A more rational approach with greater flexibility is sparking increased interest in looking to begin writing variable annuity guarantees, believes Robert Painter of Deutsche Bank
The variable annuity guarantee product is unique in today’s investment market. With the gradual demise of defined benefits, there has never been a greater need for such products as they are the only privately offered solution available to investors which can provide a level of market participation and income certainty.
In the last decade the sector has undergone a period of significant upheaval, one which saw the guarantee market slump during the recession. However in recent years it has seen increased investor confidence driven by the rebound in markets and the introduction of next-generation products which offer more rational pricing and guarantees coupled with different features.
Pre-recession, guarantee products were widespread. They had provided insurers with an access point into the high-margin investment environment and market competition was fierce. However, as players pushed hard for market share, discipline began to wane. Questions were being asked about the pricing of guarantees, the effectiveness of hedging strategies and the selection of appropriate funds.
The impact of the economic downturn in 2007 and 2008 on the variable annuities guarantee market was dramatic. The weaknesses in the sector were quickly exposed and a period of significant retrenchment lead to many major players exiting the market.
However, for those organizations which had maintained a more prudent risk management approach to such products, the market turmoil provided an opportunity to re-evaluate. A concerted effort across the sector caused an almost market-wide recalibration of the underlying model. There was a more rational approach to guarantees, greater focus on fund selection and fund design, and a more robust approach to hedging strategies.
“Perhaps the most significant development is that such products are now being constructed on an individualized basis”
There has also been an up-turn in the standing of term accumulation products. From a design perspective, and particularly in the context of CPPI (Constant Proportion Portfolio Insurance), the reputation of such products had been tarnished as a result of underperformance or mis-selling. A key factor in this was the use of co-mingled and notes-based products.
The CPPI model has undergone a major overhaul in recent years. Perhaps the most significant development is that such products are now being constructed on an individualized basis, removing the risks associated with co-mingling. Not only is individualization best supported by insurers, but by adopting such an approach it enables them to introduce greater flexibility – so much so that we are seeing increasingly similar terms and features between options-based and CPPI products. Flexibility is key to the success of any investment product and in terms of CPPI, this extends to the overall product design, the underlying guarantees, the tenor of the product, the choice of funds etc.
One of the main risks in the CPPI equation that this tackles head on is that of cash-lock, which in the past has proved the death knell for many products. However, under the new CPPI format, cash-lock defence mechanisms include the ability to: make additional contributions to unlock the product; readjust or customize allocations to reduce cash-lock risk; turn on and off locking mechanisms to manage the risk; and extend the maturity of the product to reduce or remove a policy from cash-lock.
This enhancement of the CPPI product has resulted in a number of new entrants into the market, particularly across the US, Europe and in Australia. This is perhaps not surprising given the fact that for many multi-national organizations and fund managers, such solutions offer a genuine alternative to an options-based variable annuity product and the associated costs of setting one up. A CPPI product is more cost-effective to administer, requires less infrastructure and there is also corporate reinsurance available for such solutions.
It is fair to say that the variable annuities market has undergone a major shake-up in response to the frailties brought to light during the recession. However, the product that has emerged is one now built on a risk/profit return on capital framework that makes sense. While it may not be as ‘rich’ a product as once offered, it achieves a level of security and certainty that is demanded in a post-recession environment.
Kane LPI would like to thank Robert Painter for contributing to this issue of the Kane LPI newsletter.