ACST152 Introduction to Actuarial Studies

ACST152 Introduction to Actuarial StudiesLecture 4B 2015Lifetime Annuities Lifetime Annuity Customer pays a large lump sum at retirement to a life insurer. The life insurer promises to pay a specified amount of money each year as long as the customer is still alive

Lifetime pensionSame as above, but the provider is a superannuation fund instead of a life insurer.Example: Unisuper

Lifetime Annuities / PensionsThe customer has:No investment riskNo inflation risk (if the amount of the annual payment increases in line with inflation)No longevity risk even if you live much longer than the average life expectancy, the insurer keeps paying

Economic theories suggest that customers who are risk-averse should be keen to buy annuities

But in practice, lifetime annuities are not a popular product

Sales of such products in Australia are quite lowSimilarly, low sales in many other countries

BUT : Q. what are the drawbacks of lifetime annuities ??Advantages of lifetime annuities or pensions1. Early Death & Bequests2. Liquidity3. Lack of Flexibility & Control (No surrenders)4. Insolvency Risk5. High CostDisadvantages summaryCustomer saves up $100,000 in superPays $100,000 to insurer to buy annuityInsurer pays say $8000 each year until he dies

Some customers live a long time and get many annual payments -> insurer makes a loss on these customers

Some people die early and get very few payments-> insurer makes a profit on these customers

Profits & Losses on Lifetime AnnuitiesEarly death / poo r health

For people who die early, the total annuity payments received are much less than the amount paid to buy the annuity.e.g. pay $100,000 for annuityreceive 3 payments of $8000 and die after 4 years

People who have lower-than-average life expectancy (e.g. in poor health) will usually be reluctant to buy a lifetime annuity

Disadvantages of annuitiesTo alleviate this problem, some life insurers offer policies with guarantee periods,

i.e. they guarantee that they will pay at least, say, 10 years payments (even if you die before the end of 10 years).

After death, the remaining payments go to your heirs (usually as a lump sum)Guarantee periods2. Bequest motive Lifetime annuity payments stop when you die

But you might want to leave some money to your dependants (spouse, children) as a bequest

People who have strong bequest motives might be less likely to spend all their savings on a lifetime annuityDisadvantages of annuities2. No liquidity

With a lifetime annuity, the amount paid in each year is fixed.If you need extra money for some reason (family emergency?), cant get it out.

Q. Could you ask the life insurer to cancel your annuity and give the remaining money back (surrender)?

Disadvantages of annuities3. No flexibility no surrenders

You cant usually change your mind, cancel your annuity or pension, and ask for the rest of the money to be paid back to you

Life insurers dont usually let you surrender annuities

Q. WHY ?

Disadvantages of lifetime annuities If surrenders were allowed, as soon as you got seriously ill you would surrender and ask for your money back.Life insurer makes a profit from early deathsAllowing surrenders would reduce the profits

Some insurers will let you surrender if you can prove you are in good health

Might also allow surrenders during any guarantee period (Surrender payment = PV of guaranteed payments)Why surrenders are not allowed4. Insolvency Risk (Trusting the insurance company)

At age 60, you hand over all your life savings to the life insurance company or superannuation fund....

Can you be sure that the life insurance company or superannuation fund will still be around to pay you your benefits in 40 years (when you are 100?)

Disadvantages of Lifetime AnnuitiesQ. How often do Australian life insurance companies become insolvent?

Q. How often do Australian superannuation funds which pay pensions become insolvent?

Q. How often do insurance companies become insolvent in other countries?

Q. How often do superannuation funds which pay pensions become insolvent, in other countries?Insolvency RiskHistorically before regulation Several life insurers went brokeSome were simply scams {collected all your money and then disappeared}

> Life Insurance Act 1945 led to improvements

Over last 50 years, only two Australian life insurers have gone broke (sister companies : Regal and Occidental, in 1991 an interesting fraud case)

Other insurers have sometimes been in difficulties, but have survived.

In Australia: life insurersIn Australia, not many superannuation funds provide pensions for people who are retiring (most pay a lump sum payment)

Public sector funds (funds run by the Commonwealth and State governments for public servants) often do provide pensions.

Q. If you are a government employee, can you trust the government to pay your pension?In Australia: superannuation fundsThe Australian government superannuation funds do not have enough money to pay the benefits they already promised to pay to current employees.Assets < PV of promises benefitsThis is called an unfunded liability

In 2012 Commonwealth Unfunded Liability = $200 BILLION.NSW State Unfunded Liability = $50 BILLIONPlus unfunded liabilities in other states

Unfunded liabilitiesFuture taxpayers will have to pay additional taxes to cover this unfunded liability.

The Future Fund was set up to help with this in 2006. Some of the budget surplus was set aside in a separate fund to help pay the unfunded liabilities (but its not enough).

Unfunded liabilitiesUnisuper is a superannuation fund which pays pensions to some retired academics

Had a deficit of about $1 billion

Uni refused to make additional contributions to the fund

Benefits were reduced effective 1 January 2015 (for anyone retiring after 1/1/2015)

Trustees are hoping for improved investment returns to make up for the deficit.

Unfunded liabilities in Unisuper?Other countries have had more problems

e.g. In USA about 1% of life insurers go broke on average each year (547 insurers between 1976-2002)

Rate of insolvency varies over time, e.g. GFC has led to several recent insolvencies

The UK, Japan, and Korea have also had serious problems with insolvent insurers over the last 10-20 years

Other countries ? Life insurersIn other countries, superannuation funds often provide pensions instead of lump sumsOften called pension funds instead of superannuation funds

Many problems with insolvent pension funds(especially after poor investment returns in GFC)Reduced benefits (especially in USA)Some rescued by Government bailout fundsGovt bailout funds have big deficitsOther countries? Superannuation funds1. What makes life insurance companies and superannuation funds get into trouble? (poor quality actuaries...?)

2. What regulations exist to make sure that insurers and superannuation funds keep their promises to customers?

After the break we will look at life insurance regulationQuestions to consider5. Cost. The price for buying an annuity tends to be quite high....

Q. Why are they so expensive ?

Disadvantages of AnnuitiesFor Life Insurers, the actuary estimates the present value of promised annuity benefits

This is called the insurers Liability

The Liability is calculated using reasonable assumptions about future investment returns, life expectancies, etc.

If Assets > Liabilities,

the insurer has enough to pay for EXPECTED future payments

Capital RequirementsBUT there is always the risk that future financial experience will be worse than expectedPoor investment returnsPeople live longer than expected

In order to make sure that the life insurance company will be able to pay promised benefits (even if experience is worse than expected), the insurer must hold additional capital reserves

Capital is basically extra money in case things go wrong

Government Regulations require :

Assets > Liabilities + CapitalCapital RequirementsQ. Where does capital come from?

A1. Charge higher prices for lifetime annuities and put the extra amount into capital reserves

AND / OR

A1. Insurance company owners (shareholders) pay in capital. But then they want dividends on their capital. Which means the prices for lifetime annuities must include money to pay dividends ( = the cost of capital)

Either way : Annuity prices go up to cover capital requirementsMaking annuities quite expensive

Capital RequirementsFor the reasons given above, lifetime annuities are NOT very popular in Australia (poor sales).

Most retired people prefer to keep retirement savings in an account-type product.

They take the investment risk, inflation risk, and longevity risk

The govt thinks this is a problem and would like to encourage people to buy more lifetime annuities.

Why?

Popularity