MARY HARDY is an Associate Professor and Associate Chair of Actuarial Science at the University of Waterloo, a Fellow of the Institute of Actuaries, and an Associate of the Society of Actuaries.

Investment Guarantees

Modeling and Risk Management for Equity-Linked Life InsuranceBy Mary Hardy

John Wiley & Sons

ISBN: 0-471-39290-1

Chapter One

Investment Guarantees

INTRODUCTION

The objective of life insurance is to provide financial security to policyholders and their families. Traditionally, this security has been provided by means of a lump sum payable contingent on the death or survival of the insured life. The sum insured would be fixed and guaranteed. The policyholder would pay one or more premiums during the term of the contract for the right to the sum insured. Traditional actuarial techniques have focused on the assessment and management of life-contingent risks: mortality and morbidity. The investment side of insurance generally has not been regarded as a source of major risk. This was (and still is) a reasonable assumption, where guaranteed benefits can be broadly matched or immunized with fixed-interest instruments.

But insurance markets around the world are changing. The public has become more aware of investment opportunities outside the insurance sector, particularly in mutual fund type investment media. Policyholders want to enjoy the benefits of equity investment in conjunction with mortality protection, and insurers around the world have developed equity-linked contracts to meet this challenge. Although some contract types (such as universal life in North America) pass most of the asset risk to the policyholder and involve little or no investment risk for the insurer, it was natural for insurers to incorporate payment guarantees in these new contracts-this is consistent with the traditional insurance philosophy.

In the United Kingdom, unit-linked insurance rose in popularity in the late 1960s through to the late 1970s, typically combining a guaranteed minimum payment on death or maturity with a mutual fund type investment. These contracts also spread to areas such as Australia and South Africa, where U.K. insurance companies were influential. In the United States, variable annuities and equity-indexed annuities offer different forms of equity-linking guarantees. In Canada, segregated fund contracts became popular in the late 1990s, often incorporating complex guaranteed values on death or maturity. Germany recently introduced equity-linked endowment insurance. Similar contracts are also popular in many other jurisdictions. In this book the term equity-linked insurance is used to refer to any contract that incorporates guarantees dependent on the performance of a stock market indicator. We also use the term separate account insurance to refer to the group of products that includes variable annuities, segregated funds, and unit-linked insurance. For each of these products, some or all of the premium is invested in an equity fund that resembles a mutual fund. That fund is the separate account and forms the major part of the benefit to the policyholder. Separate account products are the source of some of the most important risk management challenges in modern insurance, and most of the examples in this book come from this class of insurance. The nature of the risk to the insurer tends to be low frequency in that the stock performance must be extremely poor for the investment guarantee to bite, and high severity in that, if the guarantee does bite, the potential liability is very large.

The assessment and management of financial risk is a very different proposition to the management of insurance risk. The management of insurance risk relies heavily on diversification. With many thousands of policies in force on lives that are largely independent, it is clear from the central limit theorem that there will be very little uncertainty about the total claims. Traditional actuarial techniques for pricing and reserving utilize deterministic methodology because the uncertainties involved are relatively minor. Deterministic techniques use “best estimate” values for interest rates, claim amounts, and (usually) claim numbers. Some allowance for uncertainty and random variation may be made implicitly, through an adjustment to the best estimate values. For example, we may use an interest rate that is 100 or 200 basis points less than the true best estimate. Using this rate will place a higher value on the liabilities than will using the best estimate as we assume lower investment income.

Investment guarantees require a different approach. There is generally only limited diversification amongst each cohort of policies. When a market indicator becomes unfavorable, it affects many policies at the same time. For the simplest contracts, either all policies in the cohort will generate claims or none will. We can no longer apply the central limit theorem. This kind of risk is referred to as systematic, systemic, or nondiversifiable risk. These terms are interchangeable.

