Variable Annuities with Guaranteed Living Benefits: A Capital Structure Impact for Life Insurers?

Abstract

Traditional variable annuities build retirement income for annuitants through investments in stocks and bonds. These annuities are variable because their performance depends upon the performance of uncertain financial markets. The risk of poor performance lies solely upon annuitants, rather than upon the life insurers that market the products. The last ten years have seen the dramatic growth of a new type of variable annuity that transfers some of the investment risk to the insurers by offering guarantees. Variable annuities with guarantees bundle a traditional variable annuity with one or more contractual guarantees of (1) increase in annuitant income, (2) increase in accumulation value, or (3) annuitant withdrawal rights – regardless of the actual performance of equity and fixed income markets. For life insurers, the risk of such guarantees is a relatively new dimension of their product risk. In this article we explore how U.S. life insurers’ involvement in variable annuities that offer guaranteed living benefits (VAGLB) impacts their capital structure. To assess the risk of VAGLB guarantees, we introduce a new guarantee risk metric that is proxied by the actuarial deficiency of insurer reserves for the guarantee obligations. We apply standard capital structure models to assess the impact of guarantee risk on capital in the context of other enterprise risks and controls for the years 2006 and 2007 (before the credit crisis of 2008/2009). For life insurers that underwrite VAGLB, we find that a regime of “excessive risk” prevails for VAGLB guarantee risk. That is, capital tends to decrease with increasing VAGLB guarantee risk, ceteris paribus. This unexpected finding may be explained by the elevated use of derivatives among VAGLB underwriters. Life insurers may view their derivative hedging activity as an adequate alternative to capital accumulation for managing the risks of VAGLB.