Variable Annuities: 2008 Update ACSW Spring Meeting Tamara Burden, FSA, CFA, MAAA

Transcription

1 Variable Annuities: 2008 Update 2009 ACSW Spring Meeting Tamara Burden, FSA, CFA, MAAA

2 Agenda Quick review of VA market and living benefit riders The impact of the current financial crisis What has worked, what hasn t Companies reactions to the crisis What s next? 2

3 Review of VA market and guaranteed living benefits 3

4 What is a Variable Annuity? Assets in a variable annuity are invested on behalf of the policyholder in a separate account The policyholder chooses the subaccounts which his assets will be invested in The policyholder, not the insurance company, bears the investment risk Living benefit guarantees have become so prevalent in the market that any discussion of VAs must involve guarantees 98% of 2008 sales were in products that offered an optional living benefit guarantee 81% of policyholders actually purchased a living benefit guarantee 4 4

5 Guarantee Rider Premiums Guarantees are viewed as existing separately from the fund choice Policyholders select their funds and then are given a selection of guarantees to choose among and add to their contracts as riders Guarantees are charged for by reducing the return applied to the fund (just as if they were fund management fees) The guarantee charge usually is the same for all funds (although there may be some restrictions on fund choice or switching to control costs) 5 5

6 VA Living Benefit Sales Distribution 2nd Quarter 2008 GMIB GLWB Source: LIMRA 6

7 Guaranteed Lifetime Withdrawal Benefit Accou unt Value 600, , , , , ,000-40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 - Withdrawals Account Balance Guaranteed Withdrawal Balance Withdrawals 7

8 8 The impact of the current financial crisis

9 S&P 500 Realized Vol 1-quarter moving average 80% 70% 60% 50% 40% Great Depression Oct 87 Crash Q Selected Points Q % Q % Q % 30% Q % 20% Q % 10% Q % 0% Source: Bloomberg

10 Largest Year-on-Year Decreases in the S&P Historic Short Rate 0% -10% -20% -30% -40% -50% -60% % -25% -31% -53% -46% 20% 15% 10% 5% 0% Equity Market Turbulence Worldwide S&P lost 46% Oct 2007 to Oct 2008 In October 2008 alone: S&P lost 17% Japan: Topix dropped 21.3% Europe: FTSE lost 11.7% EuroStoxx lost 12.5% Rapid Reduction of Interest Rates US 3M Treasury yield close to zero Bond price tumbled as credit spread widened Dec 06: AA spread 33 bps Jul 07: AA spread 141 bps Mar 08: AA spread 242 bps Nov 08: AA spread 409 bps 10

11 Perfect Storm of Market Events Failure of well known financial institutions Lehman Brothers, Merrill Lynch, Bear Sterns Credit spreads widened sharply Policyholder bond investments fall Worldwide decline in equity market Rapid reduction of interest rates Increased volatility Policyholder equity investments fall Rate used to calculate fair value falls Volatility used to calculate fair value rises 11

12 Increase in Fair Value Reserves Company Caomp 2007 Reserve (millions) 2008 Reserve (millions) Source: 10K filings with SEC % incr Prudential 168 3,229 18x Nationwide 92 1,700 17x Pacific Life 222 2,775 12x Met Life 284 3,134 10x John Hancock 500 4,715 8x Sun Life 378 2,374 5x TOTAL 1.6 billion 17.9 billion 9x Met s adoption of FAS157 reduced their reserve by 1.9 billion. Without FAS157, their 2008 reserve would have been 5.1 billion. 12

13 FAS 157 Effective January 1, 2008; most large VA writers adopted it for year-end 2008 GAAP reserve calculations Three primary effects Allows companies to use their own credit rating to adjust the interest rate used to value liabilities (valuation interest rate becomes risk-free rate + credit spread) Requires companies to use additional conservatism in behavioral assumptions Emphasizes use of alternative assumptions when relevant observable market prices are not available (e.g. long-term volatility for illiquid liabilities) Company Spread (12/31/08) Source/Description A lot of variation in how the appropriate credit adjustment is determined: A 8.93% grading to 5.53% over 30 years Company s own credit-linked notes B 4.90% to 5.50% over 30 years Company s own credit-linked notes C 4.29% to 3.80% over 30 years Single A over swaps D 2.50% all years AA over treasuries E 2.25% to 1.87% over 10 years AA over swaps F 1.80% all years AA over swaps minus 50 bps 13

