Insurance company executives are going through a lot of contortions to make money in the variable insurance business today.
They have to navigate the stock market and bond market, as well as regulatory, inflation and longevity risks to make a profit on their variable insurance lines.
In today's marketplace, where gun-shy Baby Boomers and senior citizens want principal guarantees, insurers face major challenges. How long the policyholders will live and how well the financial market performs are major considerations in structuring products.
"Longevity risk is an issue," says Douglas French, global director of actuarial services with Ernst & Young, New York.
"Take a couple aged 65: One of the spouses will live one-third of the time to age 95. People are getting healthier and living longer. If the insurance company doesn't get it right it could run into problems," French said.
French says insurers need to focus on better risk management. In the past, they relied too heavily on reinsurance (see AMN November 2003, January 2004).
But reinsurers have pulled out of the variable insurance market. Those that hedged before the bear market of 2000 underestimated the worst-case scenario in the stock market. As a result, they were unprotected when stocks lost more than 50% from 2000 through 2002. Many relied on the New York Department of Insurance's directive that reserving should be based on a 33-1/3% decline in the equity markets.
Today, even if an insurer hedges, it is no sure thing. French says hedging sophistication varies dramatically in the business. And with more policies being sold with guaranteed minimum income benefits (GMIBs), there is more risk.
"GMIB is a long-term bet," he said. "You can't completely hedge it because it is too far out in the future."
Although insurers are hedging their equity risk exposure, he sees little evidence that they are protecting themselves when interest rates rise and bond prices fall. Bonds can be just as volatile as stocks. If interest rates rise 1%, longer-term and intermediate-term bonds can lose 7% to 12%, respectively. And bond losses can be as high as 20% if rates rise 2%. If the insurance company doesn't properly manage the duration of its bond portfolio in its general account, it could experience large losses.
Hedging and increased regulatory reserve requirements are adding to the cost of doing business. As a result, French expects to see a lot of mergers. The reason: Insurance companies must do a large volume of business based on economies of scale to make a profit.
"The biggest challenges are the cost of offering guarantees," he said. "Are the consumers going to pay for it? Regulatory risk is huge. You've got distribution risk. It is tough business to be in."
Not All Gloom & Doom
But it's not all doom and gloom for the industry.
French expects that the fixed and variable immediate annuity business will boom as Baby Boomers retire. Insurers will develop new-generation immediate annuities that will dispel the consumer fears that the insurance company gets to keep their money when they die.
"You will see a lot of immediate annuities to deal with a retiree's cash flow management," he said. "There will be more commutable products. Variable annuity products will follow the demographics."
But the immediate variable annuity business faces a hurdle for a couple of reasons. First, the registered representatives and agents don't fully understand the product. Agents must show clients the dangers of running out of money. Then, they need to emphasize how immediate annuities can insure the client will have income for life in their overall retirement portfolio. The policies need to be sold as part of an overall financial plan.
"People [clients and financial professionals] don't understand the risk-reward tradeoff during retirement," he said. Financial advisers have been looking at asset accumulation. "They need to start looking at cash-flow management and help clients with an orderly liquidation of assets when they retire."
French sees products like GE's "Retirement Answer" becoming more popular. GE's product is a personal defined benefit plan. The policyholder invests in an asset-allocation fund during the accumulation stage. After 10 years, he or she gets a guaranteed stream of income no matter how the fund performs. If the fund does well, the policyholder gets more income.
"The concept is great," he said. "You put all the money in one investment and are promised, for example, to get $1,000 a month."
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