September 2002

Special Comment


The U.S. Payout Annuity Market:
The Risks Are Real, But So Are The


Production Associate

Arthur Fliegelman
Scott Robinson
Moshe Arye Milevsky*

Michael D’Arcy

John Lentz

uct design, they should be able to successfully diversify this risk and consequently control the potential for
negative cr...
Risks Related to Payout Annuities
In our opinion, the major risks to an insurer on a payout annuity are the risks related ...
In order to quantify the impact of mortality improvement on an insurer’s profitability, imagine a situation, in which a li...
Declining interest rates combined with greater than anticipated mortality improvements could also
materially impact an ins...
Companies also have an interest in being sure that they are properly quantifying the risks that come
with their products. ...
The U.S. Payout Annuity Market: For Life Insurers, The Risks Are Real, But
Special Comment

The reinsurance mar...
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The U.S. Payout Annuity Market: The Risks Are Real, But So Are The Opportunities


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Moody's Investors Service research report published in 2002.

The report discusses the opportunities and risks in the payout annuity market to U.S. life insurers.

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The U.S. Payout Annuity Market: The Risks Are Real, But So Are The Opportunities

  1. 1. September 2002 Special Comment Phone 1.212.553.1934 The U.S. Payout Annuity Market: The Risks Are Real, But So Are The Opportunities This is a summary version of a paper, "Credit Implications of the Payout Annuity Market," presented at The Wharton School's Pension Research Council and the Financial Institutions Center's April 2002 symposium, “Risk Transfers and Retirement Income Security.” Readers interested in a more in depth discussion of concepts introduced in this Special Comment are referred to the following website: The paper will be included in a book entitled "Risk Management and Retirement Income Security" Edited by Olivia S. Mitchell and Kent Smetters. Forthcoming 2003. Summary Opinion continued on page 3 Special Comment Payout annuities, a form of individual annuities, permit individuals to mitigate their post-retirement financial uncertainties by transferring their financial risks into the hands of an insurance company. In return for a premium payment for a payout annuity, an insurance company agrees to make monthly annuity payments to the purchaser and/or his or her spouse. The primary attraction of this product to the annuity buyer is that subject to the financial strength of the insurer, it guarantees the buyer with an income stream that he or she can not outlive regardless of how long he or she lives. The risk of an individual outliving their retirement financial resources is very real for many Americans, particularly those with modest savings. Average conditional life expectancies at age 65 are 76 for men and 83 for women, and are still on the rise. Given this situation, Moody’s believes that there is a significant growth potential for U.S. life insurance companies in this market. Moody’s believes that the nature of this product, with a very long-dated, fairly level benefit payment stream, limits insurance company exposure to liquidity risk. However, insurance companies marketing payout annuities may assume other risks such as longevity, asset-liability, and equity market risk. Moody’s, working with a contributing author, has developed a pricing model quantifying the risks to profitability and solvency that could result from unexpected longevity increases. We believe that underestimating future mortality improvements can be extremely costly, especially for companies with substantial relative exposure to payout annuities. We also believe, however, that insurers benefit from the "law of large numbers" when they market payout annuities to a broad customer base. Because of this, and in conjunction with creative prod- The U.S. Payout Annuity Market: The Risks Are Real, But So Are The Opportunities Contact Arthur Fliegelman Scott Robinson Robert Riegel
  2. 2. Author Editor Production Associate Arthur Fliegelman Scott Robinson Moshe Arye Milevsky* Michael D’Arcy John Lentz *Dr. Milevsky is a professor at Schulich School of Business, York University. © Copyright 2002 by Moody’s Investors Service, Inc., 99 Church Street, New York, New York 10007. All rights reserved. ALL INFORMATION CONTAINED HEREIN IS COPYRIGHTED IN THE NAME OF MOODY’S INVESTORS SERVICE, INC. (“MOODY’S”), AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, such information is provided “as is” without warranty of any kind and MOODY’S, in particular, makes no representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information. Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings, if any, constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding or selling. Pursuant to Section 17(b) of the Securities Act of 1933, MOODY’S hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODY’S have, prior to assignment of any rating, agreed to pay to MOODY’S for appraisal and rating services rendered by it fees ranging from $1,000 to $1,500,000. PRINTED IN U.S.A. 2 Moody’s Special Comment
