Low rates, market volatility increase VA costs

Investors' concerns about negative market returns are likely to create a greater demand for guaranteed products such as variable annuities, but the downturn in the markets has changed the insurers' cost of managing the hedging risk of VAs.
FEB 22, 2009
By  Bloomberg
Investors' concerns about negative market returns are likely to create a greater demand for guaranteed products such as variable annuities, but the downturn in the markets has changed the insurers' cost of managing the hedging risk of VAs. To put the situation in context, consider that the cost of hedging is strongly related to interest rates and volatility. For example, from January 2004 to last month, interest rates declined. During that period, the 10-year Treasury yield averaged 4.3%. Between Oct. 8, when the Federal Reserve made the first of several rate reductions, and Jan. 31, rates averaged just 3.02%. Over the same period, volatility increased. From January 2004 to Sept. 22, the VIX index, a popular measure of volatility, averaged 15.99. It shot up to an average of 53.8 for the period from Sept. 22 to Jan. 31 — representing a standard deviation more than twice as great as that for the entire five-year period.
It is no wonder, then, that increased hedging costs have had a material impact on VA risk management. In response, companies have made many ad hoc changes such as filing a new benefit with the Securities and Exchange Commission and, in some cases, removing certain products from the market. For the most part, these changes do not affect current policyholders. However, many contracts allow for an increase in the cost of a rider on existing benefits, but only when the benefit base is stepped up to the current contract value determined by the market. Given recent market performance, an increase in the rider cost is not likely. The area where insurers retain the greatest latitude is with eligible investment options or the composition of eligible portfolios. Before the economic crisis worsened in September, insurers continued to enhance VA living benefits, but now they have shifted their focus away from competitive development. For example, many guaranteed-lifetime-withdrawal benefits offered a bonus on the guarantee during the deferral period. This commonly was around 7% but ranged as high as 10%. Some of these benefits are no longer available, and others have been amended with lower percentages. Carriers have made similar changes with rates on guaranteed-minimum-income benefits. Although insurers have been reluctant to make these changes, the current market has made it impossible for them to ignore the precipitous increase in hedging costs. Compared with the rise in the current cost of supporting guarantees, rider fee increases have been quite modest. For one thing, insurers still assume that hedging costs will normalize to a lower level at some point and that the average cost will be lower than today. In addition, some changes to features have been necessary for the sake of rational risk management. The most significant set of changes is expected to arrive May 1 in the form of updated prospectuses for all contracts. In some respects, the changes may be temporary. Insurers are counting on markets to normalize, although it is unclear when that will take place or what "normal" will look like once the markets stabilize. In the short run, products are becoming simpler. But when economic stability returns, competition will drive renewed product enhancements, although it is likely that insurers will not be able to include as broad an array of feature in a single product.

FUTURE RISK MANAGEMENT

One thing that will not change is the industry's fundamental approach to risk management. In the same way that investors will be gun-shy about equities, new-product developers will integrate the lessons learned today into their risk management practices. These will certainly be reflected in product design, especially with regard to investment options. Many insurers experienced unexpected losses because of investments that declined even more than their benchmark indexes. Thus, funds or portfolios that use indexes or exchange traded funds are easier and more reliable to integrate into hedging programs. Perhaps we can learn something about variable annuities from "The Simpsons." Fans may recall that Homer Simpson once had the opportunity to design the dream car for Middle America.He included every convenience and gadget imaginable; in the end, the car was so fully loaded that no average American could possibly afford it. By the same token, price and design considerations mean that retirement income guarantees cannot be all things to all people. As advisers consider offering guarantees to clients, they increasingly will have to focus on key facets that provide value. Tamiko Toland is editor of Annuity Insight, a service of Strategic Insight in New York that provides institutional research and analysis on variable annuities and stand-alone living benefits.

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