Variable annuity sales recover in Japan as insurers revise hedging strategies

Low interest rates and high-profile hedging losses saw Japan insurers and consumers fall out of love with variable annuities but, as sales rebound, the industry says it's on top of the risks posed by these structures

A sharp fall in equity markets in 2008, which saw losses for some Japanese insurers as a result of inadequate hedging of variable annuity risk, has led to a significant de-risking of these products today. More prudent risk management, combined with a rise in global and Japanese equity markets, has seen increased interest in variable annuity products, with sales on the rise once again.

The Japanese variable annuity market kicked off in mid-1999 following financial deregulation within the insurance industry. The launch of an ING guaranteed minimum death benefit (GMDB) product was followed by a Mitsui Life variable annuity that provided a guaranteed minimum accumulation benefit (GMAB) (see box below, 'What are variable annuities?').

Further relaxations allowing banks to sell variable annuities via bancassurance channels led to a rapid growth in sales. Banks became the predominant distribution channel for variable annuities with sales led by foreign insurers such as Hartford, ING, Manulife and local companies such as Mitsui Sumitomo and Sumitomo Life.

Between 2003 and the end of March 2008, the aggregate fund value of the variable annuity business reached ¥15.8 trillion ($154 billion) – approximately 14 times the level in 2003 – as the product benefited from rallying equity market conditions in the country, according to figures from consultancy firm Towers Watson.

However, following the financial crisis in 2008, many foreign insurers, including Hartford and ING, chose to exit the market completely due to losses suffered from variable annuities. Both Hartford and ING stopped selling variable annuity products in Japan in 2009.

With a fall in equity markets following the crisis, corresponding variable annuity portfolios fell significantly. Inadequate hedging programmes, over-aggressive minimum guarantees, and exotic underlyings that proved difficult to hedge have all been cited as reasons for the losses experienced by insurance companies.

The planned divestment of ING's Asian operations has also proved difficult, as the lack of buyers highlights how legacy exposures from variable annuities sold in Japan before the financial crisis continue to plague international insurers.

In 2013, ING took a €190 million ($262 million) charge on a hedge aimed at protecting capital for its Japanese variable annuity business. The business still has around 360,000 policies outstanding, with a total account value of €16 billion.

Hartford also reported a first-quarter loss in 2013, as the company realised an after-tax charge of $541 million related to an expansion of its annuities hedging programme in Japan.

Following the slump in variable annuity sales, banks turned to fixed interest rate annuity and whole-life insurance products. But despite the challenging market environment over recent years, sales in variable annuity products have picked up in the past 12 months, coinciding with the rise in the Nikkei. Market participants estimate that total sales for variable annuity products in 2013 were ¥1 trillion – an increase of more than 50% on sales in 2012.

Historically, when equity markets rise and there is a bullish market sentiment, investors tend to invest more in variable annuities, says Marc Saffon, head of financial engineering, cross-asset solutions for Asia-Pacific at Societe Generale in Hong Kong.

"Investment in fixed annuities was a trend we saw in 2011 and 2012. However, this has reversed in 2013 with the onset of Abenomics and a rise in equity markets. Investor sentiment has completely changed from fixed annuity or term deposit-like products back to variable annuities," he says.

A significant de-risking by insurers, through hedging of product exposure via reinsurance and product redesign, has also played a part in the shift back to variable annuities.

Hans van Alten, regional vice-president and actuary at Aegon Asia in Tokyo, says: "In hindsight, there were mistakes made and business was priced too aggressively. If you look at some of the variable annuity products before the crisis, there were guarantees on quite a few complex funds, instead of simple index funds linked to the Topix, S&P 500 or Eurostoxx 50, which are easier to hedge. Post-crisis, these complex funds or funds with too aggressive an allocation to equity have been reduced."

Van Alten points out that most products had fixed allocation in equities and bonds, so when markets moved the provider could not change the allocation. "That was risky and expensive," he says. "Currently, most variable annuity funds in Japan have the volatility-controlled mechanism with regular rebalancing based on the observed market volatility. Some insurers also had guarantees that were not hedged, or only partly hedged, and only later on added some hedges, but that was a little late in the game."

While it is difficult to ascertain the hedging strategies of all insurers, market participants say the majority of insurers are now fully hedged on their variable annuity risk, most commonly through reinsurance, provided by an overseas reinsurer or via an investment bank reinsurance vehicle.

