Lesson 9: Moral Hazard

One of the theoretical foundations of modern insurance pricing is a principle called “moral hazard.” It lies at the heart of many actuarial models, is based on common sense and I make sure to spend quite a bit of class time explaining the implications to my undergraduate and graduate students. For those of you who haven’t heard the term before, moral hazard has little to do with religion, ethics or corporate social responsibility. Rather, it is an axiomatic assumption that when individuals are protected from the negative implications of their actions — they tend to take more chances.

Some examples that are usually given to illustrate this fundamental principle is the careless rental car driver who doesn’t worry about damages he might cause, the homeowner who occasionally leaves the door unlocked, or even the bank depositor who relies too heavily on the FDIC; all of them — consciously or sub-consciously — tend to behave in a more careless manner, since they have insurance if something goes wrong.

Now it seems this exact same principle is manifesting itself in the asset allocation and investment selections of policyholders who own variable annuities. They are unequivocally accepting greater equity market risk simply because they have insurance — i.e., guaranteed living benefits — and it remains to be seen how this will impact the market and pricing of these benefits in the long run.

The evidence for all of this comes from a large database of variable annuity policyholders that the researchers at LIMRA International have been kind enough to allow us to probe and dissect (anonymously, of course).

Together with Vlad Kyrychenko (a Ph.D. candidate at York University), I reviewed the overall asset allocation of variable annuity account holders and classified their investment asset allocations within these products into two distinct categories: risky and risk-free. We were interested to see how these allocations varied by age as well as the types of guarantees (riders) selected. The kinds of questions we were interested in were: Do older policyholders allocate less wealth to riskier asset classes? Do younger policyholders embrace riskier asset classes? How does this change when various insurance riders and guarantees are elected?

After all, academics and theoreticians can develop normative models on how investors should be behaving, but it’s always interesting to see what they are doing in practice. The following figure provides a graphical illustration of the main results for just one of the insurance companies we analyzed.

The x-axis displays the age of policyholders when they opened or purchased the variable annuity. Our data extend from under age 40 on the left-hand side up to age 80 on the right-hand side. On the y-axis we plotted the average amount that was allocated to the High and Medium Risk (HMR) categories, which included equity-based funds as well as real estate and international investments.

First of all, as you can see, the older investors tend to allocate smaller amounts to risky sub-accounts within their variable annuities. This is fairly consistent with intuition and what economists call the life-cycle theory of investing.

Second, we find that when no guaranteed living benefit (GLB) — i.e., extra levels of protection — was selected by the client, the level of risky equity exposure within the account tended to be lower, by about 10 to 30 percentage points, compared to the basic case. We think this is the more interesting result.