A Strategic Analysis of the U.S. Life Insurance Industry Part II: Products
A Strategic Analysis of The U.S. Life Insurance Industry Part II: Products
By Narayan Shankar
A look at the evolution and growth of U.S. life insurance industry products.
This is the second article in a four–part series. In this series of articles, we analyze the U.S. life insurance industry's customers, products, distribution system, and regulatory and tax environment. We then proceed to discuss a generic business model for a life insurance company and the competitive environment in which companies operate. We conclude with a consideration of future trends and prospects.
Our analysis is purely strategic and avoids consideration of technical or actuarial issues. The goal is to provide a flavor of what the industry looks like, stripped of the intricate details of actuarial modeling and accounting issues. We look at the issues that business leaders without a technical background think about and see the issues as they appear to business strategists and decision–makers. These are the considerations that inform the decisions that set direction for insurance companies and shape the industry.
In the first article, we examined the industry's retail customers a/files/pubs/actuarnd the trends in their need for the industry's traditional products. We discussed the industry's response to these trends, i.e., the change in focus toward a narrower base of affluent customers with new products that satisfy specialized financial needs, as well as a broad shift from insurance toward savings products predicated on tax–advantages of annuities, again directed primarily toward affluent customers. We described the consequences of these trends and the responses to them. In this article, we consider the industry's products.Products
Overview: Table 1 shows the revenue history of the life industry by product line. Until the late 1980s, life insurance premiums were the largest source of revenue for the industry. However, with the expansion of the industry into the savings market, annuity receipts began to grow rapidly around 1980, overtaking life insurance premiums around 1990. Medical insurance has declined as a product line of the life industry, with the emergence of HMOs and managed care companies as the dominant players. However, the industry has grown its non–medical product lines in the health business, including disability and long–term care insurance.
In the following discussion, we focus on product segments that are currently dominant. Hence, we do not discuss medical, disability or long–term care products. Graph 1 and Graph 2 on page 24 and 25 show the premium history in recent years for sub–categories of products within the life insurance and annuity product lines. We discuss below some of the trends in this data.
Life Insurance: Until the 1970s, the life insurance products sold by the industry were quite simple. They came in two basic flavors–level premium whole life insurance and term life insurance. In Part I of this series, we noted a gradual shift from permanent life to term life products, as well as the increasing importance of group life as a source of financial security for the broader population. Here we consider three trends affecting product design within the permanent life product line.
The first trend is the unbundling and flexibility of life insurance products. Universal life policies attribute an "account value" to each policyholder. Premium is deposited directly into the account. Periodically, mortality and expense charges are explicitly deducted from the account value and interest is credited on the account balance. The account may be subject to certain front–end loads or surrender charges upon cancellation of the policy. Various guarantees may be provided with respect to mortality and expense charges and interest crediting rates.
The second trend is the proliferation of underwriting categories. Historically, most life insurance was issued on a "standard" basis, with a small percentage of substandard issues. Medical research over the last few decades has established the increased mortality risk of tobacco use, high cholesterol, diabetes and a number of other markers. Hence, the standard class has been split into a number of subclasses, with varying levels of premium, based on medical/lifestyle underwriting of the applicant. Premium rates can be very low for the most preferred class.
The third trend has been the introduction of variable products. With these products, the policyholder chooses the portfolio of securities in which policyholder funds are invested, and bears the risk on those investments. The insurer may provide certain guarantees (death benefit or investment return) that "wrap" around the variable product.
More recently, a hybrid of variable and universal life has been introduced, called Variable Universal Life (VUL). This product comes with optional guarantees–including a no–lapse guarantee, that keeps the policy in force as long as a minimum premium is paid in each policy period (or some equivalent condition is met), regardless of the investment performance of the portfolio in which the account is invested. Under some uses of secondary guarantee products, it is possible for a policyholder to simulate the characteristics of a very long duration term contract (such as "Term to 100").
These three trends are driven by a combination of medical and information technology that has impacted many sectors of the economy, as well as customer preferences for transparency, low–cost "pure" insurance and higher investment returns.
Annuities: Earlier in history, the life industry sold income annuities, often as a supplementary contract associated with the settlement of a death claim. Group and individual deferred annuities were sold as funding vehicles for pension purposes. However, annuities re–mained a lesser part of the industry's business until around 1980, when insurance companies began promoting individual deferred annuities as a tax–advantaged savings vehicle, complementary to IRAs and other retirement plans. These deferred annuities are seldom held to maturity or annuitized at retirement. Also around 1980, with the growth of 401(k) and defined contribution pension plans, insurance companies entered the guaranteed interest contract (GIC) business. Annuities may be fixed or variable, immediate or deferred.
