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This is the second of a series of articles that will be published on the annuity space.

Since the financial crisis of 2008-09, many insurers have rethought their strategy around the variable annuity (VA) market, with some players exiting the space, others exercising caution in continuing to offer generous benefits, and a few recommitting in terms of sales and consolidating their leadership positions. Insurers that opted to stay in the market changed their pricing, product designs and risk management approaches as a means to “de-risk” their VA businesses in the face of historically low interest rates and sometimes volatile equity markets and FX rates.

Top 5 Annuity Trends to Watch for in 2012 and 2013

While the impacts of these risk mitigation moves–including the use of target volatility funds–have been met with some success, VA products still contain residual risk, which must continually be addressed in the low interest rate environment. Additionally, insurers seeking to sell VA business with attractive risk-adjusted returns must carefully weigh the impacts of their risk mitigation approaches on other parts of their business, model newer products (such as target volatility funds) accurately and refine their product offerings appropriately.

Market consolidation 

Today, the top three writers of variable annuity products capture more than 45 percent of total premiums,a major shift in a market that was much more fragmented just a few years ago. The companies that exited the market have done so for a variety of reasons, including risk-reward trade-offs and concerns about the volatility of the business on their GAAP and statutory financial statements.

The companies that stayed in the VA market saw an opportunity to seize market share and generate more VA revenue either now or as market conditions improved over time. However, these companies are generally moderating their guarantees and also recognizing the need to strengthen their risk management activities. Thus, they are proceeding with added caution.

It will be interesting to see whether new entrants emerge to assume risks on legacy blocks of business or offer product solutions in the large and growing retirement income market.

Changing living benefits riders

The living benefit (LB) rider landscape continues to change. The number of closed and modified LBs significantly outweighs the number of new LBs, according to research from the Ernst & Young’s Retirement Income Knowledge Bank. To date, the primary de-risking mechanism has been to increase fees, while the inclusion of target volatility funds in separate account portfolios has replaced investment option restrictions and benefit reductions as secondary de-risking mechanisms.

More recent products have also included auto-rebalancing features, based on constant proportion portfolio insurance (CPPI) algorithms, which drive dynamic asset allocation within individual volatility funds and across asset classes. CPPI algorithms were also designed as a way to de-risk VA products. Companies have continued to refine their algorithms; for instance, CPPI algorithms did not initially allow policyholders to materially participate in rising markets–a deficiency in the first generation algorithm fixed in more recent generations.

Volatility-managed funds (often referred to as target volatility funds) were introduced in 2010 and are typically based on proprietary strategies; different asset managers apply their own “secret sauce” for reducing fund volatility, given their view of market trends. Given the proprietary nature of the “secret sauce,” there is no such thing as a generic volatility-managed fund.

Target volatility funds can be advantageous in highly volatile markets by reducing the risk of extremely negative outcomes, boosting comparable long-term returns and reducing “tail events” with outlier gains and losses. There are potential downsides to be acknowledged, including the chance of underperformance in market recoveries.

As more sophisticated risk management approaches are included in the sub-accounts of variable annuity products (including those funds with hedge assets) there are likely downstream effects to consider including but not limited to challenges for advisors to explain and customers to understand the risk/reward profile of the funds, and more difficulty in evaluating and making decisions around the effectiveness of these funds.

The impact of target volatility funds

Insurers have moved quickly to put volatility funds into their VA products and are now continuing to work through the impacts across their various financial and risk management objectives such as:

  • Reducing earnings volatility (GAAP reporting)
  • Reducing the required capital or capital volatility (statutory reporting)
  • Maintaining economic profitability and management of economic risks

It is impossible to optimize a hedging strategy to satisfy all three types of objectives, and optimizing for any single type requires trade-offs and compromises that may affect the others. While target volatility funds can help VA writers and corporate risk managers strike an effective balance among these objectives, they do not eliminate the risk of VA products and or need for hedging embedded guarantees in VA products.

There are also downstream impacts affecting other functional areas and stakeholder groups across the organization:

  • Sales: inclusion of funds on the ability to sell VA products;
  • Distribution: commission structures and incentives to sell products with volatility controlled funds;
  • Product Development: extent of de-risking enabled by target volatility funds and balancing with changes in product features;
  • Pricing: pricing requirements to cover guarantee and margins under varying fund performance scenarios; capital consumption of products with target volatility funds;
  • Hedging/risk: “hedge target” and hedging strategy assessment given the inclusion of target volatility funds;
  • Treasury: changing collateral requirements/margin on hedge assets;
  • Senior management: insight into ability of target volatility funds to minimize volatility in GAAP earnings and statutory requirements; funds’ impact on branding/reputation;
  • C-suite: funds’ ability to increase shareholder value,

In some of these areas, the impact of target volatility funds will clearly be high. In other areas, the impact is uncertain, and likely cannot be identified without further assessment.

Given that VA risk strategies of target volatility funds are proprietary and given that the cash flows from VA products touch material areas in insurers, such as hedging, pricing, and capital management, the importance of modeling target volatility funds accurately cannot be overstated. Insurers should carefully assess their system capabilities to ensure they can adequately model the proprietary strategies of these target volatility funds. This is a difficult task, given that target volatility strategies are getting more complex over time.

Additionally, given the numerous areas in a VA risk management framework touched by target volatility funds, it is critical to think through the implications holistically across their financial management framework.

Only after these two areas are addressed can a company decide where and how to use volatility funds. The bottom line is that any insurer that wants to place target volatility funds into VA products must be able to model them accurately and understand the potential downstream consequences of including these funds in their VA product. Otherwise, they risk getting results that don’t make sense and future unpleasant surprises.

Next: Fixed Indexed Annuity Trends

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