The variable annuity (VA) industry is undergoing a transformation in response to the global financial crisis. VA products with their associated guaranteed living benefits are in high demand as the Baby Boomers transition into retirement. VAs provide customers with the ability to participate in a diversified portfolio of investments with protection against severe, sustained declines in the market. However, it is not clear that the life insurance industry can continue to offer VAs without fundamentally changing the manufacturing process for the creation and management of variable annuities. This article highlights the need for a new approach to VAs, the Sustainable Manufacturing Model, and illustrates the basic components of the process. Milliman is actively working with life insurers, asset managers, and distributors to implement this new model.
The problem: Market sensitivity means volatile returns
During the global financial crisis, it became obvious that life insurers' existing business model is market sensitive. The graph below shows the total return of the Dow Jones Life Insurer Index versus the S&P 500 during the critical months leading into and out of the crisis.
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At the worst point of the crisis, the life insurer index showed a 71% decline versus a decline of 42% for the S&P 500. Life insurers exhibited leveraged performance during both the period of market declines and the subsequent recovery. This simple graph captures a wide range of effects across all life insurer business lines, but it is clear that the VA business alone contains several market-sensitive elements, including the leveraged market exposure created by an up-front commission payment, which is recovered via market-sensitive fees, and the market exposure from VA guarantees.
Under the existing VA business model, the customer's assets are invested in stock and bond funds. The insurer charges a basis-point fee for the guarantee(s). A mark-to-market liability and the associated hedge assets reside on the insurer’s general-account balance sheet. During periods of market turbulence, this business model will experience stress. The ongoing cost of funding the hedge program will vary with market conditions, but the fees received by the insurer do not vary. In addition, the mark-to-market assets and liabilities on the insurer's balance sheet will vary significantly during these times. Both of these factors are likely to cause material fluctuations in the insurer's quarterly earnings.
In particular, second-order risks, such as fund basis risk, will become material during turbulent periods under the traditional VA business model. For example, the impact of fund basis risk can be understood by the following simple equation:
P&L impact = guarantee delta * (actively managed fund return – index benchmark
Prior to the financial crisis, fund basis risk did not have a material impact on insurers because the guarantee delta in the above equation was small before the broad-based market decline. As the markets declined, guarantee delta increased, and this magnified the effect of fund basis risk on insurers' profit and loss (P&L) statements.
In summary, the existing VA business model contains several stress points. There is a disconnect between the cost of hedges and the funding for hedge purchases (guarantee fees). Insurers' P&L volatility increases during periods of market turbulence, and second-order risks are magnified during these times as well.
Insurers have taken many actions to address these issues, including diluting the strength of guarantees, increasing fees, and replacing some actively managed funds with index funds. However, all of these actions assume the continuation of the existing VA business model, seen as a zero-sum game: For the insurer to prosper, customer value must be reduced.
A better approach: The Sustainable Manufacturing Model
To escape the high volatility and unsustainable risk that have been obvious during the recent crisis, insurers must make changes to the underlying VA business model. Under the new approach, the Sustainable Manufacturing Model, the insurer's goal is to earn stable returns from the manufacture of variable annuities.
In particular, the Sustainable Manufacturing Model involves three fundamental changes to VA product management:
- Including capital market hedges directly within VA funds
- Designing asset allocation models to target a specified portfolio volatility
- Redesigning guarantees to reduce their interest-rate risk
Let's look at each of these.
- Including capital market hedges directly within VA funds. VA guarantees provide protection against a severe, sustained decline in the market. Traditionally, insurers use fees, paid by the customer, to purchase hedges designed to pay claims resulting from a market decline. Under the Sustainable Manufacturing Model, hedges are included within the VA funds. This has several implications. First, it eliminates a major driver of an insurer’s guarantee costs. More important, it eliminates the insurer's exposure to fluctuations in hedge costs. Rather than being viewed as a cost, hedges are now an asset allocation choice. To obtain a guarantee, customers must allocate their assets to stocks, bonds, and hedges.
The insurer is still exposed to the risk of long-term underperformance of the hedge program—that risk existed in the traditional model. However, short-term P&L volatility is significantly reduced when hedges are included in VA funds. This changes the insurer's liability in a fundamental way. The insurer's liability is calculated net of the hedging activity, which is occurring within the VA funds. This tends to reduce and stabilize the liability reflected on the insurer's balance sheet.
As another example, consider basis risk. Because of capital market hedges, the effect of a market decline on the customer’s account value is reduced. This tends to reduce the guarantee delta in Equation 1 above. As such, the impact of second-order risks on the insurer's P&L is materially lower. Therefore, insurers will be able to offer guarantees on a wide range of actively managed funds under the Sustainable Manufacturing Model—with positive implications for VA sales.
Including hedges within the VA funds also affects the customer in a positive way. The most important effect is that the customer now owns a portfolio of hedge assets. Under the traditional model, the insurer owns the hedges as a general account asset. Under the Sustainable Manufacturing Model, the customer’s liquidity is materially improved during periods of market crisis.
