Variable annuities
At my most recent job, I became familiar with the variable annuities market. Here's what I learned about the product.
Dynamic hedging and variable annuities
Variable annuities are investment products aimed to provide retirement cash-flow to the purchasers (policyholders). The idea is simple: put the retirement money on the stockmarket, charge a large fee (3%-4% a year plus a 6% upfront acquisition charge), and offer pension payments starting, say, 10 year from now, in the amount of 5% of principal a year until the death of the policyholder. The sweet part for the purchaser of the annuity is that the payments will continue even after the account goes empty. The typical rationale is that the stockmarket will provide sufficient returns to support the guarantee given the long horizon. History has proven that rationale wrong and there were cases of annuity writers losing substantial amounts of money.
As such, variable annuities contain complex investment guarantees which make liabilities for the direct writers of annuities. To manage that liability, the direct writers have three options.
1. Do nothing. The hope is that the markets always go up and the liabilities will never actualize. Face market risks.
2. Reinsure the risks. Face counterparty exposure.
3. Dynamically hedge the positions, using liquid exchange-traded instruments. Face model risk and market risk (if there is unexplained negative P&L, then we have a 'hedge breakage").
The risk factors in the variable annuity business can be largely listed as follows:
- regulatory requirements
- stock market
- policyholder mortality
- policyholder's surrender behaviour
- policyholder's portfolio allocation (in most products the policyholder can choose how to invest the money)
- basis risk
- interest rate market (some investment guarantees are attached to the rates of interest)
- model risk
Regulatory risk: the FAS rules require that the variable annuity liabilities are given the fair value and that the institution holds sufficient capital against the deterioration in the fair value. Although the liabilities are very long-dated, the movements in the model-produced fair value can be sharp and can cause the regulator to move in and take action against the direct writer.
Stock market risk: will the stockmarket provide enough returns to pay the policyholders?
Mortality risk: mortality triggers either a lump-sum payment, or annuitization of the guarantee. If the portfolio is large enough, the law of large numbers will guarantee at least some stability in the mortality distribution and so the mortality risk is considered "diversifiable".
Surrender risk: some policyholders will choose to withdraw the funds from the stockmarket account. They will forgo any guarantees of future cash flows, but also deny the writer any future fees and will leave any hedge position naked. Adjustments in the hedge will be required.
Portfolio allocations risk: when putting the money on the stockmarket, the policyholder can choose from a basket of mutual funds. The portfolio chosen may be more or less risky and this affects the value of the liabilities.
Basis risk: the instruments used to hedge the position may have different returns from the mutual funds where the pension money is invested. This can cause the hedge to be inaccurate. Smart annuity writers will restrict the choice of investments for the policyholders.
Interest rates risk: firstly, some variable annuities have returns tied to market interest rates. Secondly, the valuation of the liabilities typically uses the discounted cash flow approach and uses the "risk-free rate curve" to calculate the present value. Thus the interest rate movements affect the model fair value.
Model risk: no model is perfect and the model that most market participants are using have
deficiencies. Lapsation behaviour is one big unknown with most market parcitipants using very simple historical lapsation distribution. Calibration of the market scenario parameters is another tricky area as the products can have life of over 30 years and the choice of time period to calibrate the model is very idiosynchratic. Most of the models use Monte-Carlo to perform the valuation which introduces additional errors. My own view is that a simple model is better and that back-testing is extremely important to identify the weaknesses in the model.
Who are the participants in this market? One of the main players in the variable annuities space is the regulator which is responsible for making sure that the insurer holds significant capital against the investment guarantees made. As the most recent events (2008) show, the taxpayer will eventually foot the insurers' bill if they run out of money so it is in the taxpayers' interest that the likelihood of that event is minimised. With the maturity of the guarantees above 20 years, it's a very challenging task.
Who buys variable annuities, anyway? Turns out they are not bought but sold. The brokers who sell them receive high commission upfront, up to 6% of the principal amount invested. To account for this commission, an accounting technique (read: trick) called DAC=Deferred Acquisition Charge unlocking has been developed - the amount of acquisition charge expensed each year is determined by the stockmarket situation, the worst the performance, the higher the unlocking. Of course, the intent is to compensate through the commissions.
Many authors do not recommend the use of variable annuities as an investment, for example Larry Swedroe in ``The only guide to alterntive investments you`ll ever need``. The very high commissions involved, both ongoing fees and the sales commission, create a conflict of interest for the financial advisors and the insurance companies alike causing them to ignore the best interest of the investors.
