Insurance companies are increasingly becoming involved in the stable value wrap business. Insurers are themselves seeing the value in becoming players in the market due to strong ROEs and minimal allocated capital according to new report released by Moody’s Investor Service, titled: Stable Book Value Wraps Generate Strong ROEs, but also Sizable Tail Risks.
Since the financial crisis, insurers have been replacing banks as the providers of book value wraps to pension plans partly because as the crisis developed, banks needed to focus on their core businesses and “capital needed to be marshaled,” according to Moody’s Joel Levine, Associate Managing Director, US Insurance Team.
While insurers have enthusiastically stepped in to fill the void they may be ignoring some of the tail risks involved as they look with wide-eyes at generous returns coupled with a significant increase in fees.
Book value wraps provide stable value pension plan participants with the guarantee of benefit withdrawals at book value. The aforementioned wraps work to absorb the difference between the market and the book value of assets during the withdrawal of a benefit and are designed to pass any gain or loss back to the remaining plan participants by adjusting the credit rating on their account values over time.
Insurers generally view the business as safe because the participant behavior is easily foreseen. There are, however, a number of inherent risks involved. “Companies make estimates based on past history and company experience over a period of years but what if we enter a period where interest rates were spiking and spreads on corporate bonds were high? Participant reaction could change which would make for higher withdrawal numbers,” said Levine.
Tail risks can also affect the profitability if the difference between the market value and the book value of underlying investments is too big to be closed by adjusting the crediting rate.
“Although companies carefully underwrite the plans they insure and contracts exclude certain event risks to protect the insurer, we believe book value wraps expose insurers to substantial tail risk because they do not allocate sufficient capital to the business to cushion against potential losses in extreme adverse scenarios,” Moody’s Vice President and author of the report, Ann Perry said in a statement.
Indeed the fact that sufficient capital is not allocated coupled with high ROEs and a significant spike in fees that are charged make the business increasingly alluring to insurers. Generally, capital allocated to the product is 1 percent or less of the contract book value, according to the report, rendering the business exceedingly attractive. The report augurs that players in the market will “ramp up their book value” while others look to get involved.