Life Insurance ProduThe Psyche and Its Role in Life & Annuity Product Development

Real-World Perception

Spotlight Issue 1 - 2014

We are affected by the world around us, perhaps even more so than ever before with the increasing rapidity of communication fostered by the Internet and ever-increasing bandwidth. What used to take hours to reach us now magically pops up on our phones and computer screens in a fraction of a second. All news and commentary is real-time. There is no need to wait for the 6 p.m. news anymore—even TV news channels are 24/7 and have been for decades.

Our perception of issues such as the condition of the financial markets, unemployment and geo-political matters, for example, can color how we see the world and such perceptions are often subconsciously manifested in the media and other communication outlets. Back in the 1950s, when the U.S. was on guard against being invaded by Communist regimes and fears of nuclear war were present, science fiction movies about aliens were all the rage. Looking back, there was a direct tie-in with fears of

being invaded by a belief system that ran counter to our own and the allegory of being invaded by strange creatures from other planets.

We have been witness to how the ever increasing rapidity with which information is disseminated can affect us. It appears that we are more sensitized to world events than ever before. However, with all the information that surrounds us, we hardly have time to absorb one event before another important event occurs that supersedes interest in the earlier event.

In the life insurance and annuity markets, product development can also reflect the sentiment of the times.

Growth in the 1980s 

Life insurance and annuity products played a major part in the growth of the economic market of the 1980s. The updated valuation and nonforfeiture regulations of the late 1970s paved the way for insurance companies to offer more competitive rates and many companies went this route. Life and annuity products made their way from the kitchen table to the corporate boardroom. Companies used competitive rate structures and new products, such as universal life, to attract more high-end and financially savvy clients.

This was a very exciting time in the life and annuity industry, as sales of these newer generation products took off like wildfire for several companies. These events were mirrored in the U.S. by a new found feeling of optimism and national pride during this decade. The 1980s also showcased a friendly business environment that fueled even more fire to the sales of newer life products.

There were, naturally, several in the life and annuity industry who realized that these new products had liability

structures that were significantly different than the traditional life and annuity products of yesteryear. There was a realization within actuarial circles that these newer products could have fat loss tails (large sustained losses under certain economic scenarios) and that we, as an industry, needed to engage in more sophisticated asset-liability management. By using more active management than ever before, the industry could avoid some of these more dire loss scenarios and keep asset and liability durations balanced.

Of course, when things are perceived to be going really well, as they were during most of the 1980s, voices that reflect caution are usually ignored. Fortunately, there were several companies that were prudent enough to not lose their heads in the exuberance. These companies made the adjustments necessary to engage in proper asset-liability management and explored ways in which to mitigate losses in various economic scenarios.

During this time frame, there were several new products on the market: universal life, variable life (fixed and universal), newer generation deferred annuities and revamped immediate annuities. Interest rates were high during this decade and even though they decreased over time, interest rates at the end of the 1980s were still significantly higher than they are today.

For product development personnel, it was like being a kid in a candy store. Not only were the products new, but given that they were new, there weren't a lot of regulations in place yet. This provided a lot of diversity among like products. Also, sales volumes appeared to validate each new product and/or variation that hit the market.

In short, interest sensitive products were all the vogue and traditional products seemed stale in relation. With the exception of the new IRS regulations in the form of DEFRA (1984) and TAMRA (1988) that introduced the concepts of Guideline Premiums and 7-Pay Premiums, the 1980s were a period marked by rapid growth in new life and annuity products with regulatory bodies struggling to keep up.

The end of the 1980s was sobering and included the downfall of several insurance companies coupled by the Savings and Loan debacle. This was almost instantly followed by a recession that was exacerbated by the fall of the Berlin Wall.

New regulations were established in the life and annuity markets in the late 1980s that required more thorough analysis of these newer liabilities and the assets that supported them. Asset adequacy analysis (cash flow testing) and risk based capital were just a few of the regulatory requirements that emerged from this era.

Contraction, Growth, Litigation and Regulation in the 1990s

The 1990s were an unusual decade that carried forth a recessionary environment from the late1980s. There was uncertainty in the life and annuity market as well, as several insurers were taken over by their respective state insurance departments and some insurers went out of business altogether. There were, as previously mentioned, several regulatory moves made to prevent such a situation from occurring again, such as thorough asset adequacy analysis, risk based capital, more limitations on investments that were outside the norm (high yield bonds also referred to as "junk" bonds), the bolstering of state guarantee fund funding, and more.

Indeed, it was a bit of a wake-up call to the life and annuity insurance market that there was a need for regulations to make certain that the life and annuity industry would continue to prosper and that consumers would not ever be left holding the bag again. In short, regulations were put into place so that failure would not occur or take anyone by surprise; warning signs (e.g., risk-based capital ratios) and requirements would be in place long before a company was in real trouble, giving the state and regulatory authorities time to act.