  3. 3. uct design, they should be able to successfully diversify this risk and consequently control the potential for negative credit developments arising. Payout Annuities and Strategic Necessity Moody’s expects that as baby boomers in the U.S. shift from the asset accumulation to the distribution phase of their lifecycle, the competition among insurance companies, mutual funds and banks to manage and control these assets will intensify. The penalty for not offering products that meet retirees’ demands is the potential loss of these sizable asset pools. U.S. life insurers have a unique ability to offer customers longevity insurance through the payout annuity mechanism, and we believe that properly implemented, this can be a major competitive advantage. Payout Annuities: The Basics Payout annuities are products sold by life insurance companies that convert qualified retirement or other savings into guaranteed annuity payments. These payments can either be fixed in dollar amount or can fluctuate along with the value of underlying investments into which the customer has allocated his savings. Fixed immediate annuities (FIA) are the product’s more conservative form. For this product, the customer makes a one time, lump sum premium deposit to the insurer. In exchange, the insurer agrees to make a series of periodic payments, usually monthly to the product purchaser or his designee. With some products, the payments last only for a pre-determined length of time such as ten years. These are referred to as fixed-term annuities. Annuities that pay for the life of the annuitant are referred to as life-contingent annuity products. Variable immediate annuities (VIA) are payout annuities where the funds are invested in separate accounts, typically with a heavy equity allocation. The annuity payment to the customer will vary with the investment performance of the underlying account. VIA have modestly gained in popularity in recent years, particularly when the equity market was performing well. Whether fixed or variable, payout annuity products transfer certain risks from the individual to the insurer. Depending on the product, these risks may include longevity, interest rate, credit, equity market fluctuation and inflation risk. Benefiting from the "law of large numbers" (selling large numbers of such products to spread out the risk), and in conjunction with creative product design, insurance companies can manage and control the risks they assume in writing these contracts. The Size of the Market The payout annuity market can be broadly divided into the annuitization and immediate annuity segments. As previously explained, the products within these segments are further subdivided into the fixed and variable payout annuity products. By the annuitization market we are referring to the conversion of a lump sum of funds from a pre-existing insurance contract into a defined payment stream. Annuitization is therefore not a source of new funds to the industry, but does assure the industry continued retention of existing funds. According to LIMRA International (LIMRA), annuitizations amounted to approximately $14 billion of US sales in 2000, not including sales from the structured settlement and terminal funding markets. Immediate annuities are newly sold annuity contracts initiating periodic income payments. According to LIMRA, sales of individual immediate annuities totaled $3.8 billion in 2000. This number excludes sales made by TIAA-CREF, which itself had approximately $49 billion of payout annuity reserves outstanding on December 31, 2001. The Future of the Market The rate of growth of the payout annuity market is dependent on a number of factors, one of the most important of which is distributor education as to the benefits of a payout annuity. Financial advisors may be reluctant to spend much time learning about payout annuities, as they are often difficult products to sell and often have lower commissions as compared to other insurance products. Furthermore, after selling a lifetime payout annuity, an agent loses the potential to earn future commissions on those funds. In order for the payout annuity market to reach its full potential, Moody’s believes that insurance companies must convince distributors as to the potential benefits of payout annuities in a retiree’s portfolio. Moody’s Special Comment 3
  4. 4. Risks Related to Payout Annuities In our opinion, the major risks to an insurer on a payout annuity are the risks related to the following two guarantees: 1 Equity Guarantees. Consumers planning for retirement often seek equity market exposure while simultaneously benefiting from some form of downside protection during a severe market decline. Insurance companies have responded to this consumer interest by offering increasingly innovative product features limiting downside exposure through provisions such as guaranteed minimum income benefits (GMIB), and VIA containing "floors." 2 Payout Annuity Guarantees. Aggressive mortality, interest rate, or equity guarantees can expose insurers to material losses over the life of a payout annuity. These risks are heightened if a company guarantees payment streams to be made far in the future when there is increased uncertainty about the variables affecting the guarantee. Moody’s believes that the under-pricing of the above guarantees are unlikely to result in a dramatic insurance company "run on the bank" that will culminate in a company’s failure, except in the most extreme cases. However, we believe that a prolonged period of operating losses could severely weaken a company's capital position over time and reduce its overall financial strength. General Market Risks Key risks to the insurer in the payout annuity market include both longevity and investment risk. When dealing with VIA products, in particular, the insurance company needs to consider both longevity risks and the risk arising from equity market volatility. Both FIA and VIA payout annuities may offer the contract holder the right to commute the contract and receive a surrender payment. This option can create greater future cash flow uncertainty for the insurance company offering this option. Insurance companies that do not properly price mortality and investment or equity market risk may not meet their profitability targets, or worse. Based on our conversations with companies, their post-tax return on investment targets typically range from 10% to 