SOA 2012 Life & Annuity Symposium May 21-22, 2012 Session 8, Investment Section Hot Breakfast: Target Volatility Funds in the Annuity Marketplace Moderator: Ram Kelkar, CFA Presenter: Colin Devine, CFA, CMA, CFP
Variable Annuities Can Managed Volatility Help Us Out of this Mess? Society of Actuaries Annuity Conference May 21, 2012 Colin Devine colin.w.devine@gmail.com Key Sections 1. Where eevariable abeannuities Fit Then & Now 2. What Went Wrong A rush to exit the door 3. Fixing the Problem Are pricing mistakes immortal 4. Managed Volatility Can it help save the day? 5. ProtectedFunds Do they reduce risk? 6. Three Key Take Away s 5/21/12 1
1. Where Variable Annuities Fit Retirement equation Rising longevity, the demise of traditional defined benefit pensions and an aging population are driving increasing demand for retirement income and protection oriented products. Traditionally a form of tax advantaged investing Up until 2002, primarily used as a way to supplement tax qualified savings such as 401(k)s and IRAs by pre retiree baby boomers. Living benefits changed the equation Retail VA sales have increasingly focused on guaranteed living benefits (GLBs) for: Downside capital protection Guaranteed lifetime income Ongoing liquidity 3 2. What Went Wrong Insurers quick to provide increasingly generous benefits and slow to recognize they assumed increased risks To drive sales gains, VA writers got caught up in the feature war that saw them add guaranteed step ups, lifetime income, earlier withdrawal ages and more frequent benefit re sets. But insurers ignored key customer demographic changes These included: Steady rise in use of qualified funds to purchase VAs; by definition these contracts were not sold for tax deferral. Purchase by older age clients at retirement or post retirement. Use of withdrawal benefits within first year of purchase 4 2
2. What Went Wrong cont d. VA risk profile changed Rising living benefit utilization rates means persistency of these liabilities has risen materially. We estimate duration may now be 20+ years; far greater than historic 5 6 yrs on savings oriented policies of the past. Where have all the VA writers gone More than half of the top ten VA writers in 2008 have either formally or significantly withdrawn from the market These include ING, Sun Life, Manulife/John Hancock, The Hartford and Pacific Life. Industry sales increasingly concentrated among just a few writers notably MetLife, Prudential & Jackson National. 5 IRA Purchases Have Steadily Risen % of VA Sales IRA's 70.0% 65.0% 60.0% 55.0% 50.0% 45.0% 40.0% 35.0% 30.0% 6 3
Mortality Good news/bad News 7 3. Fixing the VA Problem Insurers all seeking to de risk in force blocks No easy solution to mistakes itk made on overly generous living i benefits. Nor is reinsurance or sale of these liabilities likely realistic. Some de risking possible Can be achieved by a combination of: modifying underlying investment options; restricting ability to make additional drop in contributions; and encouraging income oriented policyholders to select an immediate annuity as a settlement t option. Reducing volatility key improvement opportunity Expect most investment options on new VAs will utilize funds with some form of volatility risk management. 5/21/12 4
MetLife s MAX II Game changer in VA evolution Distinctive feature is explicit transfer of some of the living benefit hedging from the life insurer s balance sheet to within the actual VA contract. Key attributes Basic premise behind risk management strategy was to limit downside risk to about 10%, and annual upside potential to around 12% 14%. Runaway hit In first full quarter MAX set an all time record for sales by a single product, which it then exceeded in 3Q11. Sales slowed in 4Q11 and 1Q12 but still led the industry. Others have launched volatility protected products Insurers include: Lincoln, AXA, SunAmerica, Ameriprise and Allianz 9 4. Managed Volatility Funds Asset Allocation Traditionally insurers attempted to help control VA risk through asset allocation models or by restricting fund investments. Essentially equity allocation percentage was used as a proxy for risk. Volatility management Targets a specific level of volatility within an investment portfolio and utilizes derivatives to dynamically adjust underlying asset mix to maintain this in response to changing gmarket conditions. Can be used with a single fund or fund of funds Volatility management can be utilized to protect individual funds or as an overlay for a fund of funds portfolio. 10 5
