The U.S. Payout Annuity Market: The Risks Are Real, But So Are The Opportunities
The U.S. Payout Annuity Market:
The Risks Are Real, But So Are The
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: http://prc.wharton.upenn.edu/prc/2002conf.html. 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.
continued on page 3
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
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
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:
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."
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.
Moody’s Special Comment
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
- Stroke & Pneumonia
- Cancer & Diabetes
- Heart Disease
+ 85 bp
+ 39 bp
- 36 bp
+ 77 bp
+ 4 bp
- 111 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
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
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.
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
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.
Moody’s Special Comment
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 www.yorku.ca/milevsky.
Moody’s Special Comment
The U.S. Payout Annuity Market: For Life Insurers, The Risks Are Real, But
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.
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.
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Moody’s Special Comment