Variable annuities: waiting for the next generation

A few years ago European insurers were issuing increasing numbers of guaranteed products that resembled structured notes. What scope is there for this type of business today? By John Ferry

Before the financial crisis, a key trend for the European insurance industry was the emergence of insurance company-issued products which looked like they had been put together by a bank’s equity derivatives desk. The products, which often fell under the insurance industry’s variable annuity banner, offered guaranteed future payments along with some form of exposure to risky assets, typically an equity fund. They were attractive for insurers because they gave the industry a way to move beyond basic unit-linked investments towards products that gave investors far more control and flexibility over their policies.

French investment house Axa started the ball rolling in 2005 with TwinStar, a guaranteed minimum income benefits variable annuity aimed at German investors, offering them a relatively high guaranteed annuity rate upon retirement. Axa subsequently rolled out TwinStar in Italy, Spain, Portugal and Ireland. Other providers quickly followed. Dutch insurer Aegon, for example, launched a product in the UK called ‘5 For Life’, which offered investors the choice of a number of funds with different equity and fixed-income exposures at retirement, plus a guaranteed 5% annual payout from the age of 60 until death.

At the time, the trend towards such products looked set to intensify in Europe, but the flood of structured variable annuity products never materialised. “We have yet to see the next generation of variable annuity-type products because insurers have been busy managing their capital base and minimising the risk in their balance sheets,” says Michalis Ioannides, head of insurance solutions at BNP Paribas in London.

Insurers can also find it difficult to hedge variable annuity-type products – dealers say that as volatility across markets shot up on the back of the credit crisis, some insurers struggled to maintain hedges on their products. “Variable annuities in some instances were not hedgeable at market prices,” says Daragh McDevitt, in charge of pensions and insurance structuring at Deutsche Bank in London.

Variable annuities are deferred annuities that are linked to funds during the deferment period. They first emerged in the US in the 1970s, but by the 1990s insurers were loading the products with guaranteed benefit elements, which come in one of four forms: a guaranteed minimum income benefit gives a guaranteed level of income payout when the policy is annuitised; a guaranteed minimum death benefit provides a set minimum benefit payable on death –which could be the return of premium, the return of premium rolled up at a fixed return, a ratchet that locks in the highest fund value over the history of the policy, or a combination of all these; a guaranteed minimum accumulation benefit provides a minimum survival benefit at a specified point in the future, and hence a hedge against stock market declines; and a guaranteed minimum withdrawal benefit guarantees an amount that can be withdrawn from the policy for a specified period of time, with limits set on the withdrawals.

Hedging the underlying risks inherent to variable annuities is a formidable task. Issuers are principally open to interest rate risk, equity risk and longevity risk. A mainly static hedging programme would involve buying and holding derivatives and other assets to get as close a match as possible to the issuer’s liabilities. According to consultants Towers Watson1, issuers in the UK have tended to look for such longer-term, more static hedges in order to de-risk their portfolios, probably because UK hedging activity has focused on mature books of with-profits business. In the US, more dynamic hedging strategies tend to be put in place, largely because the variable annuity business there is much larger and more new business is coming in.

Liquidity and gap risk – the risk that markets move too quickly to execute necessary trades – became far more pertinent for dynamic hedgers of variable annuities throughout the financial crisis. At the same time, extreme volatility can also undermine assumptions made about the underlying investor base, which is an important element of risk management with the products.

Variable annuities generally offer investors plenty of flexibility, such as the ability to switch assets from an equity to a bond fund, and, in the case of a guaranteed minimum withdrawal benefits, a choice of when to begin withdrawals. Insurers tend to rely on historical data relating to switches and withdrawals to predict policyholder behaviour, but when an extreme event such as the banking crisis emerges those predictions can easily prove erroneous. A far higher number of guaranteed minimum withdrawal benefit  holders than predicted by the models might decide to start withdrawing money for liquidity purposes, for example.

Partnership potential

Of course, investment banks have been able to help with the risk management side of things. Providing liability-driven investment (LDI) solutions for life and pensions companies has been a growing part of the banking business over the past decade. Structurers at the banks would come up with packages of derivatives and other assets – which their bank’s dealing desks could provide – to match the variable annuity issuer’s expected liabilities. That meant that while in some respects the insurers were in competition with banks’ retail structured product desks when it came to issuing products, the banks could at least still profit from their activities by providing complex, structured hedging solutions for them.

