Today’s complex products look to find new balance between capital and guarantees
by Daniel H. Kruse, FSA, MAAA, JD
Mr. Kruse is Second Vice President and Actuary, Individual Annuity at Securian Financial Group, Inc., St. Paul, Minnesota. Connect with him by e-mail: Daniel.kruse@securiian.comOMAHA!
If Peyton Manning called plays for the variable annuity business, he might replace the name of Warren Buffet’s home town with a different word.
CAPACITY!
If you spend time with someone associated with the variable annuity industry today, you might hear “capacity” as many times as Manning shouted OMAHA during the Super Bowl last month. Other than the fact that many of the industry leaders have been limiting it, what makes capacity the buzz word of the variable annuity industry and what does it mean?
It should come as no surprise that managing capacity for a variable annuity writer is all about risk. The starting point is assessing how much capital is required to issue new contracts and ensure the guarantees will be met as far into the future as they reach. Writing new business consumes capital because an insurer pays sales commissions, incurs administrative expenses associated with establishing the new contract, and establishes any needed initial risk reserves. The more expensive a contract is to issue, the more capital consumed when it’s issued.
Subsequent to issue, additional reserves and capital may be required as guarantees move toward, or become deeper, in the money. For instance, as equity markets drop so do variable annuity account values, increasing the likelihood that withdrawals could exhaust the future account value. Nonetheless, a guaranteed lifetime withdrawal benefit would continue to generate a lifetime payout provided all contractual stipulations are met. The reserves and capital needed to back lifetime guarantees react directly to market driven moves in account value, changes in interest rates, and volatility in the marketplace – all of which are critical factors that affect an insurer’s ability to meet its future guarantees.
The complexity of today’s annuity marketplace makes it difficult to identify the point where annuity-purchasing consumers and insurers with a given risk capacity meet. Can insurers effectively manage their own risk capacity while meeting the needs of consumers who want downside income protection? Can insurers that want to assume less risk related to investment performance-driven guarantees find a consumer base interested in the growth opportunity with a long enough time horizon to assume more of the market volatility risk themselves?
Some insurers, having used up risk capacity in the past or preferring to not use more in the current environment, have stepped away from the annuity market altogether. Those insurers that continue to develop annuities today are exploring designs that meet the needs of annuity buyers while attempting to adjust guarantees that draw less on capital and consume less of the insurer’s risk capacity.
Enter Registered EIAs
With relatively low interest rates dampening the traditional fixed annuity market, indexed annuities continue to draw a steady flow of annuity purchasers seeking upside potential with some degree of downside protection. Companies that have traditionally not written indexed products are now introducing registered versions of the products.
Shifting risk to the annuity owner can reduce risk to the insurer’s balance sheet, creating more capacity even in a continuing low interest rate environment. Indexed annuities do not participate in the stock market. Instead, they credit interest based on the movement of a particular index, generally subject to a cap andor participation rate.
Springing from the strong equity market returns in 2012 and 2013, the marketplace has seen more variable products and marketing efforts around annuities that do not have living benefit guarantees. Different types of investment options are offered that do not create challenges for insurers to underwrite with living benefit guarantees. A package without the living benefits with the power of tax deferral to build retirement assets, is promoted as a growth oriented approach for buyers that have the risk appetite and time horizon to take a long view of the market. From the insurer’s perspective, this business consumes relatively little long-term capital and risk capacity. The challenge is whether the consumer base is willing to assume the risk without the safety net that living benefit guarantees provide during turbulent economic conditions.
There remains a strong market demand, however, for living benefits associated with variable annuity contracts as annuity consumers continue to seek the income-stabilizing security of living benefit guarantees while still participating in the equity market via a variable annuity. For annuity insurers, this creates the challenge of a market demand balanced against a low interest rate environment and market volatility conditions that strain risk capacity.
Insurers that still have risk capacity and the appetite to offer living benefits are able to create competitive products that reduce future capital needs by adjusting product designs and controlling investment allocations. Most insurers have now introduced managed volatility funds where the variable fund itself makes investments designed to reduce volatility. This means the insurer’s balance sheet does not have to absorb as wide a risk spectrum to continue offering competitive roll-up rates and withdrawal rates sought by annuity consumers. Often some, or even all, of an annuity contract’s account value must be allocated to these managed volatility funds in order to purchase a living benefit guarantee.
Living Benefit Designs
Other living benefit design elements that are getting attention include tying roll-up or withdrawal rates to a given interest rate level or some economic measure. Another is creating design options where buyers naturally sort themselves among different benefit guarantees by intended behavior. For example, whether annuity buyers plan to defer income as long as possible and grow the guarantee base or if they intend to start drawing income soon after issue might determine which specific benefit option they purchase. In making this choice, annuity buyers naturally sort themselves into a risk pool of like-minded contract owners. Any aspect that makes future contract activity affecting benefit guarantees more predictable helps the insurer align its pricing and risk controls to most efficiently utilize risk capacity.
The annuity business, with its hallmark of lifetime income guarantees, is very long-term in nature. Depending on the structure it might even spread guarantees over multiple lifetimes. These guarantees are very meaningful to annuity owners as they plan for their long-term financial security and assess how risks might affect their lifestyle. With continued consumer demand for lifetime income protection and stability, there continues to be a strong annuity marketplace for product designs that can effectively balance the consumer needs with the long-term risk elements that ensure all promises are paid in full within the claims paying ability of the issuing insurance company.
1. “I coulda had a VA,” InvestmentNews.com, February 24, 2012
The views expressed in this article are those of the author only and not necessarily representative of Securian Financial Group, Inc.