14 VA Sales Are Sensitive to Market There was $151 billion of new VA sales in the US in VA assets averaged $1.3 trillion (compare to US GDP of $14 trillion) US VA Annual Sales $ Billions

15 US VA Statistics Historical VA Assets at Yearend $ Billion ns Source: Morningstar

16 Hedging Programs Have Performed Well Milliman estimates hedging has saved the insurance industry about $40 billion in September - October 2008 alone Saved many companies from solvency issues From Oct 2008 through March 2009, hedging programs have been about 94% effective in achieving their designed goals Most hedging payoffs are due to movement in equity and exchange rates Hedging is not fool-proof In-depth understanding of risk management is required 16

17 Illustrative Hedging Results Weekly Net P&L - Hedging vs. No hedging from 11/1/2007 to 10/31/2008 (million $) P&L Nov-07 Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Hedged P&L Unhedged P&L Weekly Net P&L - Hedging vs. No hedging from 9/2008 to 10/2008 (million $) Sep-08 P&L Sep-08 Sep-08 Sep-08 Sep-08 Oct-08 Oct-08 Oct-08 Oct-08 Hedged Un-hedged

18 18 What Has Worked, What Hasn t

19 What Has Worked Insurance company hedging programs are designed to reduce the exposures to capital market risks Do not take risks to make a profit Use simple hedging instruments Futures contracts Plain vanilla options Little counterparty risk Be highly transparent Open discussion of hedging methodologies Reviewed and audited by multiple parties Contained operational risks 19

20 What Hasn t Worked Leave critical exposure unhedged Follow accounting peculiarities blindly US GAAP SOP03-1, Canadian GAAP are not fair valued Following non-fair value accounting rules blindly hurt the economic fundamentals Deviate from sound risk management principles Under pricing Unchecked fund allocation Keep hedging practice a secret Leave blind spots in hedging programs 20

21 Make Risk Management an Integral Part of the Business Start early Think through the implications of risk management from product conception Can avoid unexpected results down the road Start late It is never too late to start hedging Hedging will not recoup losses in the past, but can protect solvency in the future Have an evolving process All good hedging programs started simple They evolve towards perfection through continuous refinements Senior management support is key 21

22 22 Companies Reactions to the Crisis

23 Companies Reactions Tighten hedging programs Contain basis mismatch Reprice guarantees Flurry of M&A-related activity Decreased availability of reinsurance and structured solutions 23

24 Tighten Hedging Programs Enhanced Interest Rate Hedging Many companies that were hedging rho have unwound their rho positions and set a threshold for reinstating their rho hedge (e.g., restart rho hedge when 10yr Treasury rate > 4%) In the future, refine key rate rho hedging to better track changes in the shape of the curve Use of Milliman Guarantee Index for volatility assumption Improved methodology for VA guarantee valuation under Financial Accounting Standards Board Statement 157 (FAS 157) Recognizes the fact that VA guarantees have no liquidity and no cash value Alternative investment strategy for hedge payoffs Take advantage of current corporate bond credit spread Significantly reduce guarantee funding cost A company with $2 billion in liabilities could save over $150 million without much added risk 24

25 Contain Basis Mismatch Significant problem in 2008 and 2009 Active management of funds vs need to use widely held indices in hedging Fund managers strayed from benchmarks, sector performance varied widely Solutions: Switch from actively managed funds to index funds Use a holdings-based analysis, rather than a backward-looking historical analysis Purpose-built funds for VA platform 25

26 Existing VA Business Model Funds Stocks Bonds Guarantee Fee Insurer Balance Sheet Guarantee Liability Hedge Assets P&L Volatility 26

27 Sustainable VA Business Model Funds Stocks Bonds & Hedges Reduced Guarantee Fee Insurer Balance Sheet Reduced & Stabilized Guarantee Liability Reduced P&L Volatility Transfer of Hedge Breakage & Basis Risk to Policyholder Reduced Behavior Risk 27

28 Reprice Guarantees Arms race has been put to an abrupt halt VA writers scaling back on designs and increasing fees Change Category Sales Discontinued or Restricted Fee Increased Product Features Scaled Back Asset Allocation Changed/Restricted Total # of Products # of Companies VA guarantees had gotten to the point where the guarantees were no longer a floor protection, but the actual expected benefit Current product trend is reversing to the original fundamentals 28

