Primarily used as a retirement plan and lifetime income for those in later life stages, annuities are a type of contract and investment wherein an insurance company issues a series of periodic annuity payments to an annuity holder over a specified amount of time.
This type of investment is popular for those planning retirement, but for insurance companies, it's important to know some of the most common risks associated with annuity products and how to properly manage them.
Here, we're walking through a few different types of annuities, how they differ from one another, common risks and how to reduce them.
Most types of annuities are paid out for a fixed term or the remainder of the annuitant's life; however, each has its own unique characteristics and therefore must be managed a bit differently by the insurance company.
These annuities begin to make periodic payments to the annuitant almost immediately after a lump sum is paid.
From a management perspective, immediate annuities involve estimating life expectancies and setting annuity payment amounts accordingly. Accuracy is critical during actuarial calculations to ensure that the insurance company can meet its obligations to the annuitant.
Unlike immediate annuities, deferred annuities have a waiting period before they start making payments. During this time, the money invested grows through interest or other investment gains.
For an insurance company, managing deferred annuities involves handling the investment component and making strategic investment decisions to generate returns. There's also the task of monitoring the market and adjusting investment strategies as needed to meet future payout obligations.
A variable annuity offers a payout that can vary based on the performance of underlying investments and is often tied to mutual funds.
Variable annuities are more complex for insurance companies to manage. With this type of annuity, insurers need to oversee a diverse portfolio of investments and adjust their investment strategies based on current market conditions.
Risk management is an important part of managing any type of annuity; however, it's especially so here to ensure that the company can meet its payout obligations even if the market doesn't perform as expected.
An indexed annuity is a type of annuity contract that earns interest based on the performance of a specific financial market index, such as the S&P 500. Unlike variable annuities, which directly invest in stocks and bonds, indexed annuities provide a minimum guaranteed interest rate, along with the potential for additional interest based on the performance of the chosen index.
Essentially, an indexed annuity offers both the safety of a deferred annuity and the potential for higher returns. While indexed annuities do offer upside potential, they also typically come with caps, participation rates and other limitations on the amount of interest that can be earned.
To effectively manage any type of annuity involves a mix of actuarial calculations, investment management and risk assessment. Let's have a closer look at common risks associated with annuities to better understand how to manage them.
Annuities can provide financial security and a steady stream of income for retirees, but to deliver on the promises of each product, insurance companies must assess and manage several risks:
Interest rates are in constant flux. And, since insurance companies invest in the premiums received from annuity holders, this poses a risk if rates suddenly change. If interest rates decline, credited rates for new sales need to be lowered to reflect the new reality. If interest rises dramatically, the market value of the underlying assets will usually fall. Asset/liability matching is critically important to mitigate the possibility that insurers have to pay out surrenders to policyholders when asset market values are "underwater," that is, asset market values are less than the book reserves.
With annuities, there's a risk of annuitants living longer than initially anticipated. When this happens, the annuity provider could end up paying more in annuity benefits than what was originally accounted for, leading to increased and somewhat unexpected financial obligations.
If a deferred annuity holder passes away early, an insurance company may not have had time to recover costs associated with the policy issuance. Early death claims can lead to lower profitability for an annuity product.
Most annuity products offer the ability for deferred annuitants to surrender before selecting a payout option. When this happens, it can disrupt an insurer's long-term investment strategy. This can be especially disruptive if a large number of policyholders choose to exit or surrender at once during adverse market conditions.
As with any insurance product, insurance companies are held to strict compliance regulations. Failure to comply with these standards can result in legal and financial consequences. Moreover, regulations can, and often do, change. It's up to insurance companies to stay aware of these rules and, if need be, make any necessary changes to remain compliant.
Properly managing annuities to reduce risk involves careful consideration — both of a client's financial goals and the risk tolerance of the insurance company itself. Thankfully, there are effective strategies that insurers and actuaries can use to manage risks associated with annuity investments — with the client's and the business's best interests in mind.
Strategies to manage risk related to annuity investments include:
Diversification helps spread risk across different investment types to minimize the impact of poor performance in any single asset class. This makes handling market risk and fluctuations more reasonable.
For example, if an insurance company has diversified its annuity investments, the impact of the market downturn is cushioned because not all its assets are tied to stocks. Bonds and other investments might not be as affected, helping to stabilize the overall performance of the annuity portfolio.
Actuaries can help insurers understand factors like market conditions, interest rates and the overall economic landscape. Ideally, the goal of diversification is to balance potential returns while minimizing potential risk.
Asset/liability matching and managing is a common risk management strategy for investing.
To do this effectively, insurance companies carefully match assets they hold in an investment portfolio with the liabilities created by the annuity contract. This ensures that the duration, cash flows and risk profiles of investments align with annuity obligations. Here are a few specific examples of how asset/liability matching can help manage risk:
The active management of investment portfolios is critical to mitigating risks associated with annuity investments. Here are some common strategies insurers may use:
Stress testing is a common practice in the insurance industry. For annuities, insurers should run simulations of various market conditions to assess how those conditions may impact any given annuity portfolio. Stress testing can be conducted to evaluate the impact of:
Annuities can be complex and difficult to understand — and managing them even more so. Lewis & Ellis have decades of experience advising insurers on how to best manage annuities, with specialties in services such as:
Contact us today to learn how we can help assess and manage risks related to annuities.
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