There’s one big difference between banks and insurance companies when it comes to disclosing information to customers about the government guarantees that are in place to protect some or all of their assets.
On the one hand, the Federal Deposit Insurance Corp. requires that banks “prominently display” information about their customers’ deposit insurance in a variety of digital and physical locations. These include the bank’s brick and mortar buildings, the new accounts desk, website homepages, client portal login pages and more.
The National Association of Insurance Commissioners (NAIC), the U.S. standard-setting and regulatory support organization created and governed by the chief insurance regulators from the 50 states, does essentially the opposite. It expressly prohibits insurers from mentioning the existence of state guaranty association protections either through advertising or orally during the sales process.
The general wisdom behind this difference is the theory that knowledge of insurance policyholder protections could encourage the selection of more generous policies from lower-quality insurers, potentially resulting in a widespread misallocation of capital to riskier companies backstopped by more stable insurers. This type of “shrouded regulation” protects less sophisticated policyholders, the thinking goes, while potentially minimizing economic inefficiencies.
In a new research paper published by the Social Science Research Network, a trio of retirement experts asks whether this theory actually plays out in the annuity purchase process, and the answer seems to be “yes.” The authors — David Blanchett, Michael Finke and Michael Guillemette — find no evidence that there are sophisticated consumers strategically buying higher-return fixed annuity policies from lower-quality insurers near the guarantee limit, which is set at $250,000 in most states.
“Our results are consistent with other recent studies that show no evidence that insurance guarantees affect consumer choice of more generous products from lower-rated insurers,” Finke wrote recently on LinkedIn. “This type of shrouded regulation appears to provide important protections without resulting in a socially inefficient misallocation of premium dollars.”
This may seem like an esoteric finding with little practical import, Finke noted, but there are some key takeaways for wealth management professionals. Namely, helping clients purchase non-qualified annuities from lower-rated insurers at or just below the state limit is the best way to “maximize” the value of state guarantee protection. For example, using this strategy to help clients purchase multi-year guaranteed annuities can make a lot of economic sense — especially when spreads widen.
But the bigger conclusion, according to the researchers, is that the NAIC’s policy to bar insurance agents from discussing or emphasizing state protections seems to be having its intended effect.
A Missed MYGA Opportunity?
As noted, insurance guaranty associations limit the amount of downside protection in the event of insurer insolvency to $250,000 in most states. In general, the report explains, the guaranteed returns offered by MYGAs reflect a credit rating discount that does not account for this sizable degree of downside protection.
“This discount widens during periods of market turbulence and can present extraordinary opportunities for sophisticated investors,” the paper states. “The ability to substitute MYGAs for tax-inefficient comparable investments such as bonds or CDs in taxable accounts provides a potentially significant tax deferral benefit that can be exploited by consumers who are able to strategically realize gains in years when they have a comparatively lower marginal tax rate.”
Despite this possibility, the authors see little evidence that even sophisticated investors who buy MYGAs at or near the protection limits strategically buy higher-return products from lower-rated insurers. There is some evidence that MYGA purchases from non-qualified assets (which may reflect greater investor sophistication) favor annuities from lower-rated insurers, but that effect is also small.
“Our findings suggest that state guarantees do not influence product choice in a manner that can distort capital flows toward lower-risk insurers while still providing protections to vulnerable consumers who select lower-quality, lower-premium annuities,” the paper states. “This apparent regulatory benefit may occur because of rules that limit an insurer’s ability to communicate state guaranty protections to consumers.”
Other Takeaways
The authors note that their results are consistent with a number of prior analyses that have found annuity buyers seem to ignore state or federal government protections that could otherwise lead them to favor annuities from lower-quality providers that offer a more generous payout.
“We also find strong evidence that demand for higher-quality MYGAs increases following periods in which the S&P 500 declined in value,” the report states. “These flights to quality can result in even less efficient MYGA selection if consumers are even less likely to take advantage of credit quality spreads protected by state guarantees.”
Ultimately, the authors argue, there is significant empirical and anecdotal evidence suggesting that consumers aren’t generally aware of institutional protections against loss in insurance products and annuities. Awareness levels notwithstanding, they add, state guarantee protections are particularly valuable to lower-wealth, less financially sophisticated investors for whom a loss might have significant welfare consequences.
“[There is] no evidence of a separating equilibrium in which sophisticated consumers take advantage of downside protections to select MYGAs from higher-return, lower-quality insurers,” the authors conclude. “Shrouding state guarantee protection appears to have the dual benefit of reducing an inefficient allocation of capital while also protecting the most vulnerable consumers.”
Pictured: David Blanchett and Michael Finke
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