29 US Market Product Evolution S O P H I S T I C A T I O N ROP GMDB Enhanced GMDB (annual Ratchet 5% roll-up) Product innovation has been significant since the adoption of risk management through hedging GMIB GMAB GMWB EIA GMWB for life With Ratchet GMWB / AB Combo Joint Life GMWB

30 Evolution of Guaranteed Withdrawal Benefits Year WB Description Rider Charge (based on account value) Hedge Cost as a % of Rider Charge (static market conditions) Hedge Cost as a % of Rider Charge (actual market conditions) 2002 First GMWBs issued. 5% withdrawal until benefit balance was exhausted 25 bps 47 % 30 % 2003 First significant sales of GMWBs. 7% withdrawal until benefit balance was exhausted, with annual ratchets 2004 Add rollups to GMWBs for delaying withdrawals (max 10 years) 2005 First significant sales of GLWBs. 5% for life with annual ratchets and bonuses for delaying withdrawals 2006 Add age-based withdrawal rates (4-8%) and allow withdrawals at ages as low as bps 68 % 81 % 35 bps 68 % 62 % 45 bps 56 % 74 % 55 bps 131 % 99 % 2007 Add more frequent ratchets (quarterly) 65 bps 115 % 95% 2008 Increase guarantees (200% after 10 years, 300% after 15 years) 75 bps 107 % 103 % 2009 Reduce age-based WD % and decrease ratchet frequency, increase rider charges 95 bps 55 % 201 % 30

31 Mergers and Acquisitions There has been a flurry of M&A-related activities since Q4 2008, but there has not been a successful transaction to date (a lot of sellers shouting out to buyers who just aren t there) The difference between the weak and strong companies are not obvious during good economic times Companies that have the right products and proper hedging programs will emerge from this round of financial crisis as stronger and bigger VA writers Companies that fail in either product or hedging will find themselves retreating from the VA market 31

32 Reinsurance and Structured Derivatives Reinsurance: Before 2003, many VA writers relied on reinsurance, but all major reinsurers had left the market by 2003 By 2007, reinsurers had gradually reentered the market and prices had, at times, been quite competitive Now, reinsurers are again withdrawing from the market (e.g. Swiss Re) and quotes from remaining reinsurers are generally not attractive to direct writers Investment banks are exiting the structured derivatives market for VA guarantees or offering prohibitively high prices Reinsurance and structured derivatives cannot be the cornerstone of any VA writer s risk management strategy; companies need their own hedging capability 32

33 33 What s Next?

34 VA Continues to be a Critical Product Insurers must create a sustainable VA business model Pure protection business is still important, but asset accumulation & income products dominate sales VA guarantees differentiate life insurers from mutual funds & bank CD s Insurers must innovate to develop a sustainable, guaranteebased business model Existing guarantee business model developed incrementally and is not fully integrated with hedging techniques Global opportunity 34

35 VA Launches in Europe (through Feb 09) Multiple UK launches in Dec 2006, May 2007, Jun 2008; Poland in 2008, Jan 2009 Launched GMWB RentaSafe in Switzerland in Oct-2008 Launched Champion in Germany in Oct 2008 Launched in Germany and Luxemburg in 2008 Launched i2live in May 2007 GMWB 5-for-life and pensions product Actively looking at other markets Invest4Life launched July 2008 in Germany and in France in October Allianz Equity Index policy available for some time First mover in UK Gold and Platinum gaining momentum Switzerland for several years and launched in 2008 in Italy European roll-out of Accelerator plans in Germany ( Twinstar ), Belgium, France, Spain, Italy, UK Offshore (Isle of Man), Portugal, Switzerland GMAB products launched in Spain in 2007, Hungary in 2007 and Poland in products in 10 different countries

36 Summary Demographic trends worldwide virtually ensure continued importance of VA market Market declines during the financial crisis long-lasting change in investor psychology Increased importance of VA guarantees Financial crisis generated tremendous amounts of information to fuel product innovation VA market innovation is just beginning! Purpose built funds New designs to limit behavior risk and reduce hedge costs Recurring premium products for retirement savings VA-style guarantees coming to a 401k near you! 36

37 Thank you Milliman Dallas N. Central Expressway, Suite 1500 Dallas, TX, USA T: E: 2009 ACSW Spring Meeting Tamara Burden, FSA, CFA, MAAA 37