4. Managed Volatility Funds cont d. Can be combined with other tools to further reduce risk Managed volatility strategies on their own do not protect against overall downward market movements. They can be used with a capital protection strategy to limit downside account value risk or with an interest rate hedging strategy. Variety of hedging instruments available Most insurers are already very familiar with using futures, options, swaps and other types of derivatives to manage their VA risk. Key appeal of futures is they are publicly traded and cash settle daily. This limits both counter party risk and valuation subjectivity. Other applications Why not 401(k), mutual funds or 529s? 11 Sample Historical Analysis 250,000,000 Global Growth Model Portfolio 200,000,000 Fund Value 150,000,000 100,000,000 50,000,000 8/1/2001 8/1/2002 8/1/2003 8/1/2004 8/1/2005 8/1/2006 8/1/2007 8/1/2008 8/1/2009 8/1/2010 Date Unprotected Protected Protection Level In Milliman s back-testing analysis of a hypothetical global investment portfolio the Protection Strategy provided value to investors during the bear market from 2000-2002 and during the global financial crisis. There is no assurance that the investment process will consistently lead to successful investing. Source: Millliman 6
5. Benefits for Insurers Use of hedging directly within VA contracts Provides better risk/reward balance for BOTH insurer and policyholder as they result in more stable account values. Can substantially limit left tail event risk Assessing VA living benefit risk is both highly subjective and proven to be far more uncertain than insurers bargained for; particularly given the decline in long term interest rates. Protected strategies favorablyskew annual returns While the cost of hedging may lower a fund s long term return, it produces a markedly tighter distribution of outcomes thereby reducing the risk of unfavorable earnings events for the insurer from living benefit guarantees. 13 Annual Return Distribution Protected Growth Portfolio 1,000 stochastically generated real-world scenarios were created using the Milliman Real-World Scenario Generator TM Each scenario contains 30 years of daily returns for indices and interest rates Source: Milliman 7
5. Benefits for Insurers cont d. Important benefit of protected funds is ability to reduce sequence of returns risk Biggest economic challenge VAs face is adverse policyholder utilization. Insurers did not recognize that living benefits were purchased by a rising number of policyholders because they could be used as a long term source of retirement income without annuitization. Combined volatility and capital protection slows asset depletion rate Insurers face the rising risk of having to py pay out on VA lifetime withdrawal benefits for many years after account values have been exhausted. Milliman s studies shows that hedging directly inside the fund improves the internal rate of return (IRR) by nearly 80 bps. 15 Rates of Return Protected Growth Portfolio Over a 1 year time horizon, with no deposits or withdrawals, the Protection Strategy reduces average returns Over a 30 year time horizon with fixed withdrawals, the Protection Strategy produces a higher average internal rate of return for the investor The Protection Strategy addresses the sequence of returns problem Source: Milliman 8
6. Key Take Aways for VAs 1. Reduces living benefit guarantee risk Utilizing protected hedging strategies within investment funds results in more stable GAAP earnings and statutory capital. For VA holders it produces better potential for upward guarantee re sets. 2. Material earnings and capital improvements Can reduce on balance sheet hedging costs by 40 50 bps and produce total savings of roughly 90 bps. Also lowers rating agency and regulatory RBC charges. 3. Strategy is flexible Can be used within a fund of funds portfolio or specific funds. This allows it to be used to both de risk in force VA blocks as well as achieve a better risk vs. feature balance on new VA guarantee offerings. 6/3/2012 17 Appendix A Industry Statistics 18 9
