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posted on 12 August 2017

How Much Risk Do Variable Annuity Guarantees Pose To Life Insurers?

from the Chicago Fed

-- this post authored by Alejandro Drexler, Thanases Plestis, and Richard J. Rosen

Over the past two decades, guarantees that protect variable annuities’ balances when their underlying investments perform poorly have become quite popular. Collectively, these guarantees can pose a sizable risk to life insurers. This article explores the different types of variable annuity guarantees, the extent of the risk they pose to insurers, and the practices used by insurers to mitigate against such risk.

A variable annuity is a savings policy that is sold by life insurers. The policyholder contributes funds to the annuity’s balance, and the balance is invested in subaccounts made up of mutual funds and other investments.1 Any gains or losses from the subaccounts are passed back to the balance. After a certain number of years, the policyholder can start cashing out of the annuity by making withdrawals from or annuitizing the balance.2 Because stock investments are the largest component of variable annuities, variable annuity returns are strongly correlated with the performance of stock markets.

Although variable annuities were first introduced by life insurers in the 1950s, they only became a popular vehicle for retirement in the past two decades.4 At least two factors have contributed to this. First, tax reforms in the mid-1980s reduced the tax advantages of alternative retirement products.5 This made variable annuities, by comparison, more appealing.6 Second, in the late 1990s and early 2000s, insurers began to package variable annuities with optional guarantees.7 While the guarantees come in different forms, their general purpose is to ensure that the annuity balance is protected when its investments perform poorly.8 These guarantees have proven attractive to policyholders who are willing to pay a fee to limit potential losses to their savings. In the fourth quarter of 2016, 76% of policyholders elected to purchase a guarantee when it was available with their variable annuities.

The popularity of variable annuity guarantees has introduced new risks for life insurers. In “traditional" life insurance products such as term insurance, the main source of risk for insurers is policyholder mortality. This risk can be managed via diversification: By issuing a large number of policies, insurers can predict the mortality rate of their policyholders (using the law of large numbers) and then price the policies appropriately. However, variable annuity guarantees introduce risks that are not as diversifiable. Namely, they expose insurers to the risk that financial markets deteriorate, causing policy balances to decline and guarantees to kick in across the board. This risk cannot be mitigated by issuing a large number of policies because most policies are subject to a similar risk (i.e., the risk is systematic rather than idiosyncratic). Therefore, issuing more policies is likely to increase, rather than decrease, the amount of risk being absorbed by insurers.

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