Use of internal data in insurance
This briefing note gives a high-level overview of how insurers can make better use of internal data to gain insight and drive competitive advantage.
The variable annuity market in Japan is young, growing rapidly, and undergoing a fundamental change in regulation. This article provides an overview of the variable annuity market in Japan, summarizes the new regulations covering reserves and capital requirement, and examines companies’ reaction to these regulations.
Variable Annuities (VA) have a short history in Japan. As a result of financial deregulation permitting the sales of variable annuities, ING Life started selling variable annuities in April of 1999. The next ING product, introduced in June 1999, provided for a Guaranteed Minimum Death Benefit (GMDB) that paid the greater of the account value or the initial premium in the event of death. Mitsui Life followed ING by introducing a variable annuity that provided a Guaranteed Minimum Accumulation Benefit (GMAB), which guaranteed that the ultimate annuity principal did not fall below a pre-set level regardless of the underlying investment performance of the variable annuity. AIG, Sony Life, and other companies began selling variable annuities through their traditional insurance distribution but with limited success.
Hartford Life, a leader in the U.S. variable annuity market, entered Japan in December 2000. Hartford was unique among new market entrants in focusing on variable annuity products sold through stockbrokers. Hartford's strategy was successful; they had significantly more sales than companies distributing through their traditional insurance sales channels. With further deregulation in October of 2002, banks were allowed to sell annuity products. Figure 1 shows the dramatic growth in variable annuity assets. While some of this growth is due to appreciation in the Japanese stock market during this time, the vast majority of the growth during this period is due to new sales.
Figure 2 compares new business volume in Japan with that in the U.S. market. While the total sales in Japan are still much smaller than in the U.S., net flow is already comparable. Note that total sales and net flow are similar in Japan because the policies are relatively new and lapse rates are low.
The drivers of market growth are:
Japan is one of the most rapidly aging societies. Average issue age of variable annuities in Japan is over 65 years (even 70 years at some companies). Demand for annuity and savings products will continue as the baby boom generation reaches retirement age over the next several years.
Interest rates in Japan have been extremely low for the past decade. The 10-year treasury yield has been as low as 1.5% and bank deposits have generally credited less than 0.1%. Consumers are looking for a more attractive investment vehicle.
Concern for risk
Japanese people, especially older people, are conservative investors. They do not like losing money by investing in stocks even though the expected return may be much higher than on bank deposits. Variable annuities with minimum guarantee features are welcomed by these conservative investors.
The savings rate is higher in Japan than in the U.S. The financial assets of the individual sector are about US$14 trillion, of which 50% is sleeping in bank deposits. Variable annuity assets, as of September 2005, are still only 1% of bank deposits and so have considerable potential for growth.
Deregulation of the bank channel accelerated annuity sales. Variable annuity sales financially weakened banks by improving profit margins yet retained less risk on their balance sheets. For example, if a bank customer switched money from a term deposit to a variable annuity, the bank could receive an up-front commission of 3% to 6% of single premium as well as trailer commission of around 10 basis points (bps) on assets. From October 2002, when banks were first permitted to sell annuities, to September 2005, total annuity sales through the bank channel reached $100 billion in terms of single premium. Variable annuities account for $60 billion and the remaining $40 billion are fixed annuities. It is notable that 65% of fixed annuity sales through the bank channel are foreign-currency denominated products. Such products are quite popular because of the relatively higher credited rate.
Another regulatory change is the resumption of the "Pay-off Scheme" in April 2005. In the past, the government insured the full amount of bank deposits against insolvency. This was an extraordinary measure introduced to prevent a worsening of the financial crisis that resulted in a greatly weakened banking sector. With the recovery of the Japanese banks, bank deposits in excess of 10 million yen are no longer protected in case of bankruptcy, and many customers with large bank deposits are considering how to diversify in order to limit their exposure to any one institution.
Table 1 shows the major VA writers ranked by assets as of September 2005.
The top three companies, which account for a 50% market share, are affiliates of foreign-based companies. It should be noted that the top two companies (Hartford Life and MS MetLife) were only established within the past five years. These foreign companies developed bank and stockbroker distribution from scratch and used these forms of distribution to achieve a large market share in a short period of time.
There are several reasons why the foreign-based companies have been particularly successful in this market:
Initially, there was no regulation in Japan requiring additional reserve or capital for the guarantees offered in VA products. At the time, the only item listed on the balance sheet was the market value of separate account assets. With the rapid growth in the VA market, the regulator [Financial Services Agency (FSA)] became concerned with the increasing industry exposure to these guarantees. Per the FSA’s request, the Institute of Actuaries of Japan (IAJ) published a report recommending a reserving method in December 2003. In 2004, FSA published a new regulation as a revision of the Insurance Business Law and related administrative guidelines.
