Can Variable Annuities Really Offer Insurance Guarantees Against A Market Catastrophe?

Posted by Michael Kitces on Wednesday, November 20th, 6:42 am, 2013 in Annuities

Since the tech crash, it has been increasingly popular to purchase variable annuities with "guaranteed living benefit" riders to help protect retirement income against the risk of a market catastrophe. The basic premise of the contracts is rather straightforward: for a modest cost, the insured can transfer the risk of a severe market decline to the insurance company, and remain assured that guaranteed retirement income will be available for life, undiminished by the market decline. In the meantime, the annuity owner has the opportunity to stay invested in the market, with the hopes of generating an ever greater upside (albeit reduced by the costs of the annuity).

The problem, however, is that unlike most types of insurance - where the law of large numbers allows the insurance company to have relative certainty about the timing and magnitude of potential claims - in the case of annuities with income guarantees against a market decline, the insurance company faces virtually no risk exposure for any of its policyowners, until a major market decline actually occurs... and then, suddenly, the insurance company must set aside reserves for everyone, all at once. The end result is that market volatility can end out creating drastic volatility in the required reserves and profitability of the insurance company - to such an extent that in the past several years, many major insurers have decided to stop offering the guarantees altogether.

In the aggregate, the problem is that having a large group of prospective policyowners transfer their exposure to market risk to the insurance company may seem like the risk is being transferred from the policyowner's perspective, but the risk is actually being concentrated from the insurance company's perspective, in a remarkably undiversified manner. As a result, the policyowners actually face the danger of turning what was a systemic risk exposure to overall markets into a very specific, undiversified, unsystematic risk exposure to the credit quality of a particular (insurance) company instead. And for those who fear the danger of a "black swan" event, the reality suddenly becomes clear that the kinds of black swans that could be a blow to markets may actually be an even more severe blow to the insurance companies trying to guarantee against them, as was evidenced by the need of at least one annuity provider to access Federal TARP funds for liquidity in the immediate aftermath of the financial crisis.

Ironically, it turns out the best alternative may simply be the solution that advisors recommended before such annuity contracts were available in the first place: to invest more conservatively, and spend more conservatively, and simply stay the course and weather the storm. After all, conservative spenders following a safe withdrawal rate approach have largely recovered their declines since the financial crisis, while many insurance companies have left for good; similarly, while the safe withdrawal rate weathered the Great Depression, many insurance companies did not. Of course, in today's marketplace, the annuity companies have finally figured out how to proper structure, constrain, and price annuity guarantees to manage their risk exposures and make the products economically feasible to be offered; yet the outcome of such pricing may be leading to the point where their floor-with-upside guarantees are no longer an appealing trade-off for the (new) cost.

Fundamentals Of Insurance

The basic principle of insurance is very straightforward. Individuals pay premiums into a common pool of money with an insurance company, which the company invests for some growth (and subtracts a bit of cost for the overhead of the insurance company), and then uses a combination of the original premiums plus growth to pay out insurance claims. To the extent there's money left over (claims are less than the premiums plus growth), the insurance company generates a profit, while if the claims exceed the premiums plus growth, the insurance company has a loss. Since insurance companies are a going concern, with a steady stream of new premiums coming in, claims being paid out, new policies being established, and old policies that are allowed to lapse, the ongoing management of the insurance company is a bit more complex, but the fundamental equation remains the same: premiums + growth - costs = claims + profit margin. The insurance company sets the premiums, manages the costs, invests for growth, and aims for a certain profit margin that will be left after anticipated claims.

Of course, this also means that being able to effectively anticipate claims is absolutely crucial for the effective function of a life insurance company, which is no small feat in a world where any individual insurance claim - from the death under a life insurance policy to a fire burning down the house under a homeowner's policy - can seem exceeding random on a case by case basis. Fortunately, though, what we see from the "law of large numbers" is that, given a large enough sample size, the actual number of incidents average amount remarkably close to the expected value (assuming, for the time being, we can make a reasonable estimate of the expected value in the first place). What is "random" at the individual level is remarkably stable in the aggregate.

Thus, for instance, while in any individual scenario, the person does or doesn't die and the house does or doesn't burn down - a very random, binary outcome - with a large pool of insured individuals (or properties), the frequency of claims becomes remarkably consistent, allowing the insurance company to be able to set an effective premium that allows the whole mechanism to work in the first place. In turn, this allows for the availability of everything from life insurance to homeowner's insurance; for some newer types of insurance coverage, we may not get the expected value right initially - such was the case early on for disability insurance, and more recently for long-term care insurance - but the principle remains the same: in large numbers, claims can occur with relative consistently.

