Variable annuities (VAs) have met with success in the US and Japan and are beginning to appear in Europe. Attention is now turning to major Asian destinations, including Hong Kong, Korea and Taiwan. This briefing focuses on Hong Kong, where there is an emergence of products exhibiting VA characteristics. Examples of such products offered by major insurance providers are Manulife’s Secure IncomePlus, HSBC’s RetireEnrich Protection Plus, Sun Life’s WARMTH Series and AXA’s Smart Protector II Life Insurance. The VA market in Hong Kong has great potential to take off. A recent report by Hong Kong’s Office of the Commissioner of Insurance has indicated that annuities account for less than 2 per cent of long-term insurance business written in the Hong Kong market.
The appeal of VAs for Asian insurers stems from the demographic changes occurring across the continent. As the population becomes older and wealthier, people are increasingly reliant on access to market returns to help them keep pace with inflation and to protect their lifestyles. Unlike traditional insurance profit-sharing products, VAs offer access to market returns while offering protection and flexibility (customers can make their own investment decisions).
What is a VA?
A VA is a contract between the annuitant (the buyer) and the insurer, in which the insurer agrees to make periodic payments to the annuitant in return for the annuitant making either a single or multiple purchase payments. The value of the periodic payments is variable and depends on the performance of the annuitant’s chosen investment option, eg mutual funds that invest in stocks, bonds, money market instruments or a combination of the three.
- death benefits;
- lump-sum benefits; and
- periodic payments for the rest of the annuitant’s life.
A typical VA contract has two phases: an ‘accumulation phase’ and a ‘payout phase’. During the accumulation phase, the annuitant’s premiums are allocated to investment portfolios and earnings accumulate. During the distribution phase, the investor can withdraw money, either as a lump sum or through various annuity payment options.
How do VAs work?
The following example illustrates how a simple VA works.
An investor purchases a VA with an initial purchase payment of $1,000. The investor then allocates 50 per cent of that purchase payment ($500) to a bond fund and 50 per cent ($500) to a stock fund. Over the following year, the stock fund has a 10 per cent return and the bond fund has a 5 per cent return. At the end of the year, the account has a value of $1,075 ($550 in the stock fund and $525 in the bond fund), minus fees and charges. This process continues throughout the accumulation period. At the beginning of the payout phase, the investor may choose to receive purchase payments plus any investment income and gains either as a lump sum payment or as a stream of separate payments.
What are the key characteristics of VAs?
The rate of return of a VA is inherently unstable and fluctuates with the investor’s investment choices. However, the rate of return of a VA is partially stabilised by its incorporation of a fixed or guaranteed interest component. This component combines with a variable investment aspect and, often, a basic death benefit. The following four examples help to illustrate the use of these three components.
Guaranteed minimum income (annuity) benefit (GMIB )
This benefit guarantees a specified income stream that may be redeemed over a specified period of time, usually life. It is paid on retirement, regardless of market conditions. For instance, if $100,000 is invested in a product that provides a 5 per cent return, the investment will grow to $140,708 seven years later. This is the guaranteed value from which the annuity is calculated. The investments may appreciate by more than the guaranteed 5 per cent and ‘step-up’ opportunities may be available periodically, whereby the guaranteed withdrawal amount can increase in line with the increase in the underlying investment funds. There is sometimes a cap on the overall benefit level, however. The GMIB is used for retirement income protection.
Guaranteed minimum withdrawal benefit (GMWB)
Under this arrangement, the annuitant is guaranteed to receive a specified total withdrawal benefit which may be redeemed over a specified period (subject to a maximum yearly withdrawal amount) or is subject to a specified maximum lifetime amount. The GMWB may be equal to the total principal investment at the start or at the end of the accumulation phase. Even if the annuitant’s account value drops to zero as the annuitant makes withdrawals during the payout phase, the annuitant will be able to continue making withdrawals for the duration of the specified period or until the total amount of withdrawals adds up to the specified maximum lifetime amount. Thus, the total minimum withdrawal amount remains consistently available throughout the policy’s life, independent of market performance. The GMWB is used for retirement income protection.
Guaranteed minimum accumulation benefit (GMAB)
This benefit protects the investor against market volatility. A portion of the original contribution is invested in a fixed interest investment that is guaranteed to grow the size of the original principal. The remainder is invested in variable investment portfolios. After a specified period, the account value is set to the greater of the current account balance or the GMAB (eg the original contribution plus fixed interest on the relevant portion). The GMAB is used for pre-retirement protection of the principal.
Guaranteed minimum death benefit (GMDB)
Upon death, this benefit pays to the beneficiary the greater of the account balance or the total premium value. The total premium value may be calculated based on the roll-up method (in which individual premiums accumulate at a guaranteed rate) or the ratchet method (in which the total premium value increases to the highest account value at contract anniversary dates), in each case adjusting for withdrawals. The GMDB can be paid out in different ways, such as the full policy value in a lump sum or regular guaranteed payments for up to a maximum of a specified number of policy years. The GMDB is used for estate protection.
Given the market-dependence of VAs and their reliance on client preferences, it is not surprising that they involve a large number of uncertainties. The uncertainties include the risk that policyholders may withdraw funds or change the asset mix. Insurers have therefore implemented stringent risk management measures to monitor and hedge the risks. The two main risk management methods adopted involve the use of hedging (eg through swaps) and reinsurance. The table on the next page summarises the advantages and disadvantages of each method.
Insurers increasingly seek to hedge the exposures under VAs through derivative contracts entered into with banks and through reinsurance arrangements. The derivatives used include total return swaps and other hedges. It is vital when considering these arrangements for insurers to involve all relevant personnel, including in particular their actuaries. This will help to ensure that all relevant risks are taken into account and that the resulting structure is robust and meets the insurer’s requirements for risk transfer.
VAs have the potential to become one of the major savings products in the Hong Kong market because they are better suited to the complex and changing needs of our aging population than the products that currently dominate the market. As can be seen from the experience in Japan, where the market is expected to be worth US$350bn by 2010 (up from almost zero in 2001), VAs have great potential for growth in Hong Kong. Capitalising on this opportunity, however, will present insurers with significant risk management and product design challenges. In recognition of the risk management issues, the market is experiencing a surge in interest in the use of hybrid protection involving derivatives and reinsurance techniques. To use such techniques effectively and to meet the risk management and product design challenges of VAs, increased management attention and investment in staff and systems will be necessary.