Contrast a couple of simple examples:

* An insurer sells 10,000 term insurance contracts to independent lives, each having a probability of claim of 0.05 over the term of the contract. The expected number of claims is 500, and the standard deviation is 22 claims. The probability that more than, say, 600 claims arise is less than [10.sup.-5]. If the insurer wants to be very cautious not to underprice or underreserve, assuming a mortality rate of 6 percent for each life instead of the best estimate mortality rate of 5 percent for each life will absorb virtually all mortality risk.

* The insurer also sells 10,000 pure endowment equity-linked insurance contracts. The benefit under the insurance is related to an underlying stock price index. If the index value at the end of the term is greater than the starting value, then no benefit is payable. If the stock price index value at the end of the contract term is less than its starting value, then the insurer must pay a benefit. The probability that the stock price index has a value at the end of the term less than its starting value is 5 percent.

The expected number of claims under the equity-linked insurance is the same as that under the term insurance-that is 500 claims. However, the nature of the risk is that there is a 5 percent chance that all 10,000 contracts will generate claims, and a 95 percent chance that none of them will. It is not possible to capture this risk by adding a margin to the claim probability of 5 percent.

This simple equity-linked example illustrates that, for this kind of risk, the mean value for the number (or amount) of claims is not very useful. We can also see that no simple adjustment to the mean will capture the true risk. We cannot assume that a traditional deterministic valuation with some margin in the assumptions will be adequate. Instead we must utilize a more direct, stochastic approach to the assessment of the risk. This stochastic approach is the subject of this book.

The risks associated with many equity-linked benefits, such as variable-annuity death and maturity guarantees, are inherently associated with fairly extreme stock price movements-that is, we are interested in the tail of the stock price distribution. Traditional deterministic actuarial methodology does not deal with tail risk. We cannot rely on a few deterministic stock return scenarios generally accepted as “feasible.” Our subjective assessment of feasibility is not scientific enough to be satisfactory, and experience-from the early 1970s or from October 1987, for example-shows us that those returns we might earlier have regarded as infeasible do, in fact, happen. A stochastic methodology is essential in understanding these contracts and in designing strategies for dealing with them.

In this chapter, we introduce the various types of investment guarantees commonly used in equity-linked insurance and describe some of the contracts that offer investment guarantees as part of the benefit package. We also introduce the two common methods for managing investment guarantees: the actuarial approach and the dynamic-hedging approach. The actuarial approach is commonly used for risk management of investment guarantees by insurance companies in North America and in the United Kingdom. The dynamic-hedging approach is used by financial engineers in banks, in hedge funds, and (occasionally) in insurance companies. In later chapters we will develop both of these methods in relation to some of the major contract types described in the following sections.

MAJOR BENEFIT TYPES

Equity Participation

All equity-linked contracts offer some element of participation in an underlying index or fund or combination of funds, in conjunction with one or more guarantees. Without a guarantee, equity participation involves no risk to the insurer, which merely acts as a steward of the policyholders’ funds. It is the combination of equity participation and fixed-sum underpinning that provides the risk for the insurer. These fixed-sum risks generally fall into one of the following major categories.

Guaranteed Minimum Maturity Benefit (GMMB) The guaranteed minimum maturity benefit (GMMB) guarantees the policyholder a specific monetary amount at the maturity of the contract. This guarantee provides downside protection for the policyholder’s funds, with the upside being participation in the underlying stock index. A simple GMMB might be a guaranteed return of premium if the stock index falls over the term of the insurance (with an upside return of some proportion of the increase in the index if the index rises over the contract term). The guarantee may be fixed or subject to regular or equity-dependent increases.

Guaranteed Minimum Death Benefit (GMDB) The guaranteed minimum death benefit (GMDB) guarantees the policyholder a specific monetary sum upon death during the term of the contract. Again, the death benefit may simply be the original premium, or may increase at a fixed rate of interest. More complicated or generous death benefit formulae are popular ways of tweaking a policy benefit at relatively low cost.

