Variable Annuities (VA) – Product Trends and Risk · PDF fileVariable Annuities (VA)...

Hubert Mueller, Principal

© 2007 Towers Perrin

Variable Annuities (VA) –Product Trends and Risk Management

Joint Regional Seminars, Asia

June 18-22, 2007

© 2007 Towers Perrin 2

Agenda

� Product and Market Trends – US

� Product and Market Trends – Global

� Implications of Rating Agency/Regulatory Scrutiny

� Risk Management Methods


73.5 86.0 99.0122.0 137.7

114.0 116.0 128.5 134.0 137.5160.0

38.938.2

32.9

42.1

52.871.5

98.6 81.6 84.4 73.0

71.0

0

20

40

60

80

100

120

140

160

180

200

220

240

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Variable annuity sales Fixed and equity indexed annuity sales

Annuity Sales($billion)

Variable annuity (VA) sales increased by 16% in 2006, while fixed annuity (FA) sales declined by 3%

112.4124.2

131.9

164.1

190.5

Source: Variable sales from Tillinghast VALUE Survey, includes all non-pension variable annuity premiums (first-year and renewal, separate account and fixed account). Fixed sales from LIMRA, includes deferred and immediate annuities, EIAs, and MVA (excludes structured settlements).

Mix of U.S. Annuity Gross Sales

185.5

214.6 210.1 218.4210.5

231.0

PRODUCT AND MARKET TRENDS −−−− US

1995-2000 2000-2006 1995-2006CAGR VA = 23% 3% 11%CAGR FA = 1% 5% 3%CAGR Total = 14% 3% 8%


Typical current forms of VA death benefit and living benefit guarantees*

15 – 35 bps

Combination, or 7% roll-up

Annual ratchet or 5% roll-up, to age 80

NoneLump sum on death

GMDB

Resets/combo products

Greater of 5% roll-up and

annual reset

5% for life, periodic resets,

bonus until withdrawal

Enhanced Feature

25 – 50 bps

Return of premium at year 10

10 years

Guaranteed lump sum

GMAB

50 – 75 bps

5% roll-up**10 years

Guaranteed income at

annuitization

GMIB

40 – 75 bps

Return of premium via 7% withdrawals

for 14 years

NoneGuaranteed amounts via partial

withdrawals

GMWB

Typical Annual ChargeTypical Guarantee

Typical WaitingPeriodNature of GuaranteeType

*Many features require diversification of assets.

**Equates to less with conservative payout rates



Lifetime GMWBs are driving VA sales in the US

Company GLBs Offered 2006 VA Sales 4Q 2006 Full Year 2006

MetLife IB/WB 13,714 2% 4%

AXA IB/WB 13,230 20% 24%

Hartford GMWB 12,201 26% 7%

Lincoln GMWB 10,294 36% 22%

Pacific Life All 9,497 9% 32%

Nationwide All 5,137 59% 40%

Genworth GMWB 1,811 59% 66%

Market Estimate ------ N/A 19% 17%

VA Sales ($ millions)

Y-O-Y Increase

� AXA, Hartford, Genworth, Lincoln, Pacific Life, and Nationwide all introduced lifetime GMWBs in 2006

� 89% of VA sales in 2006 included GMWB feature

Source: Tillinghast VALUE Survey



Recent GMWB innovations have intensified focus on this feature

� First introduced by Hartford Life in 2002

� GMWB with annual reset (2004)

� Lincoln National (65 bps fee) was first, significantly increased market share

� Manulife introduced 5% bonus for each year where no withdrawal is made

� Lifetime GMWB withdrawals were introduced in early 2005

� 4% or 5% maximum withdrawal per year, varying by attained age

� Most are offering a “bonus” feature now, as long as withdrawals are deferred

� Many products have asset allocation restrictions to keep charges down

� Prudential introduced combination GMAB/GMWB, now offering daily ratchets

� 14 carriers have introduced a version for married couples recently

� Hartford Life is offering higher maximum withdrawals for older ages (Sept 2006)

� 5% for ages 60-65, grading to 7% at age 80

� Also added lifetime GMWB, but with upside capped at 10%, in Nov 2006

� Sun Life introduced “Income Storage Benefit” (March 2007)

� Unused GMWBs are stored for later withdrawal

� With the growing popularity of GMWBs, GMIBs have become less prevalent

� AXA and MetLife are the key sellers remaining



79% of total VA assets of $1.4 trillion are in the Separate Account

79%

21%

Total VA assets: $1.38 trillion (12/31/06)

Separate Account Assets

Fixed Account Assets



The largest average size VA policies are sold through wirehouses

$63,173

$79,678

$93,435

$78,277

Career Agent Independent Agent/

Financial Planner

Wirehouse Bank

Source: LIMRA International (2005 data).