Variable annuities permit the policyholder to invest money in one or more separate accounts and bear the resulting investment risk. A variety of funds are offered, resembling mutual fund styles and asset allocation strategies. Usually, a "fixed" sub–account is offered, which permits the annuity holder to invest funds at a fixed interest rate that may be guaranteed for a period of time. Transfer of funds between sub–accounts is permitted, though market–timing is discouraged. Asset management fees are deducted periodically from the annuity account.
Variable deferred annuities offer certain guarantees for an additional fee. The Guaranteed Minimum Death Benefit (GMDB) feature pays a minimum death benefit to the beneficiary upon the death of the policyholder if the account balance in the variable annuity is lower. Guaranteed Minimum Income Benefit (GMIB) allows annuitization after a certain age based on an account value that can be higher than the actual account balance of the annuity. Recently, the Guaranteed Minimum Withdrawal Benefit (GMWB) and the Guaranteed Minimum Accumulation Benefit (GMAB) have gained in popularity. All these guarantee features offer protection against weak investment results on the variable annuity.
Fixed annuities invest all the funds in the general account of the insurer. At the time of sale, the customer's interest rate is guaranteed for a certain period of time. Thereafter, the company may change the credited rate, but there is usually a residual guarantee, i.e., the credited rate can never be lower than a certain minimum specified in the contract. Equity Indexed Annuities (EIAs) are fixed annuities where the credited rate is tied to the performance of an equity index like the S&P 500, but with a minimum credited rate guarantee.
Income annuity sales remain small. Most annuities sold are of the deferred variety. Single premium deferred annuities (SPDAs) are the most popular product. Depending on market return conditions, fixed annuities may be more popular than variable annuities or vice versa at a given point in time. Within VAs, the fixed sub–account is more popular when equity returns are weak. But the sum of fixed and variable annuity deposits have been growing at an impressive rate (see Graph 1).
The Role of Guarantees: There are many flavors of variable annuity guarantees. If it were not for the guarantees, there would be no practical difference between variable annuities and mutual funds, except for the difference in tax treatment. Hence, guarantees are a key area of product innovation, with always a "hot" new design of the moment causing excitement in the marketplace. But overall, they operate on the same theme, i.e., they provide a mechanism to offer some type of mortality– or persistency–contingent invest– ment return guarantee.
Similarly, there is continuous innovation in guarantees on UL, VUL and other types of insurance contracts. For life insurance products, there are guarantees with respect to mortality charges as well as investment returns. However, as a practical matter, mortality guarantees seldom "kick in"–very rarely do insurers increase mortality charges beyond "current" levels. Hence, investment guarantees are usually more important to the policyholder and a key area of competition among insurance companies. Investment guarantees also play a central role in differentiating products provided by the insurance industry from products of other financial services firms such as banks and investment companies.
Often, guarantee designs are driven by regulatory forces, with companies finding the design that customers find attractive, which also results in the lowest regulatory cost in terms of capital and reserve requirements.
Loads: Insurance and annuity contracts usually come with front– or back–end loads. A front–end load might be a sales charge levied at time of sale. A back–end load might be a surrender charge for cancellation within a certain number of years from the date of sale. There are many designs–this is another area of continuous innovation. If properly designed, these charges inhibit disintermediation and allow the company to achieve the target lapse rates built into the pricing model without detracting from customer interest in buying the product. The specifics of the "load" design are a tactical issue and not a strategic issue.
Distribution costs are a major expense associated with life and annuity policies. These costs are usually recovered through profit margins over the life of the contract or partly through surrender charges if the contract is terminated early. Banks and investment companies also incur substantial distribution costs and recover them using a similar approach. Some type of surrender charge mechanism is common where investment guarantees are provided, such as with insurance company annuities or bank certificates of deposit, due to the elevated risk of disintermediation and the willingness of customers to accept them in return for the guarantee.
Product Risk: Like firms in any industry, insurance companies face business risks. By far the most important of these risks is the recovery of investment capital and the coverage of fixed costs. Will the company's products find sufficient acceptance among customers to achieve sales targets, justifying investment in administrative systems, product development and marketing? Will the revenue base from new and renewal business be sufficient to support overhead? In this context, it is crucial to note that financial services firms, including insurance companies, face investment risk arising from operating leverage, since this is a key source of expense coverage, capital recovery and profit for these companies. In a later article, we return to the topic of non–actuarial (business) risks when we examine a generic business model for life insurance companies.
In addition to business risks common to all firms, life insurance companies face unique financial risks arising from guarantees in insurance contracts. These risks arise from its products, rather than from its business model, operating capabilities or economic forces, which are the source of business risk for most other enterprises. Product risk is present, simply because insurance companies are in the business of accepting, pooling and managing risk.