Of course, with enough consistency, the outcome is essentially an assured loss for any individual insurance policy owner; on average, the policyowner's expected value is reduced by the costs (and profit margin) of the insurer. But access to insurance allows the individual to turn what could be a relatively extreme financial impact - like the loss of a family's primary breadwinner or the house that they live in - into a much smaller, manageable cost. While technically the expected value of the insurance transaction is financially diminished by insurance company overhead and profit margins, it provides a way for an individual facing a binary outcome - the event does or doesn't happen - to participate in the much steadier law-of-large-numbers outcomes instead.

Insuring Against A Market Catastrophe

While insurance can be a highly effective way to manage risks that are highly uncertain individually but average out effectively in large numbers, the problem with trying to insure against a market catastrophe is that the risks don't "average out" over time; instead, they clump together. After all, the reality is that if a large number of people buy insurance against a market decline - e.g., through a variable annuity with a living benefit rider (GMWB, GMIB, etc.) - then nobody will have a potential insurance claim while the market is going up, but virtually everybody will be "in the money" at the same time when there's a severe bear market.

Of course, insurance companies had some acknowledgement of this risk, which is why policies that "insured" against market declines did not pay out an immediately liquid benefit, but instead merely allowed the policyowners to draw out lifetime income which meant, at some point, they may eventually deplete their own assets and then draw on the insurance company's guarantee. Nonetheless, where a severe market decline occurs, regulators require the insurance company to ensure it has reserves sufficient to pay out on its potential obligations, requiring a huge allocation to be set aside; thus, while the insurance company may ultimately be able to make good on its guarantees, avoiding a knockout punch default, the impact to profits for the reserve allocation is so severe the "technical" knockout punch leads the insurer to leave the business anyway (as occurred with several annuity guarantee providers after the financial crisis).

The challenge is compounded by the fact that, given market volatility, the sufficiency of reserves to back market guarantees themselves become highly volatile, as a base of hundreds of billions of dollars of assets are backed by guarantees funded by fairly tiny (relative to the assets) rider fees. If there is an extended bull market - and the insurer has many years to collect fees before facing a market decline that results in a significant insurance exposure - the consequences can be somewhat more contained. But the fundamental problem remains that - unlike virtually all other types of insurance - it's not feasible to slowly, steadily build reserves against a slowly, steadily rising base of guarantees; instead, because all the contracts are tied to the same underlying stock market risk, virtually all the policies become a potential claim at the same time. For instance, if $300B of guaranteed annuities experience a severe 25% market decline, the insurance company is suddenly exposed to as much as $75B of claims, for which gathering a 0.5%-of-$300B - which is "only" $1.5B of fees - just doesn't cut it.

Notably, in other insurance contexts, companies are very cautious not to back risks that could result in a mass number of claims all at once. This is the reason why most insurance policies have exclusions for terrorist attacks and war, and similarly why it's so difficult to get flood insurance in many parts of the country (and/or why the government must often make flood coverage available as the insurer of last resort). It's a crucial aspect of insurance that in the end, its exposure to risk is well diversified (allowing the law of large numbers to work) and not be overly concentrated.

Diversifying Risk Or Concentrating It?

Ironically, while consumers view insurance company guarantees as a way to diversify their exposure to risk, the truth is that they are actually transferring their risk to the insurance company, and in the process the insurance company is actually concentrating the risk, given that a market decline can put virtually all guaranteed contracts "in the money" at once. Thus, as seen in the financial crisis, while many investors could afford the market decline and stay invested for the recovery (as the market has now reached new highs), the concentration of those risks aggregated in some insurance companies was so severe that they've discontinued the products altogether (and in one case, actually need a "bailout" loan from the Federal TARP funds!). And unfortunately for the insurance companies, the problem seems to have been exacerbated by investors who bailed out of markets (but not the annuity guarantees), effectively "locking in" their losses and virtually ensuring that they will eventually become claims against the insurance company (and of course, with the policies "in the money" few people are surrendering or lapsing them anymore, either!).

In the aggregate, these challenges raise the question of whether investors can really protect against stock market "black swans" by buying insurance, or whether attempts to do so just converts the black swan from an investor risk to an insurance company risk (and a more concentrated one at that). Bear in mind, the fundamental purpose of insurance is not to make people whole from their losses in the aggregate; it's to redistribute and smooth the losses by turning large impactful risks into smaller, manageable ones by sharing some of excess premiums of the "winners" with those who have claims (the "losers"). Except when the risk strikes all policyholders at the same time - as is effectively the case when insuring against market declines and economic catastrophes - then the insurance company simply doesn't have the resources to make the protection work, as there are no "winners" to offset against the "losers" in such scenarios. Instead, none of the policyholders are actually drawing against the insurance company's risk pool and reserves against a market catastrophe... until they are, together, all at once.