Average Size/Policy



Considerations in selling VA through various distribution channels

2006 VA Sales

Direct/Other1%Banks

13%

Career agents and controlled38%

Regional investmentfirms

7%

Independent Broker Dealer firms

31%

Wirehouses8%

Looking more like wirehouses

Share is small, dominated by Fidelity and Vanguard

Best opportunity for smaller manufacturers

� Larger independent B/D firms (including networks) are increasingly relying on preferred vendors Dominated by large manufacturers

� Preferred vendors

� Reciprocal relationships

Includes TIAA, career companies

� Heavy proprietaryfocus



Agenda






VAs are spreading across the globe

Japan

UK

Germany

PRODUCT AND MARKET TRENDS −−−− GLOBAL

Hong Kong

Korea

France

UK France Japan

− Aegon − AXA

− Hartford Life (first) − Hartford Life

− Most of the market now − MetLife Korea

− Recent new entrants

− Hartford Life � Allianz Germany � MassMutual

− AXA Hong Kong

− HSBC

− Manulife


Trends in global VA guarantees

� Europe

� GMWB and GMIB becoming popular vehicles to satisfy huge retirement opportunity

� Generally introduced by multinationals, forcing local players to“catch up”

� Hedging is still in its infancy – multinationals have the edge

� Asia

� Guarantee features tend to be more conservative

� Higher proportion of bond funds provides better protection against tail risk for insurers

� Generally no hedging in place – Exceptions:

— Hartford Japan (hedged from the US)

— AXA (hedged centrally)



The introduction of US-style VA products presents a number of challenges

� Product design

� Understanding implications of guarantee features (tail risk)

� Assumptions

� Dynamic policyholder behavior

� Longevity

� Pricing

� Modeling tail risk

� Risk-neutral vs. real-world scenarios

� May need stochastic-on-stochastic, if hedging is incorporated

� Rick and capital management

� Underlying capital requirements

� Managing tail risk



Agenda






Rating agencies’ views of capital adequacy have changed recently

� Rating agencies are increasingly considering proprietary models when assessing capital adequacy

� Building economic capital (“EC”) models into their rating process during ERM reviews

� Expecting companies to demonstrate balance between qualitative and quantitative ERM

� Linking capital adequacy requirements directly to ratings

FitchIntroduced proprietary

EC model “Prism”

A.M. BestConsiders EC part ofERM as evidenced

S&PDeveloping

“Quantum Risk”evaluationapproach

Moody’sConductsquantitative and qualitativeAnalysis of EC

RatingRating

agencyagency

approachesapproaches

to ECto EC

IMPLICATIONS OF RATING AGENCY/REGULATORY SCRUTINY


Standard & Poor’s: Strategic view of insurance company ERM

S&P emphasizes “strategic” enterprise risk management modeling

� Risk-based capital — Adopted in the 1990s and updated with latest approach introduction in 2007

� Enhanced capital modeling — Will rely more on Economic Capital (EC) for analytical purposes as modeling is updated

� Capital formula — S&P considers a company’s total adjusted capital and compares with its estimated target capital to determine capital adequacy

� Company-specific — Modeling and measurement of risk must be specific to the company to support its retained risks

� EC is evaluated as part of ERM rating

� “Strong” or “Excellent” ERM rating is a requirement for a ratings upgrade and/or partial recognition of EC model

� The vast majority of companies receive an “Adequate” ERM rating

� A “Weak” ERM rating could result in the company being put on “Credit Watch”



As of February 2007, only 13% of insurers had received “Strong” or “Excellent” ERM ratings from S&P

Source: Standard & Poor’s (February 2007)

