Variable Annuities : the future of Life Insurance ?

Historically marketed in the United States in the early 90’s, Variable Annuities (VAs) - products at the forefront of finance and Insurance which propose a number of types of guarantees and multiple options corresponding, in theory, to the essential needs of clients (availability of funds, profitability, security), stand to become the new model of saving for life assurance...: an advantageous combination of UC funds and funds in Euros making a structured product providing tax benefits to policyholders.

But despite a strong growth seen in the Hexagon, boosted by three main players being the AXA, Allianz and AG2R, these new products are still viewed with certain caution by the majority of professionals in the insurance field. How can the many risks which are inherent in diversification of the options offered to customers, be managed? In what does one invest a clients’ savings that will, not only ensure the client benefits from good returns and security but also allow the insurer himself to benefit from the resulting management fees. Numerous questions are still being asked and losses suffered during the financial crisis have not solved anything.

The Variable Annuities model is indeed a fusion of complexities as far as the valuation of hybrid products is concerned - both financial and insurance products : payoffs (gain profiles) not always easy to decipher, extremely long maturities, a list of extremely diverse risks (market risks, death risk, surrender risk, fund regression risk, capital risk, model risk, investment amendment risk etc). Cover and evaluation of these products are a challenge and require the dual expertise of accounting and the pricing of derivatives.

A wide range of collateral.

Variable Annuities provide the insured with several guarantees : GWMB (Guaranteed Minimum Withdrawal Benefit) or the GMAB (Guaranteed Minimum Accumulation Benefit) - one of these generally being combined with a guarantee in case of death such as a GMDB (Guaranteed Minimum Death Benefit). For each of these guarantees, at least one or two generally, there is a ratchet system available over a given period of time "p" (deferred period for the GMWB or the duration of the contract for GMAB). The guaranteed amount is valued at the maximum amount saved by the client during time ’p’ and is re-evaluated at a defined interval set by the insurer (usually annually).

At the end of the period "p", if the insured client had taken out a GMAB, he would receive the guaranteed amount calculated, taking into consideration the yearly charges applicable to the account. If he had signed up for a GMWB, he would receive an amount, determined in advance in the contract, which represents a percentage of the guaranteed amount. The insured client receives this amount each year until maturity date of the contract (or for the duration of his life if he has taken out a WB "for life"). If the insured dies before the contract termination, his estate will receive the guaranteed amount as valued at the time of his death using the ratchet system. Without the ratchet system, the securities could also be Roll-UP : the guarantee thus becomes the maximum between the original amount invested at a pre-determined interest rate and the current market value of the account.

Valuation based on that of finance

Contrary to normal insurance practice, payoffs of Variable Annuities are calculated by techniques usually reserved for financial derivatives. Payments made to clients (claims) above the original investment amount can be explained as the discounted amount for each time period "t", at the put options strike price of the security, which has been weighted by the probability of life (mortality) and the probability of not withdrawing from the contract prematurely. The tables of mortality are established according to the usual insurance standards and the invested sum is simulated using a classic model - such as Black and Scholes, under the neutral risk probability.

The payoff, not able to be calculated according to the closed formula in practice, the sum of puts in question, mentioned above, is approached using the Monte Carlo methods. This in itself raises another operational question, that of how to find a balance between the accuracy of the valuation and the time over which calculations are made. Variable Annuities are products with very long maturity dates. They are policies with numerous personalised characteristics (such as age, duration of the contract, sex, reason for entering into the contract). For these reasons, each contract must be individually evaluated and the time over which this evaluation is made, therefore plays a major role in the success of the contract when it reaches maturity.

Financial and actuarial risks

Variable Annuities have a very impressive range of risks that can be separated into two categories: Actuarial risks and Financial Risks.

Actuarial risks cover all risks to the policy itself, namely the mortality risk, the longevity risk and the risk of client withdrawal from the contract. A poor estimation of these risks can lead to poor evaluation of the securities and to claims that are, in theory ,lower than what is actually paid out in practice to the client. Generally speaking, the main job of the insurer is to cover these accounting risks as they know more or less how to juggle the risks of mortality and longevity using mutualisation or re-insurance techniques. The risk of a lapsed contract is still, for the insurer, the most pernicious, insofar as estimating the reasoning behind the clients’ choices is very difficult and a book under - evaluation of policies can lead to substantial losses in cover.

