Annuity IQ

Much has been made out of a recent annuity article written by Professor Moshe Milevsky of York University in Research Magazine saying that variable annuities went from being over priced to under priced. Is this a ‘flip-flop’ from the professor? Not at all, as a matter of fact the professor never endorsed or dismissed Variable annuities, just the death benefit costs.

First some background. In the mid 1990’s Professor Milevsky performed his research on whether or not variable annuity death benefits were overpriced. At the time he did the study he examined the standard death benefit whish was simply return of principal to the heirs of the annuity. His conclusion was that they only cost the insurance carrier .05 to .10% to cover the death benefit exposure.

However, at that time he did not cover the expense of an annual step-up death benefit or a compounding death benefit. When he did include the newer death benefits it was concluded that the expense did go up to about .20% or so. That is all the study did examine though, it did not cover the tax deferral or any other benefit of the variable annuity. The study was designed to show if the death benefit, alone, was over priced and he was correct in his original conclusion, at that time.

That original study was widely accepted by the anti-annuity crowd and used to persuade people from buying variable annuities. As usual though, they manipulated the information to suit their needs. Even today, in an era of decreasing M&E charges, the Annuity critics still use the line; “The death benefit in a variable annuity is worthless and over priced.” Quoting the professor and his study while at the same time they complete ignore and discount the use of living benefits.

Since living benefits have exploded in popularity this prompted Professor Milevsky to do a new study to determine if living benefit costs were too expensive or not. The professors results were that annuity living benefits were under priced. While I do not have his exact work or study, but I have read several articles on his conclusions.

What I have read is he estimates the actual cost to guarantee these living benefits are between .70 and 1.60%. He assumed that the average charge of the living benefit was .35 to .50% (which is an accurate expense for living benefits), but I have no idea whether or not he assumed this fee level or increasing over the study time period. Upon those numbers the professor painted a pretty bleak picture of what could happen to the insurance industry. But is he right?

The answer in short is yes and no. He is correct on the short term pricing structure, but over the long term they are not under priced. The professor stated that the current pricing of living benefits are between .35% and .50%, but the amount needed to be charged to keep the viability of the living benefits and insurance companies solvent is between .70% and 1.60%.

Based on the current pricing assumption the good professor is right, but I say that with a caveat. The caveat is I need to know how and what was taken into consideration of this study. The reason I need to know how the study was conducted and what the parameters were used is important because these benefits do have cost increases over time usually if there are step-ups in the benefit. The step-up in cost cannot be ignored and is factored into the actuarial equation, but most people do not know these price increases exist.

In many cases these living benefits will increase in cost upon step-up to a level meeting or exceeding the professors low end estimates, of .70%, to keep the benefit and the insurance companies’ solvent. If these cost increases were taken into consideration then the study is valid, but if they were not then the whole article and the research report is not valid.

Some of the living benefits cost increases come very close to the top end estimate, 1.60%, that the professor said was needed to be charged to keep the viability of the benefit and the insurance company alive over the long term. As stated above the actuaries already knew this and factored in a price increase in most of these benefits to cover the insurance carrier.

An actuary is not going to invent a benefit and not have the insurance carrier make money off of it. Once the benefit is created it is very rare that the insurance company would bare all the risk associated with that living benefit, so they reinsure the benefit. Reinsuring the benefit will split the risk between the issuing company and other insurance carriers reducing the risk for everyone. Reinsurance is very common and most types of insurance policies are probably reinsured.

When the reinsurance carrier looks at the benefit it is given the third degree because their company will be at risk as well. Their actuaries will look at the viability of the benefit and how it works and give it a ‘yes’ or ‘no’ to issuing reinsurance. In other words it is highly doubtful that a rogue actuary can destroy an insurance carrier as it would be reviewed by other actuaries, either in house or at the reinsurance company.

Also, even though these benefits are variable and depend on the markets performance, the issuing insurance carrier has to reserve for the benefit. Reserving for the benefit means the insurance company has to set money aside to cover its obligations for that benefit. The amount needed to be reserved will vary depending on the state of issue and the type of living benefit.

On top of all that I just mentioned there are the financial rating companies, such as S&P, Fitch and AM Best, who get to have a look at the insurance carrier’s books. They will let us know if there is a potential problem or not.

Another important point to make is the fact that many insurance companies issue living benefits. If only a couple or a few were issuing these benefits I think there would be more questions to the viability of the benefits. I would have to conclude that it is possible to find one or two rogue actuaries, but an industry full of them? That is highly unlikely.

What this study means is two fold. It will first give the annuity industry something to taught, a study showing that they are the good guys and they are the good guys. Second, it will give the anti-Annuity crowd another bullet to try and shoot the industry with. The anti-annuity crowd will now say that the annuity carriers are now going to go out of business and that is another reason not to buy a variable annuity, which is incredulous.

I believe his previous study was outdated since 1994-95 when the death benefits changed drastically and the long term Put options were extremely cheap. A Put option is a contract that bets the market will decrease in value and is often used to ‘hedge’ stock positions. An insurance carrier will use long term Put options to hedge their exposure to living benefits. Market conditions can make these investments cheap or expensive depending if we are in a bear or bull market.

For example, in a bull market put options are extremely cheap as everyone expects the market to go up, not down. If no one thinks the market is going down in value then there will not be buyers of Put options and the price is cheap, it is supply and demand that drives the price of options. This was the conditions during the first study the professor ran.

While during a bear market put options are very expensive as everyone expects the market to go lower in value, not higher. If people think the market is going to go lower then more people would be interested in buying Put options. This increases the demand of Put options and higher prices for these investments. This is a similar situation when the new study was conducted.

The bottom line is this, the study may not be what you think it is and without the exact research given to us there is no way to tell what it really means. The professor is neither friend nor foe to the insurance industry. He has never said variable annuities are bad investments nor has he said they were good investments.

Professor Milevsky has merely stated the facts that he has come up with and only time will tell if he is right or wrong. Although I believe the results to be inconclusive until we know more about the study.