Actuaries play a big role in analyzing product risks, while their role in analyzing the so–called "non–actuarial" risks (i.e., normal business or investment risks) is limited. Historically, non–actuarial risks have played a bigger role than actuarial risks in the success or failure of a company, in no small measure due to the skill and professionalism with which actuaries have identified, measured and managed product risks, making them less of a factor. For this reason, management of actuarial risks is often "taken for granted" by insurance company management, which tends to focus its value creation role on those activities that primarily involve non–actuarial business risks.
As described above, there have been major changes in life insurance company products in recent years. The new products pose new risks and many actuaries are unfamiliar with the tools and techniques needed to measure and manage them. If the actuarial profession is to maintain its impressive track record in managing product risk, actuaries need to become familiar with the new risks and master the techniques used to address them. We now briefly discuss the new and traditional risks, with a focus on highlighting the differences.
Guarantee risks normally fall into two categories–mortality or investment.
Mortality risks are generally diversifiable. Individual policies are more–or–less independent of each other with respect to mortality risk, so a large aggregation of such policies will have a highly predictable level of claims. The systematic element of mortality risk is primarily associated with epidemics and contagion or an increasing mortality trend, which are considered a very remote possibility. If one of these occurs, it is expected that the surplus maintained by insurance companies can cover the losses. Indeed, for the last several decades, a decreasing mortality trend has created favorable margins for insurance companies.
The risk from investment guarantees is not diversifiable. If one contract goes "in the money," so do most of the others, creating a catastrophic loss event for the insurer, similar to a hurricane or earthquake loss for a casualty company. The larger the portfolio of policies, the greater the catastrophe potential, since the exposure cumulates rather than gets diversified away. However, unlike the situation faced by casualty companies, tools are available for hedging security market exposure, allowing a company to substantially reduce this risk. Another mitigating factor is the observed sub–optimal exercise of options by policyholders. To encourage hedging, regulators have specified high capital requirements for those companies that fail to do so.
Variable products were originally conceived as a way to pass investment risk to the policyholder. However, insurance companies in the past have depended substantially upon investment spreads to recover capital investments and cover costs. Margins are very thin for variable products and very volatile, since revenues are tied to the market value of assets. Thus, business risk is greater for variable products. When guarantees are added on, it could be argued that variable products are more risky overall to the insurer than fixed products, especially since variable product guarantees usually involve equity market exposure.
Strategic decisions focus on pursuing market opportunities that align with a company's core strengths. The non–actuarial (business) risks mentioned previously are a critical input into this decision–making process, in order that the consequences of failure are duly considered and measures taken to avoid them. The growing prominence of enterprise risk management underscores the strategic importance of actuarial risks–an insurance company needs to have a well–designed program to identify, control and transfer (or otherwise manage) exposures it cannot safely retain.
Some product designs result in stronger guarantees and greater financial risk for the insurer. In the view of business leaders used to focusing on value creation and the management of business risks, if guarantees are accurately priced, based on finance and actuarial theory, the details of the guarantee design should not be a strategic matter other than finding the one the customer finds attractive. However, the theory and methodology of pricing these designs are still evolving, which increases the importance of pricing and risk management techniques.
Conclusion: The life insurance industry has moved from being mainly a provider of mortality protection to being a significant provider of complex savings products with investment guarantees. This changes the landscape of risk management, with systematic market–return risk replacing diversifiable mortality risk as the most important product risk faced by many insurance companies, especially due to the fact that much of the mortality risk in recent years has been passed on to reinsurers.
All the usual business risks are still present and some of them are aggravated by the new product designs, which lead to more volatile revenues and thinner margins. Investment spreads have been a major source of revenue and earnings for insurance companies in the past, due to their prominent role as a spread managing financial intermediary. This role of insurance companies has diminished with the rise of variable products. Insurers seem to be gradually cutting themselves out of the secure "spread" profits that have historically been earned from fund management. Over time, some insurance companies are transforming themselves into a distribution and administration management system for mutual funds, taking on substantial marketing risks in the process. Insurance companies have only recently begun tapping into their share of the variable annuity distribution pie, through revenue sharing arrangements.
Models and techniques to price the guarantee risk are still under development. So are the techniques to manage this risk, reflecting the complexity of variable product designs and policyholder behavior with respect to asset allocation, trading and withdrawal. This should be an active area of research for the actuarial profession, since it is a technical issue that can have a significant strategic implication for the industry.
Narayan Shankar is SOA staff actuary for life practice. He can be contacted at Nshankar@soa.org.
Quotes: "Some product designs result in stronger guarantees and greater financial risk for the insurer."