The bottom line is that, ultimately, people seek out insurance guarantees to protect against "untenable" risks in the markets. The kinds of "black swans" that can result in an economic disaster and a market catastrophe. Yet the reality is that when such extreme events occur, the insurance companies that ultimately use the same capital markets find themselves exposed to the same systemic risks and events. Clients might seek out a variable annuity guarantee to protect against the next Great Depression, yet the reality is that there were a non-trivial number of insurance companies that failed in the last Great Depression (not to mention the long-forgotten "Insurance Holidays" instituted to protect more insurance companies from default!)! Yes, it's true that we regulate insurance companies better now than we did back then, but by definition "black swans" are events that aren't predictable, can't be foreseen, and therefore can't necessarily be regulated against in advance.

This doesn't necessarily mean that a random black swan is likely to come along and wipe out a large number of insurance companies, but the point remains that if the fear is that a black swan could be coming, an insurance company isn't necessarily a safe place to hide. In fact, the client risks turning a systemic risk for their overall portfolio into a more concentrated, less diversified individual risk into a single company (since, in the end, a guarantee is only as good as the credit quality of the individual company underwriting the guarantee, which isn't exactly "secure" if you're assuming a black swan economic catastrophe up front!). Yes, there are also state guaranty funds, but it's not clear they're remotely well-capitalized enough to bail out the insurance industry in the aggregate (not to mention that most states limit their annuity guarantees), and does anyone really want to bet whether deficit-strapped the states can/will come up with the additional state-guaranty-bailout-funds if called upon?

Where To Go From Here?

So what's the alternative, for investors and clients who really want to do something to manage their exposures to risk?

Simply put, there are two primary alternatives: 1) to just not take as much risk in the first place, managing risk not by trying to shift market risk to an insurance company, but just owning less risky stuff in the first place (i.e., having a more conservative portfolio); or 2) by simply spending conservatively enough that even if "bad stuff" happens in the portfolio, the retiree who in the end is only spending a few percent a year from the portfolio allow can allow the bulk of the assets to stay invested long enough for a recovery to occur.

After all, it's quite notable that in the end, this kind of safe withdrawal rate approach survived a Great Depression that many insurance companies did not, and those following a safe withdrawal rate approach since 2008 are doing fine (given the stupendous market rally that has occurred since the decline) while a large number of insurance companies had to permanently exit the marketplace. In other words, notwithstanding how scary the ride can be at the time, the reality seems to be that just prudently managing a portfolio and drawing a conservative amount from it each year has had more success withstanding bear markets, economic turmoil, and "black swans" than the insurance companies some investors are looking to for protection. To be fair, not all insurance companies have left the business since 2008, and none have actually outright defaulted on their guarantees at this point. But we have seen a number of very consumer-unfriendly practices from insurance companies trying to get off the hook for their guarantees, from "buy-backs" to changing available investment options and constraining asset allocations and more, and we still don't know how the next bear market will play out either.

Notably, this doesn't mean that advisors and their clients should eschew annuities and their guarantees altogether. The term "annuity" is still used to label an incredibly broad range of products, and some do not face these "concentration" risks at all, whether it's plain vanilla variable annuities used as a tax-deferral and asset location wrapper, fixed annuities that may have an appealing yield, or an immediate annuity that pools mortality/longevity risk (which really does obey the law of large numbers!). Nonetheless, when it comes to offerings like variable annuities with guarantees against market risk, it remains unclear whether in the end, clients are really shifting their systemic market risk away, or actually concentrating it into an even more dangerous unsystematic specific-company risk instead! That's not diversification, it's concentration!

Fortunately, many annuity companies have at least recognized the tenuous situation of their current market guarantees, leading to contracts that have less generous benefits, higher costs (or at least, costs that the insurance company is permitted to raise significantly in the future under the contractual provisions of the annuity), and "indirect" costs like asset allocation requirements that force investors to hold a significant portion of assets in fixed income investments that may cost more than their prospective return. Which means the danger of an annuity company "catastrophe" is perhaps diminished, but at the cost that it's no longer clear whether there's any value in using an annuity to secure an "income floor with upside" when there may no longer be any upside in the first place after the embedded costs.


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