Historic VA Sales Ranking Rank Company Total Flow ($MM) Rank % Share 2011 2010 2009 2008 2011 2010 2009 2008 2011 2010 1 MetLife $29,510.1 $18,862.1 $15,855.8 $14,629.0 1 2 2 1 18.5% 13.4% 2 Prudential Financial 20,236.2 21,663.5 16,109.9 10,198.3 2 1 1 6 13.2% 15.9% 3 Jackson National 17,494.1 14,654.3 10,002.2 6,465.5 3 3 4 12 11.4% 10.7% 4 TIAA-CREF 13,543.0 14,164.8164 14,080.4 4 14,511.2 4 4 3 2 88% 8.8% 10.4% 5 Lincoln Financial Group 9,355.9 8,973.3 7,991.1 11,129.3 5 5 5 5 6.1% 6.6% 6 SunAmerica/VALIC 7,987.9 6,192.4 4,735.6 8,152.4 6 8 9 8 5.2% 4.5% 7 Nationwide 7,658.7 5,524.9 4,225.4 4,610.3 7 9 11 13 4.8% 3.8% 8 AXA Equitable 7,014.4 6,511.1 7,477.4 13,548.4 8 6 6 3 4.5% 4.6% 9 Ameriprise Financial 6,399.9 6,208.5 5,517.8 7,417.2 9 7 7 11 4.2% 4.5% 10 AEGON/Transamerica 5,407.1 3,898.4 3,358.5 3,388.9 10 10 13 14 3.4% 2.8% 11 Allianz Life 3,791.7 3,164.8 2,476.3 3,102.4 11 12 16 15 2.5% 2.3% 12 Pacific Life 3,317.7 2,773.4 3,506.3 7,818.0 12 13 12 10 2.2% 2.0% 13 Sun Life Financial 3,014.1 3,283.3 3,212.2 1,999.9 13 11 14 19 2.0% 2.4% 14 Protective 2,408.0 1,742.5 805.6 463.0 14 18 24 28 1.6% 1.3% 15 Thrivent Financial 2,395.8 2,041.0 1,414.4 1,285.3 15 16 18 22 1.5% 1.4% 16 New York Life 2,343.3 1,949.0 1,262.4 1,678.0 16 17 20 21 1.5% 1.4% 17 ING Group 1,893.3 2,409.0 4,722.8 12,721.2 17 15 10 4 1.2% 1.8% 18 John Hancock 1,786.8 2,626.9 5,298.2 9,465.6 18 14 8 7 1.1% 1.9% 19 Fidelity Investments Life 1,768.4 1,681.4 1,348.9 2,372.5 19 19 19 16 1.2% 1.2% 20 Ohio National 1,576.0 1,509.9 2,381.5 1,754.9 20 20 17 20 1.0% 1.1% 21 Northwestern Mutual 1,396.2 1,158.7 863.7 972.3 21 22 23 23 0.9% 0.8% 22 Guardian 1,157.7 780.8 882.8 486.3 22 24 22 27 0.7% 0.6% 23 Hartford 910.8 1,451.0 2,668.8 7,947.0 23 21 15 9 0.6% 1.0% 24 Massachusetts Mutual 835.1 921.7 1,195.3 2,021.1 24 23 21 18 0.5% 0.7% 25 Mutual of America 591.4 597.6 504.1 374.6 25 27 28 30 0.3% 0.3% Top 25 Writers $153,793.6 $134,744.3 $121,897.4 $148,512.6 98.9% 97.4% Industry Total $155,496.9 $138,282.9 $125,576.9 $154,789.1 100.0% 100.0% 19 Top VA Issuers by AUM Rank Company Assets ($MM) - Include Fixed 2010-2011 Change 2008-2011 Change YE11 YE10 YE09 YE08 YE11 YE11 YE10 YE09 YE08 1 TIAA-CREF $372,006.8 $374,013.1 $347,994.7 $321,804.3-0.5% 15.6% 24.8% 1 1 1 1 2 MetLife 139,501.1 125,097.1 105,002.8 79,487.7 11.5% 75.5% 9.3% 2 2 2 2 3 Prudential Financial 108,952.8 101,490.7 79,744.4 58,939.0 7.4% 84.9% 7.2% 3 3 5 5 4 AXA Equitable 84,553.3 88,739.0 81,045.9 68,259.3-4.7% 23.9% 5.6% 4 4 4 4 5 Lincoln Financial Group 81,497.7 82,237.1 72,709.6 57,476.6-0.9% 41.8% 5.4% 5 6 6 7 6 SunAmerica/VALIC 70,548.6 71,196.2 66,066.9 58,738.7-0.9% 20.1% 4.7% 6 7 8 6 7 Hartford 68,708.1 82,987.6 84,630.9 74,592.1-17.2% -7.9% 4.6% 7 5 3 3 8 Jackson National 65,216.8 54,513.4 38,396.4 25,147.5 19.6% 159.3% 4.3% 8 11 12 14 9 ING Group 63,971.1 69,405.3 66,325.9 54,232.2-7.8% 18.0% 4.3% 9 8 7 8 10 Ameriprise Financial 61,542.9 61,998.0 54,465.0 42,735.1-0.7% 44.0% 4.1% 10 9 9 9 11 John Hancock 50,860.5 55,934.8 52,792.8 40,527.6-9.1% 25.5% 3.4% 11 10 10 10 12 Pacific Life 48,122.5 51,979.0 49,501.4 39,945.1-7.4% 20.5% 3.2% 12 12 11 11 13 Nationw ide 43,943.2 42,494.3 37,668.6 30,927.5 3.4% 42.1% 2.9% 13 13 13 12 14 AEGON/Transamerica 42,170.6 41,377.3 37,151.5 30,487.5 1.9% 38.3% 2.8% 14 14 14 13 15 Allianz Life 26,809.0 25,670.8 22,368.2 18,080.9 4.4% 48.3% 1.8% 15 15 15 15 16 Sun Life Financial 20,299.5 19,923.5 16,807.0 12,404.1 1.9% 63.7% 1.4% 16 16 16 18 17 Fidelity Investments Life 18,166.7 18,096.6 15,795.2 12,958.7 0.4% 40.2% 1.2% 17 17 18 17 18 New York Life 18,113.0 17,899.8 15,892.5 13,408.9 1.2% 35.1% 1.2% 18 18 17 16 19 Thrivent Financial 16,280.0 0 15,691.0 13,364.8364 10,669.4 3.8% 52.6% 1.1% 1% 19 19 19 19 20 Northw estern Mutual 11,828.7 11,519.3 10,085.0 8,221.4 2.7% 43.9% 0.8% 20 22 22 22 21 Massachusetts Mutual 11,381.8 11,736.5 10,554.6 8,297.5-3.0% 37.2% 0.8% 21 21 21 21 22 Ohio National 11,109.0 10,935.6 9,016.0 5,601.2 1.6% 98.3% 0.7% 22 23 23 23 23 Genw orth Financial 10,585.0 12,149.6 11,927.8 10,339.0-12.9% 2.4% 0.7% 23 20 20 20 24 Protective 6,686.6 4,870.5 3,175.6 2,181.8 37.3% 206.5% 0.4% 24 27 31 34 25 Guardian 6,573.8 6,211.4 5,323.7 4,062.1 5.8% 61.8% 0.4% 25 25 24 24 Top 25 Writers YE11 $1,459,429.1 $1,458,167.5 $1,307,807.2 $1,089,525.2 0.1% 34.0% 97.1% Industry Total $1,502,294.3 $1,504,390.4 $1,354,535.1 $1,129,349.5-0.1% 33.0% 100.0% % Share Rank 20 10