by Richard Gilman, CFP®
Richard Gilman, CFP® is an adviser practicing in Boston, Massachusetts. His firm offers clients fee-based planning, investments, and customized insurance solutions. He also teaches at the graduate school at Northeastern University.
After the stock market crash in 2000 and recent Great Recession, people are very concerned about their retirement and are worried they could run out of money. They know they need to do something, but what? Many investors don't trust Wall Street, and the low interest rates on CDs and bonds are not an appealing alternative.
In 1996 the insurance industry introduced the first living benefit-a guaranteed minimum income benefit (GMIB). After the stock market crash in 2000, new and enhanced living benefit riders were introduced and they quickly became key selling feature on most VA products. This was a home run for the industry that revived a tired product and sales exploded. According to LIMRA, U.S. insurers sold about $128 billion of variable annuities in 2009 and $140.5 billion in 2010. The total number of assets placed into variable annuities reached an all-time high of $1.5 trillion in 2010, according to the Annuity News Journal.
Increasingly, the sale of VAs included some kind of living benefit or guaranteed income rider. For MetLife, 83.7 percent of 2008 and roughly 90 percent of first-quarter 2009 U.S. VA sales had some kind of living benefit rider.1 In a January 2011 announcement, MetLife and Fidelity Investments Inc. announced that sales for the MetLife Growth and Guaranteed Income variable annuity, which combines a guaranteed income with the potential for investment growth, totaled more than $1 billion.
By 2008, about 80 percent of new sales included a rider, and the majority of VA sales were in qualified as opposed to non-qualified dollars. In conjunction with this shift, the share of VA assets invested in equities increased from around 50 percent in 2002 to more than 80 percent in 2007. In addition, a push to broaden third-party distribution increased pricing pressure and the need to upgrade product features.
There is no question that Americans need to plan for retirement. By offering an income that can't be outlived, annuities are being touted as a solution. And annuities may be a solution; however, there is little discussion about what happens if insurers can't meet these future obligations.
The disclosures on VA sales literature clearly state that the contracts' financial guarantees are the sole responsibility of the issuing insurance company. There is no FDIC or SPIC coverage. Currently, when an insurer fails, the company is either acquired by a stronger insurer or is taken over by a state guarantee fund. Rules vary by state and coverage is limited. In Massachusetts, the maximum amount of protection provided by the state guaranty association is $100,000 per contract owner. For any one life, the guaranty association is not liable for benefits aggregating more than $300,000.
To support the various guarantees, insurers use a variety of complex risk management and hedging strategies. Some of these strategies are untested, and insurers could face many challenges in the coming years including:
Black swan events. The possibility that black swan events occur more frequently than modeled or assumed. According to Nassim Taleb's bestselling and often-cited book, The Black Swan, we really can't predict unforeseen or extreme future events, yet many strategies are back-tested against what we do know or have experienced.
Global events. Most of the large insurers are now global companies selling VAs in other countries. Events occurring around the world can affect the stability of these companies.
Interest rate risk. In an extended period of low interest rates insurers have a mismatch between low, risk-free rates and higher roll-up or bonus rates. This can result in embedded losses every year that are obviously not sustainable. To help address this problem newer products are being offered with floating roll-up rates that are linked to CPI or risk-free rates of return.
Lower than expected long-term return on equities. Given the capital market crisis, it is may be unrealistic to assume a return to the strong, long-term equity returns of the 1990s. Faced with uncertainty about expected returns, insurers could encounter higher earnings volatility, lower profits and higher claims, reserves, and required capital. The result could be lower profits on their VA products.
The design, effectiveness, and cost of hedging strategies. Economic conditions change daily and hedging costs generally are not locked in over the lifetime of the product. Unlike traditional insurance liabilities, which are not leveraged to the market and can be managed by pooling risk, derivatives have to be managed differently. The goal is for the rider fee to exceed the cost of hedging. Yet some risks, such as policy-holder behavior, mortality, or currency volatility, may not be hedgeable. 2
Actuarial pricing assumptions that don't hold up over the long term. As competition for market share heats up, insurers started offering complex guarantees that may not be profitable under all market conditions. Any drop in the equity markets reduces the fees that insurers earn from underlying variable annuity accounts, yet the cost of maintaining ongoing hedging strategies could increase. 3
A potential future decline in revenue as assets and fees income decrease while the cost of hedging remains. M&E expenses, rider fees, redemption penalties, etc. have to cover the cost of hedging. However, fees are tied to the net asset value in a contract.
Mortality or longevity risk. With people living longer, contract assets may be depleted but the guarantees remain. Some riders, such as guaranteed minimum income benefits and guaranteed lifetime withdrawal benefits, increase exposure to longevity risk.
Assumed contract lapse rates. Higher contract retention normally helps boost revenue and profitability for most traditional non-lapse-supported insurance products and for VA base contracts. However, guarantees (death or living benefits) are derivatives. Higher persistency may affect profitability because either over- or under-hedging can result in losses.
Actual contract holder behavior relative to pricing assumptions. Unlike other insurance products, VAs are not underwritten, and companies have limited ability to manage who purchases a contract and when they decide to exercise the income rider. Early exercise of income riders and longevity could be a future problem and affect an insurer's profits. 4
Reinsurer stability. The availability and stability of reinsurers who cover most guaranteed death and living benefits.
Over the past decade, insurers have aggressively marketed the benefits of these products to advisers and the public. As an adviser, I feel there is a need to have better disclosure about the risks as well as the rewards. People are buying these products with the expectation of a guaranteed lifetime income. However, unlike traditional annuitization strategies, guaranteed income riders are a relatively new product and we really won't know how this all plays out for 10, 20, or even 30 years.
1 MetLife Inc., Form 8-K, filed 06/03/09 for the period ending 06/03/09.
2 MetLife Variable Annuity Risk Management, JP Morgan conference presentation by Stan Talbi, executive vice president, June 3, 2009.
3 Transamerica's The Messenger, "Variable Annuities: The Lessons of 2009," by Simpa Baiye, April 2010; and Transamerica's The Messenger, "Variable Annuity Guarantees: What Went Wrong & What's Next," by Simpa Baiye, October 2009.
4 Society of Actuaries, Risks & Rewards, February 2010, Issue 55.
Additional Resource: Towers Perrin, "Variable Annuity Guaranteed Minimum Withdrawal Benefit (GMWB) Features in a Challenging Market," 2009. Now available through Towers Watson at: http://www.towerswatson.com/research/1470.