Financial risks on Variable Annuities remain the most dangerous risks. They consist mainly of interest rate risks, risk to changes in the underlying funds, the risk of long-term volatility, convexity risk, regression of funds risk, the risks associated with the selection of funds, capital cost risk, model risk. Although certain risks such as the interest rate risk and risks associated with changes to the underlying funds, ways are not always explicitly covered by some participants, there are ways and means to effectively juggle the possible consequences of these risks, such as long term maturity swaps and futures.

The risk of funds regression (basic risk), which is a major problem for Variable Annuities occurs when there are no instruments to hedge the underlying funds because of their very nature, particularly when they are non short sellables, such as Mutual Funds. The usual way to alleviate this is to create a benchmark portfolio that can replicate the behaviour of the underlying funds for which one buys hedging instruments. The result of this is a difference between the hedging assets and the securities themselves, mainly because the replicating portfolio differs from the portfolio of the initial funds that were benchmarked.

When considering volatility risks (vega), there are few instruments that exist to cover such long maturity, even though some participants try to use products such as variance or futures volatility swaps. Convexity risk (gamma, rho convexity) measures, according to the insurer, the efficiency of the hedging, relative to the variation of the underlying funds.This type of risk must normally be taken into consideration when one uses linear instruments such as futures for hedging (in delta) of payoffs for securities which are not linear. As for the risk inherent in the choice of funds, this occurs when the insured changes the investment profile of his account, thus entailing movements in portfolio volatility which could impact upon its value.

The risk of capital is another major risk. If one can mitigate the effects of a significant deficiency, and a possible need for funds owing to bad evaluation of a product, no insurer wants to have to tie up too much non-revenue earning capital. The insurer is therefore going to redouble his efforts at innovation in line with regulations to estimate, in the most reasonable way, the sustainability of their business, and the amount of capital to commit to their products. The model risk, which is another important element in the evaluation of Variable Annuities, is related to the under-estimation by the financial model of the cost of the security to hedge the product. This maybe due to several factors, including poor estimation of calibration parameter, not taking into account transaction costs or just an inconsistent model (constant interest rates, constant volatility etc).

If Variable Annuities have a multitude of different risks, they are fortunately not all of the same importance and some of them are, generally speaking, negligible form the time their potential impact has been reduced by the insurer. For those which remain as risk, such as rates risk, risk of variation of the underlying or the risk of regression of the funds, in practice, it is not possible to cover them all perfectly. Assurers generally try to minimise them with the best possible instruments and techniques on the market at the time.

What is the future for Life Insurance ?

Although the risks of Variable Annuities are extremely dangerous for the insurer to control, these products still address many of the basic needs identified by the insured : a need for secure funds linked to the need for good profits with, more than anything else, the ability to withdraw the entire sum at a moment’s notice. In France, with the current shortcomings in the pay as you go pension system, people are now searching for innovative solutions which can act as supplementary pension schemes, mainly to ensure a pension payment for life. Guarantees such as GMWBL (life-time payments after a defined deferred period) proposed by certain products seem to satisfy this need effectively.

The consideration of Variable Annuities are the future of life assurance on the theoretical plan is certainly viable, since these products, at first sight, provide, for the insured, all the benefits without the disadvantages of the usual insurance products. But the fundamental question remains and it is possibly the most important one : are the insurers, who engage in this form of business, able to, one day, (bearing in mind that the the cost of entry with a premium for variable Annuities still remain very high), totally control and master their products to the point of simplifying them for the man in the street, offering the product to them at reasonable rates by lowering their own charges, yet still ensuring that they are profitable in the long run ? It is a gamble that does not seem to have been mastered yet. Growth in this market over the last few years, over far too short a period, cannot, in reality, predict how profitable these products will be on termination of the contract