According to Japanese regulations, if insurers are able to demonstrate that variable annuity risk is appropriately hedged, for example through reinsurance, they are able to gain a ‘reserve credit', which does not require them to set aside additional capital for these exposures.

"Foreign players usually have a dedicated offshore reinsurer within the group and 100% of the guarantees are reinsured. Local players often work with third-party reinsurers or investment banks. Most of the investment banks also have an offshore reinsurance company to cover the life and policyholder behaviour risk," says van Alten.

For investment banks, the provision of reinsurance services via separately capitalised reinsurance vehicles within the banking group is another lucrative service – particularly to local insurers – on top of variable annuity product design. With limited reinsurance capacity in the domestic market, insurance companies have started to look more actively at outsourcing some or all of the market risk accrued under their variable annuity programmes to investment banks.

The hedging of variable annuity risk via investment bank reinsurance vehicles has two main benefits, dealers say. Japanese insurers are able to obtain regulatory capital relief under Japanese solvency rules as the hedge is via a reinsurance contract. A hedge with the investment bank does not yield as much capital relief as a reinsurance contract with an offshore reinsurer.

Secondly, the reinsurance vehicle is able to take on actuarial risk, such as death or lapse risk, which is not able to be done under a swap with an investment bank. For dealers, the key is to ensure their reinsurance vehicle is sufficiently capitalised in order for the Japanese insurer to get capital relief under the reinsurance contract.

"It is common for foreign insurers to use a group reinsurance company, so they can avoid the capital burden on their Japanese balance sheet. For other insurers, they can transfer the risk to a third party, such as ourselves. We are not like the traditional reinsurer, who uses capital to cover the risk, instead we use structured derivatives to provide the hedge. Typically, the strategy only involves listed futures and we do delta-hedging daily and, where necessary, we hedge the gamma and vega," says Kazuya Hata, ALM adviser in Nomura's insurance solutions group in Tokyo.

The introduction of a volatility control target mechanism, where funds are automatically rebalanced by moving either from equities to bonds or cash, has also meant that rather than the traditional CPPI (constant proportion portfolio insurance) products that suffer from 'cash-lock' in a sharp equity downturn, investors in these products are still able to participate in a subsequent market rally. Around 95% of new variable annuity sales now use this mechanism, as opposed to the traditional CPPI mechanism for protection of principal at maturity.

"The volatility control is the most popular form of variable annuity as Japanese yen CPPI products have a bad reputation because of the cash-lock. It is also not that easy to structure a Japanese yen CPPI product because of the current low interest rate environment," says Hiroyasu Koike, head of risk solutions and insurance solutions group at Nomura in Tokyo.

The 10-year swap rate in Japan is currently close to 80 basis points and has been at this level for the past two years.

"What this has meant is that insurers have had to come up with solutions to make this product work and the target volatility mechanism is a solution in a low interest rate environment," says Cyrille Troublaiewitch, Citi's head of multi-asset group, Asia in Hong Kong.

Another relatively new innovation as a result of the low interest rate environment is the emergence of foreign currency denominated variable annuity products. In June 2013, Crédit Agricole Life issued an AUD 10-year variable 105% annuity that has so far raised ¥37 billion while Daichi Frontier Life issued an AUD denominated 110% variable annuity in October 2013 which has raised ¥10 billion to date.

Majdi Jemel, Tokyo-based head of financial product development and sales for Japan at BNP Paribas, says that although most distributors would have only considered Japanese yen-denominated products in the past, the perception that yen weakening will continue due to Abenomics has meant that clients have been looking to diversify into foreign currency products.

"The trigger for distributors to consider foreign currency products has been the weakening of the yen and that interest rates in Australian dollar, euro and US dollar are still higher than Japanese interest rates, so that allows for a wide range of products to be structured," says Jemel.

The Crédit Agricole Life and Daichi Frontier Life products are structured in a way that is similar to a CPPI product. A zero-coupon bond plus leverage on the underlying equity exposure is sold in a general account and special account format. The general account represents the fixed cash amount that will provide for capital return at maturity, while the special account provides leveraged return through the use of derivatives and a volatility target mechanism.