12% for fixed annuities, and over 15% for VIA. The worst case scenario for companies offering a fixed FIA is a prolonged declining interest rate environment combined with unexpected mortality improvements. For VIA, the worst case scenario is declining equity markets, thereby lowering insurers' fees and possibly also triggering some minimum payout guarantees. Unexpected mortality improvements could also hurt VIA profitability. The Nature and Pricing of Mortality Risk The appropriate mortality assumptions used by insurance companies for pricing purposes are heavily dependent on the annuity applicants. For instance, companies naturally expect a degree of adverse selection, as healthy applicants are far more likely to purchase longevity protection than those who don't expect to live long. On one study, the cost of adverse selection was valued at approximately 12% of the annuity premium for a 65-year-old man.1 Thus, the question arises: what would be the financial effects on an insurer issuing payout annuities if longevity was to suddenly dramatically increase? The impact of this would depend on the exact timing and magnitude of the medical breakthrough that made the increase possible. We use a pricing model to account for the effect of a medical breakthrough on mortality. For a description of the model, please refer to the soon to be published book, "Risk Transfers and Retirement Income Security.2" 1 Brown, Jeffrey, Olivia S. Mitchell, and James Poterba. “Mortality Risk, Inflation Risk and Annuity Products.” NBER WP July 2000. In Zvi Bodie, Brett Hammond, and Olivia S. Mitchell, eds. Innovations in Financing Retirement. Pension Research Council. Philadelphia, PA: University o Pennsylvania Press, 2002: pgs.175-197. 2 This special comment is a summary version of a paper presented at the Wharton School’s Pension Research Council and Financial Institutions Center’s April 2002 symposium. The paper will be included as a chapter in the aforementioned book. 4 Moody’s Special Comment
  5. 5. In order to quantify the impact of mortality improvement on an insurer’s profitability, imagine a situation, in which a life annuity is issued and priced at age 62, with an expected 100 basis point profit margin. The life expectancy at the issue age is 83.8, which is the life expectancy with no mortality improvement other than that already built into the actual table used to price the annuity (featured below). Table 5 Single Premium Immediate Annuity Issue Age Mortality Status Quo: - Stroke & Pneumonia - Cancer & Diabetes - Heart Disease *Reduction 0% -10% -40% -80% Unisex 55 Life Exp. Spread 82.9 83.8 87.4 97.7 +100 bp + 85 bp + 39 bp - 36 bp Unisex 62 Life Exp. Spread 83.8 84.7 88.1 97.9 +100 bp + 77 bp + 4 bp - 111 bp Unisex 70 Life Exp. Spread 85.6 86.4 89.4 98.6 +100 bp + 60 bp - 67 bp - 257 bp The above table displays the ex post spread that would be earned from an immediate annuity block of business, assuming an ex ante desired spread of 100 basis points. Thus, for example, if life annuities were sold to a 62 year-old with the intention of earning a spread of 100 basis points, then a 10% aggregate reduction in mortality (from the elimination of strokes and pneumonia) would reduce the spread to 77 basis points. If, however, the insurance company underestimated the true force of the mortality improvement on the group, the profit spread after the event would clearly be lower than 100 basis points. The question is, “by how much?” Let's imagine that science finds a cure to all strokes and pneumonia. In this case, we assume that the force of mortality would be reduced by 10%. If cancer and diabetes were also cured, the reduction would be 40%. And if heart disease were also eliminated, mortality would be reduced by 80%. In each case, we would reduce each factor rate in the appropriate cohort table used to price mortality by that percentage. Thus, at each age, a fixed fraction of deaths would be eliminated as a proxy for the reduction in the various causes of death, according to our calculation. The most interesting bit of information yielded by the calculations we undertook using our methodology is that, the higher the customer's age when the contract is issued, the greater the impact on profitability of a given percentage improvement in mortality. For example, eliminating strokes, pneumonia, cancer and diabetes (yielding a 40% drop in mortality) would leave the issuer with a profit spread of 39 basis points of contracts issued to customers at age 55, but a negative 67 basis point spread if issued at age 70. We repeated our calculations using individual annuity mortality tables, and obtained results on the same order of magnitude. Another interesting result of these calculations is that, despite the extraordinary 80% reduction in mortality rates resulting from a hypothetical elimination of cancer, stroke, pneumonia and the other aformentioned scourges, the number of years added to the average life expectancy still range from only 10 to 15 years, at best. In other words, a massive 80% reduction in the death rate for any given age stills add only 15 years to an individual's life expectancy. Although we do not profess to be demographic or actuarial experts, the following two messages from our calculations is clear. First, a relatively small change in realized mortality can have a fairly large impact on contract profitability. Second, and more important in our opinion, the marginal impact of this profit decline is greater the older the issue-age of the business. In other words, at younger ages the impact of any fixed percent reduction in mortality is negligible, while it becomes much more important at the older ages. Assessing Investment Risk When developing an investment strategy for fixed payout FIA, the investment manager must design an investment strategy to make fixed dollar payments for an uncertain length of time. Different investment managers will take different degrees of investment risk in order to meet their pricing objectives. Insurance companies typically invest primarily in bonds and other fixed income instruments. To attain the investment yields necessary to be competitive in issuing payout annuities, companies purchase higher yielding, lower credit quality assets. They also invest in markets that offer incremental income, such as private placements and commercial mortgages. Given these investments, credit losses and assumed reinvestment interest rates are two key variables that insurers must consider. Clearly, credit defaults and the resulting losses impact a company's reported profitability. Moody’s Special Comment 5
