Spotlight Issue 4 - 2013
When I started researching to write this article, I was amazed at how many topics there are in the life and annuity market to discuss. The proverb “may you live in interesting times” certainly holds true for those of us in the life insurance and annuity market. Some may even go as far to state that perhaps these times are too interesting!
In any case, if I left a few things on the cutting room floor, it was not my intention! There are so many relevant topics floating around our industry today that it was really hard to choose topics for this one article.
At the beginning of the year, I drafted a spotlight article on how the prolonged low interest rate environment was affecting the profitability and design of life insurance products. Shortly thereafter, I attended the ReFocus conference and, lo and behold, low interest rates were the main theme of the conference.
The prolonged low interest rate environment has been a major topic of concern for life insurance and annuity companies for several years now. Many at the conference felt that we would see low interest rates in the market for 3-5 years before they started to move back up to more normal levels. This implied that many of the attendees felt like there was no light at the end of the tunnel. This was quite similar to the 1970s when everyone felt that large scale inflation was perpetual and that the prime rate would always be in the high teens.
Times have certainly changed since then, but the fact remains that continued low interest rates are a concern. They impact our market in more ways than just product design. Their impact is directly felt by those whom our industry serves, such as the retiree worrying about a lack of interest income and being able to keep up with inflation. While inflation as measured by the aggregate CPI has climbed steadily, certain components that affect seniors have risen more dramatically. As more people retire, our industry is provided with opportunities to offer products that can deliver the income retirees need to sustain themselves; and provide inflation protection as well.
We’ve seen some upward movement in the interest rate market and whether or not this trend continues is anybody’s guess. Low interest rates impact life insurance and annuity carriers in a number of ways, from earning compressions due to lower than expected spreads, to managing inforce blocks of business that have high guaranteed interest rates, the increased present value of LTC benefits, the large cost of immunizing guarantees in indexed products, etc. However, high interest rates are not entirely the answer. If interest rates move up too quickly, that could be even more devastating to insurance companies than the current interest rate environment. A slow but steady rise would help companies best. Of course, the market doesn’t always behave the way we would like it to.
The T-Bond fell from 3.1% in August 2007 to 1.6% last August and has risen to 2.5% as of this writing. This is a rather steep increase in rates, which could be problematic (disintermediation, e.g.). This is on the heels of the Fed announcing that it will pare down and ultimately eliminate the bond buyback program and allow interest rates to start drifting up.
Companies have been challenged in the current environment for other reasons besides low interest rates. Even though the rising stock market has helped bolster assets under management (AUM), for example, market volatility has been detrimental for companies that purchase hedging instruments as volatility directly drives hedge prices up. Companies purchase hedges for a variety of reasons, not just for overall risk management. Hedges also play a large role in the index product market.
Is stock market volatility here to stay, some wonder? My instincts tell me that this is not your father’s stock market, where you picked up the phone to call your broker and they placed an order for you. With the advent of computer technology, a fair share of the ordering and selling is automated, taking nanoseconds to complete. Add the ability to input buy and/or sell price limits and I think you see what is being implied (get used to volatility as a way of life).
Insurers have been increasing their capital as a percentage of risk based capital (RBC) for years now. Back in the mid-1990s, it appeared that holding 175% RBC company level was sufficient. Now, the average is upwards of 400%.
On top of all of this, life insurance and annuity companies are going to have to deal with the Principles Based Approach (PBA) to reserving in the U.S. This is a dramatic departure from how statutory reserving has been mandated in the U.S for many years. While current statutory practices are trying to bridge this gap, statutory reserving for the most part has used prescribed, deterministic formulas that are intended to lean towards maintaining conservative solvency. Generally accepted accounting principles (GAAP) was developed back in the 1970s as U.S. statutory reserving was considered quite conservative and not indicative of what a company is actually earning. With PBA, a lot of the old statutory methodology goes out the window as companies have to incorporate more of a cash flow process to developing reserves, along with a lot of stochastic modeling. Fortunately, the PBA phase in period is about 3 years in length; yet, companies will need this time to adequately implement PBA.
There are many other challenges that could be brought up, such as compliance, expense management, etc., that life insurance and annuity companies face. However, I think you get the picture. We live in interesting times and there is no shortage of things to do and deadlines to meet.
Nevertheless, it is my own personal opinion that we are truly fortunate to be involved in such a great part of the financial services industry as the life insurance and annuity markets. This is one of the most innovative and creative aspects of the financial services market that I know. We are constantly coming up with new products and ideas to best serve our customer base; always pondering about the future and the movement of various subpopulations (e.g., baby boomers) and markets (e.g., middle market), how to best serve them and what we can do to improve. The people in our industry are not in it for a quick buck, but for the long term by providing value added services and products. Let’s face it, most industries’ client relationships end pretty much at the point that the service or product is purchased. Our product can last a lifetime, as can servicing that product and the relationships that our clients have with our respective company.