"Because the products are structured in this way it carries very low capital usage for the insurance company. These products also have a market value adjustment feature that allows the company to mitigate interest rate risk through this product. The market adjustment feature allows the insurance company to reflect the mark-to-market on its investment to the client when they decide to lapse the product. If interest rates rise, the insurer does not have to redeem 100%, but 100% minus the cost of redemption, which means you are protected against lapse risk and interest rate risk. As a result, risk and capital usage are considerably reduced in this product," says Jemel.

Rising equity markets also mean some existing or legacy policies have now come back at close to par. Policies that were issued more than five years ago, which were too expensive to hedge due to the fall in equity markets, are now less prohibitive to hedge than before.

"Even if insurers wanted to hedge, it would have been impossible to hedge those policies without losing money because it would have been too expensive due to the high cost of reinsurance. Now we reach a level where insurance companies are able to ask themselves what they want to do with the outstanding policies. They have the choice between hedging the risk at a price they can afford, or keeping the risk on their book," says Citi's Troublaiewitch.

The first generation of variable annuity products mature in the coming years – expected redemptions from variable annuity products are set to exceed $1.5 billion in the first half of 2014, according to figures from Nomura. The challenge is then for insurers and banks to roll over this flow into new products.

"How insurance companies hold this money and roll it over into new products is key. The average age of previous investors who have bought variable annuities was 60 and now they are 70 years old. What insurance companies need to understand is what form of insurance they now want. We need to find new solutions and this may be in the form of a shorter term variable annuity or a regular annuity payment product. This is the conversation we are now having with insurers," says Saffon at Societe Generale.

The next step in innovation, according to BNP Paribas' Jemel, is for the Japanese market to evolve into regular premium products, similar to what is currently seen in the Korean variable annuity market.

"Once interest rates in Japan increase I think we will start to see regular premium products where young investors are looking to build a retirement tool," he says.

Troublaiewitch says future products should combine features of both a fixed and variable annuity, where the accumulation period and the withdrawal period should be combined into one product.

"Rather than selling a 10-year product followed by another 10-year product, issuers should look at selling a 20-year product made up of a 10-year accumulation period where you grow your investment, and 10-year withdrawal period where income is paid out to the policyholder. If you combine these two periods into one product, it makes the design much easier and the value proposition for the client much higher. This would also help address the problem of low interest rates," he says.

"If the product is properly designed with de-risking mechanisms – since we can go relatively long dated in yen interest rate hedges – insurers will be able to find appropriate hedges or reinsurance for this risk," he adds.

What are variable annuities? Within the Japanese context, a variable annuity is an insurance contract which, at maturity, guarantees a minimum payment (usually 100% or higher) in addition to any appreciation in a managed portfolio of funds. In Japan, products are generally single premium products, which means the investor invests a lump sum at the beginning of the product and tenors of 10 and 15 years are the norm. Variable annuities can be broadly broken down into four categories. Guaranteed minimum death benefit (GMDB) pays the greater of the account value or the initial premium in the event of death. Guaranteed minimum accumulation benefit (GMAB) guarantees the return of principal at maturity in addition to any gains in the underlying investment performance. Guaranteed minimum income benefit (GMIB) guarantees a level of annual income on retirement, during a fixed period or until the policyholder's death. Guaranteed minimum withdrawal benefit (GMWB) guarantees the policyholder can monetise a fixed percentage of their initial investment annually.

 

Japan vs Korea There are two main differences in the risk profile of variable annuity products in Japan and Korea. First, the relatively low interest rate in Japan compared with Korea means that products are harder to structure and required to be held for longer tenors. Second, the single premium of the annuity product in Japan, compared with a regular product premium paid by the investor, means the risk from a Korean product is easier to hedge. Currently, the 10-year Japanese swap rate is 0.8% while in Korea the 10-year rate is 3.3% – the higher interest rate makes it easier to provide a guarantee on the product, dealers say. "When you look at the Korean variable annuity market, the majority is regular premium – meaning policyholders are going to invest on a regular basis. For example, if you buy a 10-year policy, you will invest your premium every month for the next five years. This dollar cost averaging, which most investors are familiar with, makes it much easier for insurers to manage the risk of their policies," says Cyrille Troublaiewitch, Citi's head of multi-asset group, Asia in Hong Kong.