Guaranteed Minimum Accumulation Benefit (GMAB) With the guaranteed minimum accumulation benefit (GMAB), the policyholder has the option to renew the contract at the end of the original term, at a new guarantee level appropriate to the maturity value of the maturing contract. It is a form of guaranteed lapse and reentry option.

Guaranteed Minimum Surrender Benefit (GMSB) The guaranteed minimum surrender benefit (GMSB) is a variation of the guaranteed minimum maturity benefit. Beyond some fixed date the cash value of the contract, payable on surrender, is guaranteed. A common guaranteed surrender benefit in Canadian segregated fund contracts is a return of the premium.

Guaranteed Minimum Income Benefit (GMIB) The guaranteed minimum income benefit (GMIB) ensures that the lump sum accumulated under a separate account contract may be converted to an annuity at a guaranteed rate. When the GMIB is connected with an equity-linked separate account, it has derivative features of both equities and bonds. In the United Kingdom, the guaranteed-annuity option is a form of GMIB. A GMIB is also commonly associated with variable-annuity contracts in the United States.

CONTRACT TYPES

Introduction

In this section some generic contract types are described. For each of these types, individual insurers’ product designs may differ in detail from the basic contract described below. The descriptions given here, however, give the main benefit details.

The first three are all separate account products, and have very similar risk management and modeling issues. These products form the basis of the analysis of Chapters 6 to 11. However, the techniques described in these chapters can be applied to other type of equity-linked insurance. The guaranteed annuity option is discussed in Chapter 12, and equity-indexed annuities are the topic of Chapter 13.

Segregated Fun Contracts-Canada

The segregated fund contract in Canada has proved an extremely popular alternative to mutual fund investment, with around $60 billion in assets in 1999, according to Risk magazine. Similar contracts are now issued by Canadian banks, although the regulatory requirements differ.

The basic segregated fund contract is a single premium policy, under which most of the premium is invested in one or more mutual funds on the policyholder’s behalf. Monthly administration fees are deducted from the fund. The contracts all offer a GMMB and a GMDB of at least 75 percent of the premium, and 100 percent of premium is common. Some contracts offer enhanced GMDB of more than the original premium. Many contracts offer a GMAB at 100 percent or 75 percent of the maturing value.

The rate-of-administration fee is commonly known as the management expense ration or MER. The MER differs by mutual fund type.

The name “segregated fund” refers to the fact that the premium, after deductions, is invested in a fund separate from the insurer’s funds. The management of the segregated funds is often independent of the insurer.

A policyholder may withdraw some or all of his or her segregated fund account at any time, though there may be a penalty on early withdrawals.

The insurer usually offers a range of funds, including fixed interest, balanced (a mixture of fixed interest and equity), broad-based equity, and perhaps a higher-risk or specialized equity fund. For policyholders who invest in several funds, the guarantee may apply to each fund separately (a fund-by-fund benefit) or may be based on the overall return (the family-of-funds approach).

Variable Annuities-United States

The U.S. variable-annuity (VA) contract is a separate account insurance, very similar to the Canadian segregated fund contract. The VA market is very large, with over $100 billion of annual sales each year in recent times.

Premiums net of any deductions are invested in subaccounts similar to the mutual funds offered under the segregated fund contracts. GMDBs are a standard contract feature; GMMBs were not standard a few years ago, but are beginning to become so. They are known as VAGLBs or variable-annuity guaranteed living benefits. Death benefit guarantees may be increased periodically.

Unit-Linked Insurance-United Kingdom

Unit-linked insurance resembles segregated funds, with the premium less deductions invested in a separate fund. In the 1960s and early 1970s, these contracts were typically sold with a GMMB of 100 percent of the premium. This benefit fell into disfavor, partly resulting from the equity crisis of 1973 to 1974, and most contracts currently issued offer only a GMDB.

Some unit-linked contracts associated with pensions policies carry a guaranteed annuity option, under which the fund at maturity may be converted to a life annuity at a guaranteed rate. This is a more complex option, of the GMIB variety. This option is discussed in Chapter 12.

Continues…
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