The end of the recession in 1993 led to the start of a renewed growth cycle in the life and annuity markets, though this time growth was mainly fueled by variable products that benefitted from the long bull market run of the 1990s.

The vast increase in sales in the variable market was also somewhat aided by negative developments in the fixed market. Many interest sensitive products sold in the 1980s were illustrated at market interest rates of that time. As fixed income interest rates available on newer investments continued their gradual downward decline, products that had been sold on a "vanishing" premium basis began to un-vanish. Interest rates that had been used in the original sales illustration were unsustainable; and keeping

vanishing premium policies inforce required more premium payments than the original illustration had implied.

This began an era of class-action litigation that affected the entire interest sensitive fixed life market and there were very few, if any, life insurance companies selling vanishing premium products that escaped unscathed. This era of class action litigation also helped prompt the development of the Life Insurance Illustrations Model Regulation of the mid-1990s, which was intended to provide a more balanced and realistic view of interest sensitive life insurance illustrations and to curb certain abuses.

So, while the fixed insurance market was impacted by class action litigation and companies were rushing to re-think fixed interest sensitive product designs, the variable market continued to gain momentum as the equity markets took off.

It was an interesting phenomenon as there was a lot of speculation in the 1980s (when the first companies involved in the variable life and annuity markets began issuing such products) that policy holders would not favor the uncertainty that came along with variable products by not knowing how much interest would be credited on their policies as well as the uncertainty regarding volatility of equity returns.

What appeared to happen was quite the opposite. Policy holders favored this uncertainty over company declared rates on fixed products. This was partly driven by the impact of class action litigation of the fixed interest sensitive insurance market and the ultimate perception that companies had the ability to "manipulate" rates on declared rate products to the detriment of the policyholder.

As money was pouring into the variable insurance space, more money was being poured into the equity markets by those wishing to join in the double digit growth of the equity markets in general. Indeed, it was a great time for the variable market and the thought was that the bull market would never end.

Gains in the equity markets were huge at the end of the 1990's. The NASDAQ increased 85.6% in 1999 alone. Exuberance was the word of the day. It reminded me then of the story of Joseph Kennedy (patriarch of the Kennedy family) who in the late 1920s, when the stock market was still climbing at a then record pace, was given stock tips by a shoe shine boy. He realized that the stock market was too popular and that a big crash was around the corner.

In the late 1990s, it was an airline stewardess who mentioned to me on the sly that she was in the financial planning profession as a second job and was directing all of her clients to invest heavily in the stock market. I recalled the famous Joe Kennedy story and made a note to myself to reevaluate my portfolio ASAP and see if I were overexposed to dot coms and other fast growing sectors. Not only did the Joe Kennedy story come to mind, but so did the articles I read warning that price to earnings ratios on many NASDAQ stocks were out of whack and that the equity market was tremendously overvalued.

The 1990s closed on a huge bang and the start of the new millennium seemed to promise more growth and unparalleled growth. Somewhat unnoticed during the 1990s were products and/or riders that were developed to mitigate the downside risk of the variable market. At that point in time, only a small percentage of the investing and variable product population even fathomed a thought that the party in equities would come to a close.

Equity indexed products, as they were referred to back then, started with the first annuity product in the mid-1990s. Growth in this market was slow, given the newness of the product and the robustness of the equity markets and its positive impact on variable products.

Indexed products were built on a platform that would allow them to respond favorably to increases in various stock indexes, such as the S&P 500, while mitigating downside risk. Since indexed products did not directly place funds in equities themselves, but rather derivatives (call options) of equities, there was not much to lose. This was especially true given the underlying interest guarantee, something that variable products did not offer in their subaccounts.

Also notable were the development of variable product riders, which at the start were mainly on the annuity side, that would provide increased value when equity markets went down. The literal alphabet soup of variable annuity riders (GMIB, GMAB, GMWB...) were intended to help mitigate the downside risk inherent with variable products. These types of riders would be helpful in coaxing more risk adverse individuals into the variable market by providing them with some downside protection.

While indexed products and variable annuity riders garnered attention by risk averse individuals as methods of mitigating downside risk while maintaining upside potential, both were complicated benefits that were difficult to explain to potential clientele. As a result, sales of these products were minor and slowly began increasing as the 1990s wore on.

The New Millennium – Contraction, Economic Scandals and the Dash for Safety
If the 1990s were a decade of growth and prosperity, the new millennium was a sharp about-face that started almost as quickly as it began. The stock market began correcting in April 2000. As it struggled to regain momentum, September 11, 2001 quickly and harshly put the markets back into a long downward spiral (Figure 1). The Dow Jones Industrial Average (DJIA), for example, dropped more than 2,500 points in a matter of weeks following the incident.

