LIFE INSURANCE, FINANCIAL GUARANTEES AND HEDGING
1. What new product opportunities are created by changes in savings, protection, investment, inflation, public policy in developed and developing countries?
2. How will proposed changes in accounting, regulatory and performance measurements affect life insurance risks and risk management practices?
3. How can insurers manage risks that policyholders seek protection from through hedging strategies and tools?
4. Is the life insurance business better off diversifying risks (e.g., longevity, investment, marketing) through integration with other financial services or by concentrating on the special needs of life insurance alone?
5. How can life insurers apply their special skills to capture a stronger position in privatized retirement savings markets?
Life insurance, annuities and related products around the world provide a mix of death protection, savings, investment, retirement income and tax deferral or avoidance. Economic conditions, savings and protection habits and public (mostly tax) policy have strongly influenced product design and provider corporate structures (e.g., public and private, stock and mutual). Relative product complexity, reluctance to discuss prospects of death and the wide range of policyholder objectives addressed has made distribution approaches and compensation a perpetual leading issue in being successful in the business.
Life insurance has served a wide range of societal needs. In ancient times it provided for socialization of burial expenses and survivor benefits for families and social groups. It provided for widows and orphans. It provided basic savings for the unbanked. At the other end of the economic spectrum it has provided investments, retirement plans and estate and tax tools.
In providing these services, life insurers have had to rely on long-term estimates of longevity, inflation, investment income rates, regulatory and tax regimes, lapsation and distribution cost/performance, among other factors. Long considered one of the most stable and reliable businesses, some spectacular failures (e.g., Executive Life (US), Equitable (UK), some Japanese life insurers) have demonstrated how companies can run afoul of economic and political trends. Life insurance is becoming increasingly complex both in terms of financial reporting and products and customer behavior.
The recent financial crisis has further complicated the position of life insurance and its providers. Recent work by the CFO Forum in Europe on Market Consistent Embedded Values (MCEV) has been directed toward dealing with the volatility in asset values and calculation of a liquidity premium to account for abnormal conditions, while attempting to account for long-term business performance using market consistent measures. The long term nature of insurance creates a dilemma for those trying to reflect current market conditions in corporate financials. Insurers have varying degrees of protection from asset value fluctuation as they are not required to liquidate some portion of their assets until policy claims are made sometime in the future. However, in some extreme circumstances (such as experience in the recent financial crisis) they could be required to liquidate assets at fire sale prices to meet current obligations. If they are normally required to record assets and liabilities at “current market value,” how do they deal with disorderly market values not set within deep and liquid markets?
Prospective changes in regulatory solvency rules (e.g., Solvency II, IAIS guidelines) and in accounting rules (e.g., IFRS) are leading to a more market-consistent, economic , and globally-consistent, approach to reporting insurer balance sheets and income statements. Simple ratios are being replaced by complex standard or company-specific models to better understand and report company financial and risk positions. This has come with many debates about what the proper basis for this reporting should be.
As insurers are being pushed toward greater recognition of the volatility that their assets and liabilities are exposed to (at least within “normal” markets), their customers are increasingly concerned about gaining protection against volatility in investment markets that affect their asset values in homes, savings and retirement plans. Introduction of lifetime guarantees and various forms of annuities provide certain protection for policyholders subject to the insurer’s ability to maintain the ability to meet these obligations.
A major influence on the shape of life insurance and annuity markets is the aging of the global population. Heavy reliance in many jurisdictions on pay-as-you-go retirement plans offered by governments inherently assume ample current employed workers able to provide sufficient social taxes to meet the needs of a relatively small retirement pool. Aging has upset this balance. In response, governments in many countries have established tax-advantaged, private retirement savings programs managed by life insurers and specialized retirement savings institutions, to supplement or replace public programs. In many countries, this private retirement-related business has become much larger than life insurance business in terms of accumulated reserves.
In a related trend, countries where employer-based defined benefit plans placed the requirement on employers and insurers to maintain adequate funding for formulated benefits, have shifted to greater reliance on defined contribution plans. These give prospective and active retirees control over investment decisions but also require them to accept responsibility for accumulating enough to cover an uncertain period of retirement (e.g., longevity, inflation risks). This trend, with recent experience in volatile investment markets, adds to demand for guarantees on retirement income sources for retirees. Most retirees lack the skills needed to plan for adequate retirement income. The uncertainties also make it difficult for the growing number of professional advisors to give sound advice.
Life insurance was once considered a low risk industry, primarily exposed to longevity risk that was relatively easy to measure for death protection. This has been complicated by the shift to greater emphasis on “living too long” longevity risk. Modern product designs add increasingly complex investment and inflation risks on the saving portions of products. As standard life product sales have declined and products have become more complex, the cost of distribution has risen and become more difficult to manage, posing, perhaps, the greatest business risk of all.
Increasing emphasis on savings and investment and broadened powers of banks have resulted in a large role for bancassurance for life and annuity products, and competing bank products, in many countries. This has provided an opportunity (not always taken) to reduce distribution costs by leveraging the bank’s brand awareness, customer access and breadth of customer relationship. Despite the apparent linkage between insurance and bank products, and their customers, many banks have found it difficult to manage the two product lines and to coordinate a common distribution system.
In response to aging and increased customer demand for flexibility and guaranteed benefits, life insurers have introduced a range of product features to increase customer appeal. For example, guaranteed minimum withdrawal benefit provisions offer U.S. variable annuity contract holders annual withdrawal privileges, to go with guaranteed interest rates on investments and guaranteed annuitization rates. Insurers now face the task of designing investment strategies that cover the complex array of asset values , interest rates and inflation risks posed by the combination of benefits extended to multiple generations of policyholders.
Life insurers use hedging strategies to reduce risk associated with product benefits. Hedge funds have changed the impression of hedging by using hedging tools, e.g., short selling, derivatives, to seek extraordinary gains with relatively high net risk. Life insurers use complex models to seek investment opportunities that mitigate the impact of market movement on a particular pool of assets. This is a continuous process to keep up with changes in market conditions. The recent financial crisis increased capital market volatility threatening the effectiveness of hedges and hedging methods. Hedging methods have been expanded to take account of more factors and have had to address the potential for “extreme tail” events. Just as the convergence of accounting, regulatory solvency and performance management has required companies to integrate previously separate functions, challenges to effective hedging has required greater coordination of the hedging function with product development, pricing and investment policy. Further, life insurers are trying to ward off new regulatory constraints on hedging resulting from the recent economic threats.
No longer a quiet, low-risk business, life insurers participate in some of the most complex risk, investment and marketing circumstances in financial services. Changes are likely in competitive market structure, risk management methods and staff composition to address these issues.
1. How have the economic crisis and aftermath affected insurance lines, e.g., higher claims, decline in sales, growth in sales, new products?
2. How has the experience in financial services affected the direction of insurance regulation? Is insurance regulation affected by mistaken assumptions about industry needs and norms, e,g., excessive restriction on the use of needed hedging facilities?
3. How will the recent experience change risk management practices in the industry?
4. Will problems in the derivatives markets reduce or change the use of capital markets for insurance activities?
5. What new market opportunities are created by the recent crisis?