Overall ERM Evaluation Overall ERM Evaluation Overall ERM Evaluation Overall ERM Evaluation (207 Insurers - All Sectors)

Strong 8.5%

Excellent

4.3%

Adequate

81.6%

Weak 5.6%



Fitch: New view of insurance company capital using a proprietary model

“Prism” is Fitch’s new EC model

� Introduced in June 2006

� Global and fully stochastic — captures the risks, recognizing diversifications and concentrations

� Covering life, health and non-life business

� Fitch introduced Prism first in the U.S., U.K., Germany and France

� Consistent with VA C-3 Phase II approach – using CTE-levels varying by rating

� Will work with companies’ models and consider overall risk management of the company

� Expected to provide partial credit for hedging

� Companies can submit their models for a non-binding evaluation of likely capital requirements



Moody’s: Holistic view of risk management

Moody’s view of risk management is based on four pillars

1. Risk governance

2. Risk mitigation

3. Risk measurement

4. Risk infrastructure and intelligence

Ratings connect amount of capital on balance sheet…

� Converging regulatory and economic views of capital adequacy

� Calculating EC focuses on areas to be included in modeling

� Emerging risks

� Asset liability

� Mismatches

� Operational risk

� EC modeling provides:

� Understanding of an effective risk management framework

� Common risk language across the firm

� View of relationships and tradeoffs between different risks



A.M. Best: Strong EC model seen as a valuable tool for insurers

Enhancing BCAR capital adequacy model to:

� Address new risks

� Measure the volatility and correlation of risk

Rating evaluation process considers:

� Strength of the risk mitigation process

� Insurer’s financial flexibility as part of long-term strength

Including in their process

� Stochastic modeling

� Evaluation of company’s EC models – partial credit likely

New ERM Framework

� Introduced March 2007

� Explicit mentioning of EC

� Partial credit for hedging is anticipated



Key focus of principles-based regulation (PBR)

� Captures all of the material risks, benefits and guarantees associated with the contracts, including “tail risk” and the funding of the risks

� Utilizes risk analysis and risk management techniques to quantify the risks; may include stochastic models

� Incorporates assumptions and methods that are consistent with those used in the overall risk management process

� Permits the use of company experience to establish company-specific assumptions

� Provides for the use of assumptions set on a prudent estimate basis that contain an appropriate level of conservatism when viewed in the aggregate

Within the next few years, PBR will apply to risk-based capital (RBC) and statutory reserves for all life and annuity products sold in the US



Current status of RBC models (www.actuary.org)

� C-3 Phase I now mandatory for all companies with assets > $100 million

� C-3 Phase II (variable annuities) has been effective since 2005

� Life insurance (“C-3 Phase III”)

� Work is well underway

� Methodology is similar to C-3 Phase II, using CTE 90 (TailVaR)

� Expecting year-end 2008 implementation

� Fixed annuities (“C-3 Phase IV”)

� Work is just starting

� Key focus on EIAs

� Methodology and timelines similar to C-3 Phase II (year-end 2008)

� Will include all annuity products, once completed

� Common issues for C-3 Phases III and IV

� Will apply to both in-force and new business

� NAIC is looking to have draft capital models by mid-year 2007

� Once completed, these will encompass all life and annuity products

� PBR peer review is likely to be extended to capital models as well



New principles-based regulation requires more sophisticated stochastic modeling

Distribution of Total Asset Requirement (TAR)

CumulativeProbability

0%

CTE (90) is average of the worst 10%

100%

10%

TAR CTE ( 90 )

Statutory ReserveC-3 Phase II Capital

$ TAR



Impact of PBR on VA product design/pricing

� May see flurry of product development activities

� Leading-edge companies are using their knowledge of the new regulation to their advantage by introducing features that mitigate tail risk

� Since PBR is prospective for life/fixed annuity reserves, companies may implement conversion programs to move inforce blocks to new policy forms

� May see an increase in the frequency of experience studies to mitigate volatility assumptions

� Increased use of stochastic pricing is emerging

� Run without, then with capital included

� Required capital is based on tail risk

� Rating agency capital models are starting to incorporate the new PBR methodology

� Leading-edge companies are evaluating tail risk before introducing new products/guarantees