The new regulation becomes effective in the fiscal year ending March 2006. It requires reserves for Minimum Guarantee Risk (MGR) and an additional solvency risk item (R7) for the variable products with minimum guarantee. The new reserve requirement is applicable to new business issued after April 2005, though companies can voluntarily include the existing policies. The new solvency item is applicable to all policies including existing policies. While there are two methods, "Standard Method" and "Alternative Method," it is thought that almost all companies will follow the "Standard Method." Both the reserve and the solvency risk requirement can be reduced for any risk transferred through reinsurance. The solvency risk item can be reduced for capital markets hedging provided the hedging has been demonstrated to authorities to be "effective." However, the reserve requirement cannot be reduced for hedging.
Under the Standard Method, the reserve requirement is calculated as the present value of future additional benefits provided by the guarantee (i.e., paid benefit in excess of account value) minus the present value of future income related to guarantee [i.e., portion of the Mortality & Expense (M&E) fee attributable to the guarantee]. Future expenses are calculated using a form of the Black-Scholes put option formula.
When such convenient "closed form" formulas are not available (e.g., in the case of a recurring premium or dynamic lapse), companies apply Monte-Carlo type approximation, using assumptions consistent with the Standard Method. Future income is calculated similarly.
As with the Standard Reserve requirement for traditional products, valuation assumptions are specified by the regulator. Expected return is assumed to be the same as the valuation interest rate, which is currently 1.5%. Some may feel this is a risk neutral valuation because 1.5% is close to the current treasury rate, but this is not precisely true. The valuation interest rate is based on historical average of treasury yield; the sudden change of market interest rate is not directly reflected in the valuation interest rate. Volatility is specified for each asset class (e.g., 18.4% for Japan equity). While reserve varies by many factors such as guarantee type, fund type, account value level ("in the money-ness"), age, etc., it is generally in the range of 3% to 10% of paid-in single premium if the guarantee is at the money (i.e., account value equal to guarantee amount).
Table 2 lists the key characteristics of the approach that is expected to be adopted in the U.S. for reserving VA guarantees and the approach being taken in Japan.
In addition to the prospective reserve defined above, the company also needs to fund a "contingency reserve" by accumulating the guarantee fee less any losses paid on the minimum guarantee.
The additional capital requirement component (R7) is 2% of the guaranteed amount when the account value is 110% or less and 0% when the account value is larger than 110%. In the case of a Guaranteed Minimum Withdrawal Benefit (GMWB) the additional requirement component is the guaranteed amount in excess of account value. It should be noted that this is a minimum requirement. Companies operating in Japan generally maintain capital and surplus equivalent to three to five times the minimum standard. The new requirements are a significant consideration for leading VA companies.
Companies' reaction to the new regulation
The new regulation resulted in additional reserve and capital requirements for VA writers. Companies took action by redesigning and re-pricing products to reflect the new landscape created by the new regulation. In addition, companies focused more on managing the risk contained in their products. In terms of risk management, companies can be segmented into three groups, (1) Naked, (2) Reinsured, and (3) Hedged.
Typically these are large multi-line companies in Japan. VA minimum guarantee risk is not a serious issue at present since VA is only a small portion of the total business portfolio. The increase in reserve and capital requirements due to the new regulation are often not material for these companies.
Multinational companies have made the most extensive use of reinsurance. Reinsurance is a convenient measure in reducing reserve and capital requirements as well as in mitigating minimum guarantee risk. Although third party reinsurance capacity is very limited, multinational companies can transfer risk to their headquarters or reinsurance affiliates, where risks can be managed centrally and often more effectively and at less expense. While such strategy is not available for domestic companies, it is anticipated that third party reinsurers will be more active in this area.
A few companies in Japan have implemented a hedging program. However, fewer companies have done so than in the U.S. because many of the multinationals use internal reinsurance and thereby manage the risk offshore. For large domestic companies, the risk is a relatively small part of their overall portfolio. Hedging can be useful in reducing the underlying economic risk as well as the required capital needed to back the VA guarantees. However, the reserve rules do not allow credit for hedging programs. The situation is not perfect for companies wanting to hedge, since the mismatch in accounting for the value of the hedge position, and the reserve actually held, causes volatility in results.
Despite the introduction of new regulations, VA sales in the fiscal year 2005 accelerated as the Japanese economy recovered and the stock market appreciated. While there are signs of rising interest rates, VA will continue to be one of the major saving products for aging society. VA is also utilized as a wealth transfer product because of the tax advantage of death benefit proceeds that other investment products such as mutual fund do not have.
In December 2005, further deregulation of the bank channel expanded to allow single premium whole life and endowment products to be sold through bank branches. It is expected that banks will be allowed to sell all types of insurance products in 2007, which may trigger another revolution in the insurance industry.
In 2005, the Japanese government initiated the privatization of Japan Post, which includes Postal Insurance, the largest insurance operation in the world. Postal Insurance grew to its current size by utilizing Japan Post's powerful distribution network, which naturally extends to every corner of the country. With the privatization, other financial institutions will be able to partner with Japan Post to distribute their third party products through the Japan Post network.
For decades after World War II, the Japanese life insurance and annuity market was characterized by evolutionary change. The past decade has redefined that evolution through a series of deregulation efforts. The companies that have reacted to and leveraged off of these changes have grown significant new product lines and distribution systems. This process is not complete. The changes expected to take place over the next few years offer similar opportunities to existing players and new entrants alike.