- Asset allocation models targeting a specified volatility. The second component of the Sustainable Manufacturing Model involves a change to asset allocation models. Asset allocation models are commonly used in the VA market. A typical VA product may have five asset allocation models: conservative, moderately conservative, moderate, moderately aggressive, and aggressive. Under the traditional approach, each model targets a specified equity allocation, such as 30%, 45%, 60%, 70%, and 80%. The equity allocation is a proxy for a level of risk. However, it is important to remember that it is only a proxy. For several reasons, it is highly advantageous for insurers to target the level of risk directly. Under the Sustainable Manufacturing Model, each asset allocation model would target a specific portfolio volatility, such as 6%, 8%, 10%, 12%, and 14%.
As equity market volatility increases, fund managers shift assets from equities to bonds. Similarly, as market volatility declines, assets are shifted from bonds to equities. Managers adjust the allocation periodically to stay on target by means of transfers among underlying funds or the use of a hedge overlay.
For the insurer, this approach has significant financial management implications. Under the traditional model, the insurer must estimate "implied" volatilities in order to calculate the guarantee liability. Implied volatilities are estimated from transaction prices from the options market. Unfortunately, during a period of market crisis, the options market may experience wild price fluctuations. Options market turbulence is often caused by forced liquidation among highly leveraged hedge funds and investment banks. While forced liquidation among hedge funds has no direct effect on the ability of insurers to meet guarantee obligations, it can translate into material P&L volatility for insurers.
Under the Sustainable Manufacturing Model, the estimation of implied volatility becomes a moot point. The asset allocation models are managed to achieve a target volatility. This target should be used directly in the calculation of the insurer's guarantee liability. Because the target does not change, this approach eliminates a major driver of insurer P&L volatility.
From the customer's point of view, asset allocation models that include volatility management offer certain benefits. First, volatility tends to be a leading indicator of negative market performance, so that a prompt response to signs of volatility can stave off declines in asset value. Second, the traditional approach may be misleading for some customers. Under the traditional approach, the level of portfolio risk is allowed to increase unchecked during a crisis. For example, a 60% equity portfolio may be "moderate risk" most of the time, but during periods of market crisis, customers may be dissatisfied with the level of losses. Shifting the asset allocations can reduce those losses for customers.
- Redesigning guarantees. The third component of the Sustainable Manufacturing Model involves modifying the design of guarantees to reduce their interest rate risk. It is important to recognize the level of interest rate risk contained in VA guarantees. VA guarantees are similar, in many respects, to long-term put options. As such, they are sensitive to the level of interest rates. Declining rates increase the value of traditional VA guarantees.
Insurers are reducing the level of interest-rate risk by using floating-rate elements in the design of VA guarantees. For example, one method involves linking rollup rates and guaranteed withdrawal rates to the 10-year Treasury rate. Such a change will dramatically alter the interest-rate sensitivity of a VA guarantee.
One of the important benefits of the Sustainable Manufacturing Model is a reduction in behavior risk associated with VA guarantees. During the global financial crisis, insurers tended to focus on capital-market risks. However, it is very important to manage the behavioral risks in these products as well. For example, it is possible that we will experience a rising interest-rate scenario as the Federal Reserve withdraws its accommodative monetary policy. The current Fed policy is unprecedented in the depth of the support it has provided to the market, and the withdrawal of that support may produce unexpected effects. If rates move up dramatically, VA customers may opt for traditional fixed-rate products. Such disintermediation risk can be reduced by adopting product designs that are less interest-rate sensitive.
Another way of reducing behavior risk is by incorporating hedge assets into the underlying VA subaccounts. Under the traditional model, hedge assets reside on the insurer's balance sheet. Any situation that leads to a negative mark-to-market on the hedge assets creates a disintermediation risk. In simple terms, customers withdraw their funds and leave the insurer with hedge losses.
Implementing the model: Variations, challenges, and benefits
Some VA writers are actively searching for extensions to the Sustainable Manufacturing Model. For example, one possibility is to have the fee for a VA guarantee fluctuate within a range based on independent, observable values. These could include treasury rates, realized volatility on the S&P 500, the S&P Volatility Index (VIX), etc. A relatively small range between a minimum and a maximum fee can materially stabilize the risk profile of VA guarantees.
There are many challenges to implementing the Sustainable Manufacturing Model, beginning with material/technological issues. Insurers will need improved systems for the design, analysis, and ongoing management of the proposed products. The Sustainable Manufacturing Model requires the creation of new types of VA subaccounts that contain hedge assets. These subaccounts will require the ongoing management of a hedge program, and the insurer will need to coordinate residual on-balance-sheet hedging. Traditional asset managers are generally not well positioned to manage hedge assets within VA subaccounts. They have established their brands around intelligent security selection, but, in general, they do not have in-depth knowledge of the risk management involved in VA guarantees.
In addition, implementing the Sustainable Manufacturing Model will likely confront human-resource challenges. In particular, it will be necessary to get buy-in from financial advisers and to educate them in the benefits and details of the redesigned VAs. Life insurers must secure the enthusiastic support of their distribution force for new products to be successful.
In return for overcoming these challenges, there are significant benefits for companies that succeed in this effort. The capital market and behavioral risks associated with VA guarantees can be materially reduced. The new paradigm may offer a way to achieve both profit margins and sales goals.
Initial responses to the new model indicate that VA writers will most likely take an incremental approach to implementing it, picking and choosing specific elements of the model. In addition, insurers may follow the traditional approach for some product designs and adopt elements of the Sustainable Manufacturing Model for others.
It is clear that there are significant changes underway in the VA market. We can expect a new market equilibrium to emerge over the next 12 to 24 months.