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However, rather than undermining the value of the product due to the recent bear market, VAs have proven their valuable benefits to investors for their unique and significant role in portfolio diversification and as a source of stability for investors in or near retirement. As the markets return to normalcy, the appetite for VAs is poised for a comeback which will perhaps outshine the growth of the past decade.
The reason for this optimistic outlook: Many investors continue to face volatile financial markets, dwindling pensions and a money-strapped Social Security system that may be incapable of providing the income they need for a secure and, very likely, extended retirement. Given the challenges in retirement funding within today’s risk-averse investment climate, the VA, coupled with an appropriately diversified portfolio, can serve as an important retirement-income solution.
Insurers learn new lessons
But the most recent past hasn’t been kind to VAs and the insurance firms that provide them. The collapse in capital markets resulting from global deleveraging was a perfect storm for insurers. With management fees, insurance guarantee costs and profits highly dependent on market values, the broad drop in equities and decline in interest rates were damaging.
With nearly every asset class in decline, the insurers’ hedging models, which are built to mitigate the adverse impact of market movements on the value of the guarantees offered by insurers to policyholders, were quickly rendered ineffective. By the time the models were adjusted, hedging instruments—which among other tasks helped decrease asset correlations—were frequently too expensive to be of benefit. In addition, the crisis also exposed weaknesses in hedging strategies insurers employed to offset the cost of policy guarantees that in some cases were unable to keep pace with the rising values of these guarantees.
Furthermore, the pricing formulas for VAs’ long-dated guarantees assumptions on projections of future volatility became quickly outdated during the recent market dislocation. Consequently, due to the high and constantly rising costs, as well as the complexity of the liabilities, many insurers were not hedging to offset the value of the guarantees, so significant increases in their liability values were reflected in their balance sheets, putting pressure on GAAP earnings.
Statutory capital and reserve requirements for insurers also played a role. In 2005, a statutory regulation called C-3 Phase II, which mandates that VA insurers maintain enough capital to accommodate the worst-case scenarios derived from Monte Carlo simulations, modified the process insurers use for quantifying the risk embedded in VA guarantees, such as equity, interest rate, basis, pricing, policyholder and longevity risks. As 2008 drew to a close and companies completed their calculations of capital and reserve requirements, they found the strength of their capital position substantially eroded.
The fact that customers were not rushing to exercise their guarantees had no bearing on these requirements. The exponential relationship of market movements and capital and reserve requirements made matters worse, as even small market declines resulted in outsized capital increases.
In summary, two things became clear: (1) fee income that is account value-based (rather than the greater of account value and guaranteed value) will be much lower in the foreseeable future while insurers’ hedging costs will be much higher; and (2) prices on new policies would need to far better reflect the current value of their guarantees.
Looking to the future
While these challenges remain real, the market turmoil of 2008 also demonstrated that VAs continue to play a vital role in investors’ portfolios. Insurers are quickly absorbing the lessons of 2008 and are seeing opportunities to better position themselves. To optimize VAs as a viable investment instrument, we expect they will reassess key variables in their product design, such as the effectiveness of their hedging programs and the simplicity of product design and fee structure to name a few.
Some insurers have already begun to retool their hedging programs to better manage unfavorable market movements and correlated changes in equities and interest rates. They’ve also focused on reducing the complexity of their current policy design, especially in terms of policy guarantees, which have evolved from simple solutions to promises that include optional features and riders. Moreover, insurers are now more attentive to the fact that increases in underlying fund choices available to policyholders, coupled with minimal limitations, add to the insurer’s inherent market risk and complicate hedging efforts.
In the end, VA providers with the best risk management capabilities should emerge from the current crisis in a stronger position, offering solid products that continue to play a critical role in meeting retirement needs. Indeed, there are compelling reasons to believe that a surge in demand is just over the horizon. Insurers who persist in refining their products and hedging programs should be in the best position to exploit that increased demand.
Investors (especially baby boomers) will continue to seek ways to allocate a portion of their portfolio to the kind of guaranteed, lifelong income their parents enjoyed via their company pensions. And as these investors intensify the search for defined benefit-like retirement alternatives, VAs may increasingly be seen as a vehicle of choice, given their role in portfolio diversification and providing a source of stable income.