I know that the majority of stock analysts out there who describe the life insurance and annuity market as staid and boring would not agree with me. Stock market capitalization of life companies is currently well below historical norms mainly due to compressed spreads, LTC and variable annuity living benefits underpricing and high guaranteed interest rates on inforce products. Yet, in the timeframe that I have been in the financial services industry, I have witnessed innovation after innovation. I’ve witnessed the advent and growth of the variable and indexed markets, the growth of the term market, and experienced the plethora of living benefit riders in variable annuity products that are starting to make their way into non-variable channels. I’ve been involved in the development of shadow account products and several other ways that the industry has continued to create and innovate.
I don’t always follow the stock analysts anyway. If I had, I would have sunk money into the dot coms and telecommunications several years ago only to have my lunch handed back to me when those markets crashed. Are these the markets the analysts considered attractive? Do the analysts notice the potential for volatility and for massive capital loss?
I witnessed the life and annuity markets come crashing down in the late 1980s and early 1990s. Junk bond and real estate markets tanked and there were several companies with large amounts of each in their portfolios. The work that has been done since then to prevent this from happening again is yet indicative of more innovation in the life and annuity market. Asset liability management, such as in the form of mandatory cash flow testing, establishing RBC and action levels, the model life insurance illustration regulation, and the wave of compliance/regulation to deal with new product innovations, to name just a few. All of this is done to keep our industry safe and predictable. We provide many things to our clientele, but the paramount item of what we provide is safety and security. So, if we’re boring, all I have to say is that our industry was here yesterday, it is here today and it will be here tomorrow. What is so boring about that?
Some may argue that the financial crisis that we’re just now getting over saw a few issues pop up with life and annuity companies. Very few companies whose main or entire focus is in the life and annuity market sought relief under Troubled Asset Relief Program (TARP) and those that did promptly paid their debt back. This led some to wonder why the federal bailout was even extended to the life insurance industry.
Low interest rates have forced life insurance companies to find unique ways and products to manage through the issues that have arisen. The focus on cash accumulation fixed UL products of yesteryear, for example, has fallen by the wayside and has been replaced with products that rely more on the market (e.g., indexed products) and/or providing pure protection (e.g., shadow account products) versus the old declared rate strategy.
Aside from low interest rates, there have been other pricing-related issues including the underpricing of shadow account UL from companies who expected that long term lapse rates would be around 4%. Actual results indicate something closer to a 1% ultimate lapse rate and since shadow account UL is lapse supported, lower lapse rates hurt the bottom line. Also, shadow accounts have high reserving requirements and many companies have rethought their designs as a result.
The new century has already witnessed a few crises that have caused a flight to quality products that are more predictable and/or mitigate downside risk. Back in 2000, for example, VUL held about a 36% market share with respect to annualized life premiums. That figure is down to around 10% or less in today’s market. On the other hand, whole life and UL have about a 72% share of annualized premiums today as compared to 41% in 2000.
There has also been a lot of innovation in life insurance riders, such as those that protect against longevity beyond the stated contract maturity age so that coverage can continue beyond maturity, as well as guaranteed death benefit protection riders and riders that protect against a policy becoming over-loaned. I recall being on the receiving end of a phone call several years ago with a policy owner that received a six figure 1099 because their policy lapsed with a loan. That was a memorable phone call and my ears still ring to this very day.
Many life products have pushed back maturity ages beyond the traditional age 100 to reflect increasing life expectancy of the insured population. We’ve seen issue age upper limits increase and innovations in underwriting methods and systems to help companies battle the age old problem of issuing life insurance contracts in a timely fashion.
With the passing of the Pension Protection Act (PPA) in 2006, the ability to attach LTC riders to both life and annuity products was facilitated. More companies have started to issue these popular hybrid products. This was yet another way to address the issues that have arisen and will continue to arise as the baby boomer generation continues to age. For companies who don’t want to deal with all the regulation inherent in issuing an LTC rider, chronic illness riders have been used such that benefits are accelerated if the insured cannot perform 2 of 6 activities of daily living (ADLs).
We still have our challenges, but we continue to meet them head on. Of concern, though, are those challenges that have existed for quite some time, such as recruiting and maintaining agents. The average age of a life insurance agent is in the upper 50s. Only a few companies still have captive agents that follow the model that existed when I entered the industry 30 years ago. Back then, the company was king and could for the most part pick and choose with whom it wanted to do business with. With the advent of non-captive agents and marketing groups, now it appears that the shoe is on the other foot. The fact that we cannot get enough young people to replace those who are retiring from the industry, increases the leverage of those who continue to sell. It is said that the average age of a non-insurance oriented financial services professional is in the mid-30s. That creates a 20+ year gap in the average age of insurance sales professionals versus non-insurance sales professionals. Selling life and annuity products is very hard work and the time it takes to make it to the top may appear to be a lot longer than it would take to make it to the top of a non-insurance sales profession. While the advent and continual development of the Internet and online capabilities has opened channels and increased sales for certain products, such as term life, there are still a good number of product types that fare better with agent involvement.
