LOMA Releases New Report: Managing Guarantee Risk on Variable Annuities: An Introduction

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ATLANTA, GA – Sept. 14, 2006 – The US has approximately $1.12 trillion in variable annuity (VA) assets out of total life insurance industry assets of $4.3 trillion. The vast majority of these VA assets carry additional option-like investment guarantees, which give customers the right to transfer part of the risk of poor investment performance to the insurer, contingent on certain behavior or death. These guarantees boost the consumer appeal of variable annuities. However, the techniques required to manage guarantee risks — stochastic modeling, financial engineering, and hedging — are highly complex. Few insurance decision-makers outside of actuarial and investment departments are familiar with them. Their contributions to VA decision-making are, therefore, less informed than they might be. LOMA’s new research report, Managing Guarantee Risk on Variable Annuities: an Introduction, provides a brief, high-level view of the three key technical processes that support VA guarantee management is designed to fill this gap.

Stochastic modeling provides a better way to measure equity market risk than traditional deterministic estimates, which do not measure such risk adequately. VA guarantees typically carry significant equity market risk.

Financial engineering, with its reliance on risk-neutral models, provides one way to calculate the market value of guarantee risk for purposes of hedging.

Hedging allows insurers to trade away aspects of guarantee risk that they do not wish to retain.

Use of these techniques has played an important role in the continuing consolidation of the variable annuity industry and in its shift to independent distribution channels. To manage VA guarantees successfully, variable annuity firms need significant intellectual capital in their actuarial and investment departments and significant systems resources. Both are expensive. Insurers that have mastered these techniques bring a facility to product development that other insurers cannot match. They can be highly responsive to requests by distributors to modify products to make them more attractive to potential customers. They can manage the risks associated with them effectively over time. Thus, over the past decade, the number of US VA providers has declined while the number of unique VA contracts has increased.

Mastery of the techniques described in this report is one of the hallmarks of today’s successful VA insurers. Everyone involved in the variable annuity industry can become more effective contributors to their organizations by learning certain basic aspects of these techniques.

For more about LOMA, visit www.loma.org.