Digging into ING US (VOYA)

After taking a position in ING US (NYSE: VOYA) at about the $25/share level, I have been fortunate to participate in the rise to above $30. The original target was around the 40-50$, with stop around $20, the ipo price. The recent rise and earnings report make this a good time to reevaluate the thesis.

The firm posted an operating gain of $0.71/share, but on a net basis lost $0.56/share. Why? In a phrase, variable annuities (p134-135). Variable annuities took a (408.4) million capital (loss) related to hedging. How can such "hedging" turn a respectable gain into a loss that reduced book value? 

To answer that, we start with the basics. What is a variable annuity? It's a hybrid product which, after an investment period by the buyer, pays an income stream that usually varies with the market. Basically, it attempts the best of both worlds by giving income but more so when the equity market rallies. Insurers such as VOYA can invest initial proceeds in equity (funds) to match this potential liability. They can then add a margin for profits/cushion against potential mismatches.

At the same time, many variable annuities have a minimum return guarantee. If the market falls significantly, insurers may often still be on the hook for income. How can the insurer handle this? Investing in fixed income can provide relatively stable residual income, but in the current environment they can probably not buy enough. My hypothesis - invest more in equity but hedge with put options (and other derivatives such as variance swaps). In fact, VOYA has over-hedged:

That is why VOYA posted gains last Q2 (when equities fell) vs. a loss now.

How does this reconcile with the results? Yes, the loss was not insignificant, but from the most recent 10-Q (page 107), we see that persistently low interest rates increase the hedging costs for such variable annuities. VOYA also states that it focuses on capital adequacy vs. GAAP volatility.  Going forward, I'd like to see the swings diminish as the book runs off.