Risk Management
Like

It’s Good to be the Insurer

Hans Albrecht
May 4, 2017
251 Views
0 Comments
3 minutes read
It’s Good to be the Insurer

 

Option pricing, or insurance, is a relative value product. For instance, a $300 annual premium for $1 million of life insurance coverage for a young, healthy individual is reasonable. However, that same $300 price tag to insure a 65 year-old smoker with high blood pressure is way too cheap.

When it comes to life insurance, the concept of ‘risk’ can be defined as any possible event that could lead to the insurer making a pay-out. This risk can be estimated by looking at past historical evidence that speaks to how risk played-out for a similar individual. Life insurance underwriters look at a person’s propensity for events such as injury, illness and death. They then assign an appropriate premium and spread that risk across many individuals. What they are really doing is looking at something option traders call historical volatility, or ‘risk’ for a typical individual of that age and health.

In option markets, risk is simply the ‘risk of movement’. In this context, think of the risk of a stock moving through a strike being similar to the risk of an individual falling very ill (being healthy or being ill straddling the ‘strike price’). Both have consequences for the insurer and both need to be assigned a probability and value: that is your option cost!

Both insurers and options traders are looking at historical volatility to gauge this past risk in order to assign an appropriate level of option pricing to that risk. Lately the VIX, which is a measure of 30-day insurance on the S&P 500 Index, is pricing in a great deal of risk versus underlying movement/risk. The VIXC, our Canadian counterpart to the VIX, hasn’t been reaching quite as high but has also been pricing in more elevated option pricing versus underlying movement.

As of April 17, a VIX of $16.23 was simply overpricing a 10-day historical volatility (movement) of $6.96. Think of this as the insurer, broadly speaking, charging $16.23 for $6.96 in risk. Similarly, the VIXC was pricing a thinner but still generous 37% higher option pricing than recent movement. On the US side, this spread is about as high as we’ve seen it in the last five years. Selling insurance is not a bad business to be in.

 

Hans Albrecht
Hans Albrecht http://www.horizonsetfs.com/

Vice President, Portfolio Manager, and Options Strategist

Horizons ETFs Management (Canada) Inc

Hans Albrecht is vice president, portfolio manager, and options strategist at Horizons ETFs Management (Canada) Inc. He co-manages one of the largest option books in Canada, $800 million in covered call ETFs and oversees day-to-day options activities. Mr. Albrecht also was an options floor market maker and traded a large volatility book for National Bank Financial for many years. He has lectured at McGill and has appeared on numerous expert derivative panels. He has been quoted in Bloomberg, Investment Advisor, Globe and Mail, and is a regular on BNN. ETF Lipper Award winner.

5 posts
1 comments

Leave a Reply

Your email address will not be published. Required fields are marked *