Dynamic hedging and variable annuities
Variable annuities are investment products aimed to provide retirement cash-flow to the purchasers (policyholders). The idea is simple: put the retirement money on the stockmarket, charge a large fee (3%-4% a year plus a 6% upfront acquisition charge), and offer pension payments starting, say, 10 year from now, in the amount of 5% of principal a year until the death of the policyholder. The sweet part for the purchaser of the annuity is that the payments will continue even after the account goes empty. The typical rationale is that the stockmarket will provide sufficient returns to support the guarantee given the long horizon. History has proven that rationale wrong and there were cases of annuity writers losing substantial amounts of money.
As such, variable annuities contain complex investment guarantees which make liabilities for the direct writers of annuities. To manage that liability, the direct writers have three options.
1. Do nothing. The hope is that the markets always go up and the liabilities will never actualize. Face market risks.
2. Reinsure the risks. Face counterparty exposure.
3. Dynamically hedge the positions, using liquid exchange-traded instruments. Face model risk and market risk (if there is unexplained negative P&L, then we have a 'hedge breakage").
The risk factors in the variable annuity business can be largely listed as follows:
- regulatory requirements
- stock market
- policyholder mortality
- policyholder's surrender behaviour
- policyholder's portfolio allocation (in most products the policyholder can choose how to invest the money)
- basis risk
- interest rate market (some investment guarantees are attached to the rates of interest)
- model risk
Regulatory risk: the FAS rules require that the variable annuity liabilities are given the fair value and that the institution holds sufficient capital against the deterioration in the fair value. Although the liabilities are very long-dated, the movements in the model-produced fair value can be sharp and can cause the regulator to move in and take action against the direct writer.
Stock market risk: will the stockmarket provide enough returns to pay the policyholders?
Mortality risk: mortality triggers either a lump-sum payment, or annuitization of the guarantee. If the portfolio is large enough, the law of large numbers will guarantee at least some stability in the mortality distribution and so the mortality risk is considered "diversifiable".
Surrender risk: some policyholders will choose to withdraw the funds from the stockmarket account. They will forgo any guarantees of future cash flows, but also deny the writer any future fees and will leave any hedge position naked. Adjustments in the hedge will be required.
Portfolio allocations risk: when putting the money on the stockmarket, the policyholder can choose from a basket of mutual funds. The portfolio chosen may be more or less risky and this affects the value of the liabilities.
Basis risk: the instruments used to hedge the position may have different returns from the mutual funds where the pension money is invested. This can cause the hedge to be inaccurate. Smart annuity writers will restrict the choice of investments for the policyholders.
Interest rates risk: firstly, some variable annuities have returns tied to market interest rates. Secondly, the valuation of the liabilities typically uses the discounted cash flow approach and uses the "risk-free rate curve" to calculate the present value. Thus the interest rate movements affect the model fair value.
Model risk: no model is perfect and the model that most market participants are using have
deficiencies. Lapsation behaviour is one big unknown with most market parcitipants using very simple historical lapsation distribution. Calibration of the market scenario parameters is another tricky area as the products can have life of over 30 years and the choice of time period to calibrate the model is very idiosynchratic. Most of the models use Monte-Carlo to perform the valuation which introduces additional errors. My own view is that a simple model is better and that back-testing is extremely important to identify the weaknesses in the model.
Who are the participants in this market? One of the main players in the variable annuities space is the regulator which is responsible for making sure that the insurer holds significant capital against the investment guarantees made. As the most recent events (2008) show, the taxpayer will eventually foot the insurers' bill if they run out of money so it is in the taxpayers' interest that the likelihood of that event is minimised. With the maturity of the guarantees above 20 years, it's a very challenging task.
Who buys variable annuities, anyway? Turns out they are not bought but sold. The brokers who sell them receive high commission upfront, up to 6% of the principal amount invested. To account for this commission, an accounting technique (read: trick) called DAC=Deferred Acquisition Charge unlocking has been developed - the amount of acquisition charge expensed each year is determined by the stockmarket situation, the worst the performance, the higher the unlocking. Of course, the intent is to compensate through the commissions.
Many authors do not recommend the use of variable annuities as an investment, for example Larry Swedroe in ``The only guide to alterntive investments you`ll ever need``. The very high commissions involved, both ongoing fees and the sales commission, create a conflict of interest for the financial advisors and the insurance companies alike causing them to ignore the best interest of the investors.
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