The middle market continues to be a challenge to many companies with respect to truly being able to offer competitive and meaningful products that get their attention. While more people in this market are realizing the necessity of life insurance to protect heirs, for example, the recent financial crisis and ongoing unemployment and underemployment issues make it difficult to increase sales in this market. At the end of the day, the protection that life insurance offers will take a back seat to having a roof over your head, clothes on your back and food on the table. It may not be until we see the middle market back on its feet in the form of lower unemployment that this market will begin to grow anew.
The annuity market has seen its share of challenges, perhaps even more than the life market. Low interest rates have had a major impact on annuities. Companies have scaled back on annuity operations or exited the market completely. At the same time, some non-insurance players have entered the annuity market as well as investment firms (e.g., Blackrock) whose position in investments perhaps gives them a slight edge in this turbulent market, though time will tell.
Low interest rates and market volatility have had an impact on both the regular fixed annuity and fixed indexed annuity markets. With respect to indexed annuities, low interest rates make it more expensive to immunize the indexed product’s underlying guarantee while market volatility increases the price of call options. This leads to lower caps, interest rate guarantees, participation rates, etc., as companies try to cope. Volatility has also impacted hedges used by variable annuity issuers to hedge some of the living benefit riders attached to their products.
While low interest rates have had a detrimental effect in annuity sales, variable annuities have seen their fair share of woes in addition to lower sales. The living benefit riders that were introduced back at the beginning of the new millennium were, for the most part, aggressively priced. As many companies witnessed in the ensuing years, these benefits came into the money more often than expected. Agents and policy owners were quite aware and took advantage of the extant benefits, and companies have lost money. Current living benefit and death benefit riders are either much less flexible, more expensive or both. Companies have also tried to scale back benefits in trying to level out the risk profile, especially benefits that allow for additional premiums post-issue (market timing). In actuarial circles we talk about “fat” risk tails, which means when certain features are in the money, carriers stand to lose a lot of money.
Nonetheless, creativity abounds in the annuity market every bit as much, if not more, than in the life market. New variable annuity subaccounts that are targeted towards life stages (target age retirement funds, e.g.) or managed from a risk controlled perspective to mitigate the volatility of the holdings have emerged. Companies have begun to focus on income annuities as the baby boomers begin to retire in the form of deferred income annuities (a combination deferred annuity and immediate annuity). There have also been new living benefit riders, such as the guaranteed living income rider (GLIR), which are intended to prevent annuitization of variable products from running out of funds. We’ve seen more reinsurers enter the annuity market, which has helped the direct carriers. We’ve seen other financial service providers on the asset side adopt some forms of annuity living benefits, such as the contingent deferred annuity, which has a similar purpose as the GLIR in preventing immediate annuity-like retirement income draws from mutual funds from running out of cash.
Compliance issues have been prevalent in the annuity market as well. The new model annuity disclosure regulation is similar, in my mind, to the life insurance model illustration regulation of the mid-1990s. The intent is to help present a balanced view of the product, to prevent misleading or biased illustrations, and ultimately provide the owner with enough disclosure and uniformity of presentation to make an informed decision on purchasing an annuity (this is coupled along with a more standardized version of the annuity buyer’s guide). Though most people in the industry may see this as another expensive compliance mandate, I see it as another way of making our industry more secure, both from a real and perceived perspective.
The life insurance and annuity markets continue to grow and create. While there are many challenges, hoops and hurdles to overcome, we should all take comfort in that many of these changes make our industry not only dynamic, but safe for those who do business with us and who put their lives and prosperity in our hands. While things can get a little hectic and sometimes a little too exciting, ours is an industry that provides a valuable set of services to the people that place their faith and trust in us.
So, if we’re perceived as boring, staid and slow moving, I challenge that perception and point to many things that we have done, either as an industry or in the compliance area that point to constant innovation and creativity. Sure, life insurance and annuity products may not sound exciting to the average person out on the street, where they are bombarded by more tangible images and advertisements of exciting, though not always necessary products. But, at the end of the day, when the chips fall and that life insurance or annuity contract is all that stands between financial preservation and financial ruin, there are many who will be grateful for their existence.
William "Bill" Aquayo
SVP, Actuarial Research
FSA, MAAA, CFA, ChFC, CLU