Implications of PBR on VA product design/pricing (continued)

� Assessing, measuring and determining the risks associated with products will be the major change in product development and pricing

� Companies that price using a “deterministic” pricing model will need to educate pricing staff on stochastic approaches

� Substantially more discussion with the Valuation Actuary will be needed

� Need to determine approach to calculate expected statutory reserve levels for pricing (stochastic-on-stochastic)

� May need to increase modeling capabilities and/or size of actuarial staff

� Incorporating hedging into pricing necessitates using risk-free rates (need to check for “No Arbitrage”) and making an assumption about volatility

� Exact impact on the level of capital and reserves by product and in aggregate is not known yet



CFOs are overwhelmingly in favor of the new principles-based framework, but much less supportive of how it is being implemented

Support for the New Principles-Based Framework

Support for How Principles-Based Framework Is Being Implemented

26%

32%

37%

5%

46%

18%

36%

Stronglyin favor

Somewhat in favor

Neutral

Strongly in favor

Somewhat in favor

Neutral

Somewhat against

Source: Tillinghast CFO Survey 2006



Impact of PBR on companies

� Increased scrutiny of regulators and rating agencies

� All major U.S. rating agencies are currently developing or enhancing their capital adequacy models

� Analysis of PBR as part of ERM/EC assessment

� Focus on efficient use of capital

� Leveraging regulatory work into better EC models

� Implementation of EC via stress testing or full stochastic model

� Greater focus on risk management and reducing financial volatility

� Risk assessment and analysis

� Mitigation of tail risk

� Better integration of functions will be needed

� Pricing & product development

� Valuation

� Capital management

� Corporate decision making



Agenda






There are three primary ways to manage risks from VA product guarantees

Product Design

Reinsurance

Hedging

� The line between product development and risk management is becoming blurred

� Asset restrictions more widely used� Caps and deductibles increasingly used

� General lack of capacity is forcing more active internal risk management� More alternatives recently� Tail events may still be an issue

� Increased regulatory scrutiny

� Requiring hedging programs as part of rolling out new GLBs is common practice

� Expected for large companies� Real test of hedge effectiveness is yet to

come

RISK MANAGEMENT METHODS


Implementing hedging programs for VA living benefits can help alleviate increases in RBC requirements in the US

C-3 Phase II and VA CARVM

Living Benefits Driving Sales

Increased Capital and Reserve

Requirements

Improved Risk Management,

including Hedging Programs

May helpreduce

� Likely impact: (1) Growing importance of scale(2) Further market consolidation



An informal industry survey of 20 large US VA players indicates that most companies have some hedging program in place

Source: Tillinghast Survey 2006

Dynamic hedging —Delta only: 12 (60%)

Dynamic hedging —beyond Delta: 6

(35%)

Static hedging only: 1

No hedging in place: 1



Case Study: Impact of hedging on VA RBC and VA reserves

Key points

� Hedging reduces capital but increases reserves (=CTE65) at time 0; TAR (=CTE90) is lower with hedging

� Capital reduces over time for both, eventually going to 0 due tomoneyness of GMAB and overall fee revenue

Total Assets for No hedge VA

-

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

0 1 2 3 4 5 6 7 8 9 10

Projection Year

TA

R Capital

Reserve

Total Assets for Hedged VA

-

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

0 1 2 3 4 5 6 7 8 9 10

Projection Year

TA

R Capital

Reserve



� Common issues in the industry include

� Overly optimistic views of:

— Effectiveness of delta-hedging

— Economic assumptions, such as implied volatility

— Capital offsets from hedging (C-3 Phase II)

� Residual risks larger than expected

— Basis risk

— Policyholder behavior

� Knowledge and communication gap between technicians and management

� Underestimating resources to efficiently manage hedge operations

� Effectiveness of hedging will become more critical in the future

� Mitigating earnings volatility is key for public companies

� Rating agencies’ ERM assessment includes analysis of VA hedging

� “Smart modeling” techniques will be needed

Ability to assess and improve hedge effectiveness is becoming a key differentiator in the marketplace



Questions and Comments

Hubert Mueller, Principal

Towers Perrin

Hartford, Connecticut (USA)

Phone: (860) 843-7079

[email protected]

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