  6. 6. Declining interest rates combined with greater than anticipated mortality improvements could also materially impact an insurer’s profitability. This is particularly true if the insurer uses shorter duration assets to back longer duration payout annuities, a situation that is often the case since long enough dated assets can be very limited in supply. Conversely, rising interest rates could negatively impact profitability for those companies that invested in long, illiquid assets. Companies caught in this position may need to liquidate depreciated assets to meet ongoing benefit payments. Commutation Rights In response to market demands, many companies have begun offering annuitants the right to commute, or end, their contracts and receive a certain portion of their future annuity payments up-front. In order for the insurer to protect itself from adverse selection, there are normally limitations on an individual’s right to commute life contingent payments. In order to protect themselves against potential sales misconduct charges related to these complicated products, we believe companies should ensure that contractholders fully understand the commutation process. Risks Unique to the Variable Immediate Annuity Market Companies offering VIA base the level of the annuity payment made on the performance of the investment supporting the contract, thereby avoiding any investment risk. However, the insurers’ VIA product fees are also typically based on the account value, thereby linking the profitability of the product to the performance of the underlying assets. In addition, companies issuing VIA remain exposed to longevity risk. Poor equity market performance also increases the value of minimum guarantees the insurer has provided, thus increasing the importance of proper risk management. Potential Liquidity Risks Allowing contract holders the ability to shift funds between the general account and the variable account can also present risks to the insurer, particularly liquidity risks associated with contract holders’ ability to move en masse between the fixed and variable accounts. Sizable asset reallocations from the fixed account to the variable account could in theory expose insurers to the need to sell substantial amounts of bonds on short notice. Depending on product design, individuals could also potentially anti-select against the insurance company by shifting funds between fixed and variable in order to increase their payments. However, thus far we have seen little evidence that this is a meaningful risk in actual practice. Basis Risk Tied to Indexed Payments Companies offering inflation-indexed annuities are exposed to the basis risk of providing for indexed payments. For the companies offering products indexed to the consumer price index (CPI), the scarcity of appropriate investments that can be used to offset this liability exposure must be considered as part of the asset-liability management process. Managing Payout Annuity Risk To properly manage a block of payout annuities, it is necessary to first quantify the potential risks. In undertaking this task, one needs to understand the incremental risk that these products add to an insurance company’s overall risk profile. For the vast majority of life insurance companies, payout annuities represent only a small portion of a company’s overall business and they are therefore a relatively small risk factor. In fact, in such a case, the added costs required to reduce a company’s risk exposure to these products may not be justified in practice. Prudence dictates, however, that companies develop longer-term plans for keeping their risk management process up-to-date with their expanding sales. 6 Moody’s Special Comment
  7. 7. Companies also have an interest in being sure that they are properly quantifying the risks that come with their products. This is particularly necessary for products possessing so-called "tail risks." Such products may meet financial objectives in most scenarios when subjected to scenario testing, but have exceptionally poor financial results in the remaining extreme scenarios, such as the 1% tail. VIA products and products containing guaranteed minimum income benefits can be exposed to such tail risks. The Benefits of Diversification Insurance companies can mitigate the longevity risks of payout annuity products by taking offsetting positions on mortality exposures through their life insurance products. However, because the customer profile of payout annuity and life insurance buyers are quite distinct, determining the value of such diversification benefits can be tricky. In fact, some believe that there may not be substantial diversification benefits for life insurers being active in both life insurance and FIA. The argument goes as follows: FIA are sold primarily to the elderly, while life insurance is primarily purchased by the young and the middle-aged. An increase in population longevity will therefore adversely impact the liabilities of the FIA block, while only marginally impacting the profitability of the latter. Furthermore, the proponents