). Section c) is about risks you never intended to cover. Section i) is about moments when you have the risk, you have the mandate, and you deliberately do nothing.
Two grounds come up repeatedly and both are economic rather than philosophical. Below a minimum notional size, a hedge costs more in execution and administration than the exposure justifies, so positions are accumulated and rolled into the next cycle instead. And where a crediting strategy is deeply in the money, the cost of the hedge approaches the discounted value of the maximum payoff — at which point you are paying nearly the full liability to insure against it, which is not a hedge, it is a prepayment.
Neither of those decisions is controversial. What matters is that both are written down with their reasoning, so the person facing them at the desk applies a rule instead of forming a view.
The third place, and the one that binds it
The trading rules carry a sentence that most programs do not have, and it is the sentence that makes the other two enforceable:
If a trade is not made after exceeding the risk tolerances, the reason for not trading will be documented.
Tolerances get breached. That is what tolerances are for. The interesting question is never whether a breach occurred, it is what happened next — and in most programs, the honest answer is unrecoverable, because a breach that produced no trade also produced no record.
Which means a deliberate, well-reasoned decision not to trade and a breach that nobody noticed look identical in the file six months later. The requirement to document the non-action is what separates them, and it costs one paragraph at the time.
It also has a second-order effect worth naming. Once people know that not trading requires an explanation, not trading stops being the frictionless default. The path of least resistance moves.
Partial by design is not the same as partial by accident
One more thing the honest version makes possible. Indexed programs frequently hedge only a portion of index credits on purpose — because the crediting mechanism and the rider guarantees carry offsetting exposures, and hedging both at full notional would be paying twice to stand still.
That is a sophisticated position, and it is indistinguishable from under-hedging unless the document says which one it is. A program that hedges a stated fraction, recalculates that fraction on a stated cadence, and names the residual as an accepted risk, is making a considered choice. A program that simply ends up partially covered is making the same trade by accident and calling it a strategy afterwards.
The test
When you are handed a hedging program to assess, go to section c) first, before objectives, before instruments, before effectiveness.
If it names specific risks, in language that would let you recognize one when it happened, the program was designed by someone who thought about what they were buying and what they were not. The other nine sections will probably hold up.
If it is three lines and the word immaterial, you have a document that describes a set of trades. The trades may even be the right ones. But nobody has written down what this program is prepared to lose, which means nobody has decided it — and that decision will get made anyway, in a meeting, after the loss, by whoever is in the room.
Scarborough Road works with insurers and asset managers on derivatives governance, hedging operations, and the investment data infrastructure that demonstrates the governance was followed. If you have a hedging program that has never had its unhedged risks written down, that is the conversation to have.
General commentary on hedging governance practice. Not legal, actuarial or investment advice, and not a substitute for review against your own products, domiciliary requirements and hedge accounting policies. No specific insurer's program, systems, indices, counterparties or limits are described.