The question now is how this interplay is likely to develop in future. Will the retail structured products desks at banks be able to step in and fill the gap left by the stalled trend for variable annuities? Or are the banks hoping for another upsurge in variable annuity business that could provide them with opportunities to create lucrative hedging solutions? “I think we’re going to see more of a partnership between banks and insurance companies as variable annuity-type products start to make a comeback,” says McDevitt. “We can provide constant proportion portfolio insurance structures, for example, which let insurers dynamically hedge their underlyings.”

In the meantime, banks are assisting the insurance sector in other ways. Thomas Burkard, Frankfurt-based head of fixed-income sales for Germany and Austria at JP Morgan, says insurers in his region want to take advantage of the long end of the rates curve. “We’ve seen massive interest in buying constant maturity swap (CMS) floaters, which lets the insurer participate on the long end of the curve but also hedge themselves with a minimum coupon against their liability structure,” he says. So the products let the insurance company meet their minimum guarantee obligations in terms of paying their policy holders while also offering an additional pick-up because of the yield curve. The maturity on the CMS trades is usually long, at 15, 20 or 25 years, says Burkard.

However, it is becoming more difficult for banks to price value into CMS deals now that markets have stabilised. “The curves have steepened massively, so CMS participation in general is much lower. At the same time, in the past the floor was subsidized by the fairly high funding spread you could achieve from the issuers. With spreads tightening in the markets, that has reduced,” says Frank Haering, JP Morgan’s London-based head of German-speaking countries.

The answer is to make the derivative cheaper. “Structurally, they now need to be made cheaper by either capping the maximum payment or adding other features, such as an issuer’s right to increase the notional in the future or to redeem the bond before maturity,” says Haering. Burkard says insurance companies also bought a lot of high-grade corporate bonds last year.

“They benefited from the high coupons, particularly in the first half of 2009, and this brought positive market-to-market performance because of spread tightening on those portfolios. So the question for them at the end of 2009 was what should they do with these portfolios,” he says.

Insurers were reluctant to offload their investments and realise a profit because they would then be left wondering where to reinvest the cash – with historically low interest rates and equities considered too risky, they could have been stuck. The answer has been for the insurers to hold on to their fixed-income investments but for banks such as JP Morgan to hedge out the risk of widening spreads taking away their mark-to-market gains by using contracts written on the iTraxx credit default swap index.

It is scenarios such as this, rather than all-encompassing LDI solutions, in which the insurance industry is using investment bank expertise at the moment. But at some stage the European insurance industry will no doubt seek once again to issue insurance products which, with their future payment guarantees and synthetic hedging underpinnings, take a lot from the retail structured products arena. Solutions desks at investment banks will then be able to pick up where they left off, while investors will find more structured products emerging from the insurance sector and not just the banks.

The first wave of structured insurance products

One of the highest-profile variable annuity products to have hit the European markets is Axa’s TwinStar, which launched in 2005. Investors in TwinStar had the option to take a defined annuity payment or a lump-sum payment on the annuitization date at time of retirement. If the investor took the lump sum there was no capital guarantee, so he or she simply got the mark-to-market value of the underlying accumulated funds, which could be invested in either TwinStar Classic or TwinStar Invest. Classic paid a guaranteed annuity rate that was somewhere above market annuity rates and was linked to a managed fund (with a multi-manager mandate run by Axa). TwinStar Invest paid a slightly lower guaranteed rate and let the customer choose between 13 mutual funds – the money could be invested, for example, in the Templeton Growth Fund, an international equity fund. In this version, the customer could also switch between funds during the lifetime of the product.

Another insurer that jumped on the structured product bandwagon was Allianz, which in 2006 launched an index-linked insurance policy called Best Invest – also known as Index Policy. The German version of Best Invest was a 12-year product that paid 124% of the initial premium at maturity plus the average performance of the Dow Jones Eurostoxx 50, so it was structured as a zero-coupon bond plus equity options on the Eurostoxx 50. At maturity, the policyholder could choose to receive a lump-sum payment or a lifelong annuity, and could stipulate in advance that the policy term should be longer than 12 years, in which case the lump sum for the duration of the policy would be automatically invested in a mutual fund of their choosing. It then became a standard mutual fund exposure with no capital guarantee. Allianz bought the underlying structured notes from Goldman Sachs and Dresdner Kleinwort Wasserstein.

Aegon’s 5 For Life product offered investors an annual 5% payout guaranteed from age 60 onwards. However, policyholders could choose to receive less than this amount, leaving them more money with which to take exposure to the product’s underlying funds following retirement. The clients could choose from a list of four funds with differing exposures to equity market risk versus fixed income, and could also lock in mark-to-market gains at various stages.