of this view argue the duration and lapsation behavior of these liabilities are mismatched and therefore cannot properly provide a hedge for each other. Moody’s believes that, although the liability mismatch argument could be true for (short) term life insurance policies, the argument is less clear when applied to non-participating whole-life policies. Both life insurance and FIA are sensitive, albeit in opposing directions, to changes across the length and breadth of the mortality table. The magnitude of sensitivity is highly dependent upon a number of factors, particularly guarantees. An insurance company may be able to offset poor mortality experience on a life insurance block by increasing cost of insurance charges; however, the insurer may not be able to decrease guaranteed payments on payout annuities to offset unexpected mortality improvement on its payout annuity block. Policyholder behavior has a significant impact on the analysis. For example, healthy life policyholders may surrender if faced with increased mortality charges, thus subjecting the company to adverse selection. The issue ultimately becomes one of locating a proper hedge ratio in the face of uncertain mortality. In determining this ratio, one would need to look at the mortality table as well as product design, incorporating data indicating how susceptible a life insurance policy is to surrender.3 For products with embedded equity guarantees, it may not be possible to diversify away the associated risks. In these instances, the insurance company must look to other solutions, such as reinsurance. Product Design Represents the First Line of Defense Product design is the first and most important line of defense to protect an insurer’s financial integrity and profitability. It is often the case, in fact, that a simple change in product design can significantly reduce a product’s risk, dramatically reducing the risks of the insurer selling the product. Restricting the investment options of annuity products that pay guaranteed living benefits such as GMIBs or VIA, may, for instance, reduce the volatility of returns and hence the value of the option granted to the contract holder. Moody’s believes companies should be wary of incorporating product features into their products if those features cannot be accurately quantified or hedged -- regardless of the demand for those features from customers and distributors. Doing otherwise is a potentially dangerous proposition, particularly in the case of expensive living benefit options. Reinsurance Involvement to Map Out Risks Reinsurance allows primary companies access to the product design and mortality expertise of the reinsurers. Reinsurers are typically able to draw upon experience from a large and diverse client base, which can be invaluable to a ceding company, particularly when entering a new product line. 3 For those interested in an elaboration on how this mortality risk management and hedging strategy would work please refer to the following: Milevsky, Moshe A. and David S. Promislow (2002), "Can Insurance be Used to Hedge Annuities: An Introduction to Stochastic Mortality Models", Schulich School of Business Working Paper, available at Moody’s Special Comment 7
  8. 8. The U.S. Payout Annuity Market: For Life Insurers, The Risks Are Real, But Manageable Special Comment The reinsurance market for fixed and variable payout annuities in the US is, at present, poorly developed; we believe mainly because of an absence of significant demand from primary insurers. In addition, many major reinsurers have been unwilling to accept longevity risk, unless they are able to build in a substantial margin for mortality improvements. The reinsurers’ position is consistent with their expectation of steady US mortality improvements in the years ahead, as evidenced by the rates offered on reinsuring life insurance contracts. Moody’s believes that the reinsurance market for payout annuities will nonetheless expand over time as primary company exposure to this market increases. It is also possible that offshore reinsurers that benefit from less restrictive regulation and lower taxes will find long-tailed payout annuity contracts an attractive business. We believe that the financial strength of the reinsurer will be an important risk consideration in these instances because of the long-tailed nature of payout annuity contracts. Distributor and Customer Education Moody’s has no doubt that distributor education will be an important part of the payout annuity market’s long-term success. Education will take on added importance as product complexity increases, raising the potential for sales misconduct. It is imperative that customers understand the potential disadvantages and shortcomings of payout annuity products. Contract holders should understand, for instance, the consequences of being re-underwritten for a life contingent commutation, namely, that he or she will likely receive less money than if he or she were healthy. Conclusion As the baby boomers reach retirement age, insurance companies will continue to look for ways to attract and retain retirement assets. Although payout annuity sales remain modest compared to sales of other insurance products, the potential benefits are material for companies able to manage even a small portion of the growing pool of retirement assets. Insurance companies have prepared themselves for this growth by meeting consumer demands for liquidity, equity market participation, and minimum payment guarantees with increasingly innovative products. Should the market meet growth expectations, the next challenge for insurance companies will be to protect themselves from the product guarantees that they have made. To order reprints of this report (100 copies minimum), please call 1.212.553.1658. Report Number: 75924 8 Moody’s Special Comment