Over the last decade, sales of variable annuities (VAs) with investment guarantees, equity-indexed annuities (EIA), and structured notes increased dramatically. What these products have in common is that they offer investors upside participation when the equity markets rally, while limiting the downside when markets decline.

Effects of the financial crisis

During the financial crisis that began in 2008, demand for these products increased as more and more investors began to realize the benefits of investment guarantees. However, when interest rates held at record lows and volatility reached historic highs, product providers discovered that the increased cost of providing guarantees was unsustainable. Providers reacted by taking one or more of the following measures, resulting in reduced sales:

• increasing the fee for providing guarantees
• reducing the level of benefits
• reducing product flexibility
• discontinuing certain products altogether

The financial crisis also brought to the fore issues with these guarantee products that investors had tended to gloss over in the past, particularly the fact that guarantees are not liquid, that investors are exposed to the credit risk of the guarantee provider, and that there is a lack of transparency about exactly how the providers manage the risks.

• Illiquid guarantees. The length of the guarantee period is normally several years, and the guarantees offered generally provide a payment to the investor if the investor suffers a loss at the end of the guarantee period. However, investors suffering a loss prior to the end of the guarantee period do not receive any payoff. Investors who bought guarantees just prior to the financial crisis received no payoffs to offset investment losses they suffered as the markets declined. In other words, the guarantees were illiquid prior to the end of the guarantee period.
• Exposure to provider's credit risk. Because the guarantees provide a potential payoff many years into the future, investors are exposed to the risk that the company providing the guarantee may not be around to make good on any potential payments. During the financial crisis, this problem was highlighted when a number of insurance companies came very close to going under.
• Lack of transparency. Guarantee providers normally manage the risks associated with guarantees in a number of ways—predominantly through hedging or reinsurance. During the financial crisis, it became apparent that a number of insurers made the mistake of either hedging their assets only partially or having insufficient reinsurance coverage. Such miscalculations left them vulnerable to the extreme risks that arose during this volatile period.

Toward more sustainable guarantee products

One particular product design that is gaining attention is one in which the investor, and not the provider, owns the hedge assets. According to this product design, the investor would own not only the underlying mutual funds but also the hedge assets that have typically been held by either the life insurance company or the investment bank. The life insurance company could then supplement the product with either a life wrap, providing additional life cover, or a wrap that covers risks not covered by the hedges, such as fund-performance basis risk relative to the hedge assets.

The graph below shows the mechanics of such a product. The example assumes that the investor purchased on January 1, 2000, an annually ratcheting guaranteed minimum accumulation benefit (GMAB) with a term of 10 years.

The yellow line shows the performance of the investor's portfolio. If the investor decides to liquidate the investments prior to the end of the 10-year period, the investor would receive the value represented by the yellow line less any liquidation charges.

The orange line shows the value of the hedge assets used to hedge the GMAB liability. These assets would be held by the life insurance company on its balance sheet until the end of the 10-year period, when it would be paid to the investor.

The blue line shows the performance of the proposed product. Because the investor owns the hedges, the value of the blue line equals the sum of the value of the yellow line and the value of the orange line.

Advantages of investor-owned hedge assets

A guarantee product in which the investor owns the hedges addresses a number of concerns highlighted by the financial crisis:

• Liquidity is improved because investors can liquidate the hedges they own at any time (assuming exchange-traded liquid hedges are used).
• Credit risk is reduced because when exchange-traded hedges are used, the investor is exposed to the credit risk of the exchange, but this is minimized through initial and variation margin requirements. For over-the-counter (OTC) hedges, it would be possible to set up collateralization provisions to minimize credit risk.
• Transparency is improved because the investors are able to see on a regular basis what hedges they own and what risks are being hedged.

Conclusion

The recent financial crisis has put variable annuities to the test. The next wave of VA products to emerge will take lessons from this crisis. Giving the investor ownership of the hedge is one way to help improve transparency and mitigate risk.

For more information, see Ken Mungan and Deep Patel, "Sustainable manufacturing of variable annuities: Toward a new model."