Every advisor knows that changes in interest rates affect the piles of bonds that support U.S. insurers' life insurance policies and annuity contracts.
Most know that a big wave of bond issuer defaults could hurt annuity issuers' bonds.
Some might not have thought much about another potential threat to retirement savers and their advisors: liquidity risk.
For annuity issuers and other financial institutions, liquidity is "being able to easily enter or exit a position in a security at or near the current market value of the security," according to a new report on complex assets that was prepared by a team at Milliman and distributed by the Society of Actuaries Research Institute.
For a retirement saver, insurer liquidity means that the insurer that wrote an annuity or a cash-value life insurance policy can pay the expected benefits at the expected time, and that the saver can really get some cash out early, and relatively easily, by using any product loan, partial value withdrawal or surrender provisions mentioned in the product marketing materials or in the product contract.
For a look at seven ideas the Milliman team has that could help advisors think about annuity issuer liquidity, see the gallery accompanying this article.
What it means: One of the big questions for retirement savers for the next 20 years is how well life insurers will meet baby boomers' expectations for returns and crash resistance.
The new Milliman paper may give advisors the tools to think about liquidity and other issues that will determine the answer to that question.
Liquidity and annuity issuers: Many of the world's insurance regulators started out as bank regulators. Bank regulators live in fear of "bank runs," or situations in which terrified customers run to banks to yank their cash out.
Traditionally, U.S. life insurers and many of their regulators have argued that banking-minded regulators talk too much about the extremely unlikely possibility of runs at life insurers and too little about the risks involved with making good on long-term obligations to the customers.
Some life and annuity products offer customers no ability to pull cash out early. Life insurers have many tools, including big charges and ponderous processes for responding to withdrawal or surrender requests, to turn runs on life and annuity issuers into nervous strolls.
Solvency II: European financial services agencies — which often combine banking and insurance company regulation — have developed a strict approach to setting liquidity requirements for life and annuity issuers.
The European Union's Solvency II directive and the United Kingdom's Solvency UK regulatory framework require insurers to manage investments according to the "prudent person principle." That "requires insurers to only invest in assets whose risks they can properly identify, measure, monitor, control and report," the Milliman team wrote.
The Milliman report: In the new report, the Milliman team focused mainly on "securitized assets."
Securitized assets are instruments backed by pools of business loans, mortgage loans, credit card receivables or other types of assets.
Managers may divide the offering into two or more tiers. Holders of securities in the top tier may earn a relatively low return and get paid first. Holders of the securities in the bottom tier may earn a higher rate but face the risk that they might lose their money if too many borrowers stop making debt payments.
U.S. life insurers have been expanding investments in securitized assets in the past 20 years because the securities pay high rates of return, have had low default rates and fit well with U.S. insurance company investment rules.
The Milliman team wrote the report for actuaries, insurance company investment managers and regulators, to help the companies and regulators keep life and annuity issuers healthy.
The Milliman team's views: The Milliman team noted that buying high-quality, illiquid assets may be a good thing for life insurers that make life insurance or annuity benefits promises that last for a long time.
"When insurers match long-term liabilities with illiquid assets that generate contractual cash flows, they can hold onto those investments to maturity instead of being forced to sell them during stressed market environments," the Milliman team said. "In this situation, illiquidity is not viewed as a drawback but as a strategic fit to effectively manage assets and liabilities."
But the team did cite liquidity as one concern that life and annuity issuers should consider when managing their own assets, and especially when adding relatively complicated investments, such as direct lending collateralized lending obligations, or securities backed by pools of loans made to small businesses and divided into different tiers.
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