As the decade trudged on, financial scandals abounded: Enron, Adelphia, and Tyco to name a few. There was also a sharp correction in the telecommunications industry. Finally, as the coup de grace, the decade ended with the longest and deepest recession since the stock market crash of the 1930s, driven by the debacle in the subprime mortgage market.

A sense of security makes us all feel good and allows us to take risks and chances that we might not otherwise take. Insecurity, on the other hand, especially in the financial markets, can bring things to a complete standstill and the recession that started in 2007 brought a complete sense of shellshock to those of us in the financial services industry. Job losses and foreclosures spiked; the economy was on the brink of disaster in September 2008.

The impact on life insurance and annuity sales was almost instantaneous starting with the market correction in April 2000. At that time, for example, new variable life sales held a 36% market share of annualized premium in the life insurance market. By 2012, the market share of new variable life sales had diminished down to less than 10%.

The switch from interest sensitive life and annuity sales, such as variable products, over to products that had stronger guarantees and were more protection oriented (i.e., a par whole life) transpired over this period as clients fled to safety. There were some variable policies that lost upwards of 50% of their value in short time frames.

The harshest impact on policy values was felt right after September 11, 2001, as equity and fixed income markets took one of the biggest downturns ever recorded. The nation's psyche was reeling from the first major attack on the continental U.S. since the War of 1812, which was both frightening, traumatic and sad. The impact was almost instantaneous and drove a huge amount of the insecurity that followed. The U.S. and neighboring countries would deal with the impact of 9/11 for many years to come.

Products such as indexed annuity and indexed life, which had made their debut in the 1990s, flourished in the first years of the new millennium. Many who had purchased variable products in the 1990s started shifting their new purchases towards indexed products, so that they could still enjoy some of the appreciation in the equity markets, but eliminate a good portion of the downside risk.

Variable annuity riders that protected against downside risk (GMIB, GMAB, etc.) saw a spike in sales and some of these riders began to be offered on variable life products.

Whole life, both participating and non-participating, saw a resurgence in sales as well. The mentality of purchasing life and annuity products went from products that offered the most accumulation with very little downside protection (variable) to products that offered little or modest accumulation with significant guarantees in place (fixed) and/or downside risk protection (indexed).

New products, such as shadow account UL, which is more akin to a term product in a UL chassis, also saw a spike in sales as many life companies started to develop and issue these products.

Unfortunately, in addition to all the market and emotional volatility that took place during the first decade of the new millennium, interest rates continued their downward trend. This combination of volatility and low interest rates were very detrimental to the annuity markets in general, as well as the variable and indexed life markets.

Shadow account UL products also took a hit as Actuarial Guideline 38 was implemented to ascertain that insurance companies were holding adequate reserves. AG38 has been tweaked a few times since its introduction mid-decade in order to cover up loopholes and has become quite stringent in the level of reserves required. Many companies have taken steps to avoid high AG38 reserves by cutting back on guarantees and or the maximum shadow account period.

What Lies Next?
It is very difficult to spot turnarounds in the economy and consumer confidence ahead of time. This is an obvious fact, but what is less obvious is how we're affected by the times that we live in.

More than ever, our access to information increases every day with the ever-increasing capacity and new discoveries in the technology world. In some respects, this has had some downsides with regards to information overload and how that impacts us all.

The life and annuity markets are sensitive to many different types of information, not just financial data. When things are going smoothly, people are more willing to purchase and when things are unstable or volatile, we retreat and only purchase those items that we deem absolutely necessary.

Part of the problem is not being able to, or not being willing to, spot the light at the end of the tunnel. When the equity markets were roaring in the 1990s, the investing attitude became somewhat cavalier and it seemed like the good times were going to go on in perpetuity. With all the economic, emotional and political turmoil that we've experienced in the first decade of the new millennium, it seemed as if we'd never be able to pull out of this rut.

In fact, indications based on individual life insurance sales for 2013 show that a transition is taking place. 2013 variable life product sales by annualized premium increased by 24% over 2012 (Figure 2). This may be due to the effects of the bull market in equities that has been in place over the last few years. On the other hand, 2013 UL sales by annualized premium fell by 7% over 2012. This could be due to more companies reining in shadow account UL sales to relieve the AG38 reserve impact. Life sales in aggregate were slightly less in 2013 than in 2012

(by 3%), though hopefully this trend will reverse itself as the economy and unemployment continue to improve.

While the "great" recession that started in 2007 lasted several years, and market interest rates are still very low to this very day, that doesn't necessarily translate into a dim future. Economic cycles come and go and, even though what we've been through has been unusually harsh over the last dozen or so years, the economic signs have been

Summary

there the last couple of years that point to a sustained recovery. I'm not predicting anything, just going along with the adage "what goes up must come down" and, with respect to the financial markets, "what goes down must come up".

In short, prepare for the best!

 

William "Bill" Aquayo
SVP, Actuarial Research
FSA, MAAA, CFA, ChFC, CLU
Insurance Technologies

 

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