Risk Mismatch Raises Questions for VAs as Pension Vehicle

Pricing and hedging challenges attached to variable annuities (VA) with living benefits raises questions about their suitability for consumers in search of retirement income, according to a new study by a pair of economists.

When insurers that sold VAs with living benefits saw the valuation of existing liabilities rise, they raised costs and trimmed benefits, the study found. Those liabilities rose with the falling stock market and lower interest rates after the financial crisis.

The study, titled “The Fragility of Market Risk Insurance,” was conducted by economists Ralph Koijen and Motohiro Yogo. Results, based on data from 2005 to 2015, were published this month by the National Bureau of Economic Research.

Studying the behavior of variable annuities with living benefits through a tumultuous financial decade sheds light on the dynamics of a trillion-dollar sub-segment of the insurance market that anchors the retirement of millions of consumers.

Modeling supply and demand characteristics of VAs with living benefits may also serve as a cautionary tale as insurance companies become more like pension funds with risky assets and guaranteed liabilities, the authors wrote.

“The persistent under-funding of pension funds may foreshadow similar problems for life insurers in the future,” Koijen and Yogo wrote.

In 2015, insurers held about $1.5 trillion worth of VA liabilities on their books and VAs have grown to be the largest category of life insurer liabilities.

Risk Mismatch

Traditional VAs consist of mutual fund investments and a death benefit, but VAs with living benefits often take the place of defined benefit pensions as employers move to a defined contribution 401(k) model.

Living benefits are sold a “riders” that guarantee minimum withdrawals, income and accumulation levels to the VA contract holder.

Funding those living benefits and their minimum guarantees over many years, decades even, requires hedging and the economists describe VAs with minimum return guarantees as the equivalent of “long-dated put options on market risk.”

Yet many hedging strategies remain imperfect and this leads to a “risk mismatch” when the value of VA liabilities rise in during periods of falling markets, falling interest rates and rising volatility, the experts wrote.

State guaranty funds, liabilities with longer maturity dates that make them less vulnerable to runs, and regulation that improperly rewards hedging strategies cause insurance managers not to fully hedge their variable annuity risk.

In 2008, the mismatch rose quickly as VA liabilities skyrocketed with collapsing stock prices and the rapid drop in interest rates that followed.

As the valuation of liabilities rise, the steeper the drop off in VA sales for the cross section of insurers under the study, the research found.

Supply Shock

VAs with minimum return guarantees entered a period of “supply shock” as insurers reacted by raising “shadow costs,” the economists wrote.

Average fees on the minimum return guarantees rose from 0.59 percent in the fourth quarter of 2007 to 0.96 percent in the second quarter of 2009, the researchers found.

Since then fees have increased but at a slower pace.

After raising fees and lowering rollup rates, or rates at which investments within the accumulation period grow, insurers pulled back on the generosity of living benefit guarantees, eliminating them outright or getting out of the business altogether.

Rollup rates, which peaked at an average of 4.9 percent in the second quarter of 2011, have dropped to 3.4 percent in the fourth quarter of 2015.

In 2015, following a period of “derisking” when insurers sought to limit their exposure to guarantees, VA liabilities were $1.5 trillion, or about 34 percent of total liabilities across 38 insurers.

In 2005, variable annuity liabilities were $1 trillion, but accounted for 36 percent of total liabilities across 45 insurers.

Koijen teaches at the Stern School of Business at New York University and Yogo teaches in the Department of Economics at Princeton University.

InsuranceNewsNet Senior Writer Cyril Tuohy has covered the financial services industry for more than 15 years. Cyril may be reached at cyril.tuohy@innfeedback.com.

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Cyril Tuohy is a writer based in Pennsylvania. He has covered the financial services industry for more than 15 years. He can be reached at cyril.tuohy@innfeedback.com.