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Japanese Variable Annuity Market: Background, Update and Outlook

Japanese Variable Annuity Market: Background, Update and Outlook
by Liang (Jason) Zhang

The land of the rising sun has a new nickname–the land of rising opportunity.

It all started with the "Big Bang," or the financial deregulation in Japan from 1998 to 2001, which consisted of a series of measures basically to make it theoretically possible for Japanese and foreign institutions alike to perform banking, insurance, stock brokering and investment services in yen or any other currency. However, only a handful of insurance companies took up this opportunity and started to introduce variable annuity products to the Japanese insurance market, which grew from a market of less than $1 billion in assets in 2000 to over $50 billion so far. (See Chart A)

The variable annuity product concept was very unique, compared to the dominant traditional life products in the Japanese insurance market at that time, but the way of distribution was even more foreign (no captive agents, sales personnel or even financial planners)–only through third-party banks and securities firms. Looking back it can be seen that the success of the variable annuity market in Japan was indeed inevitable, although it did take great vision and a tremendous amount of effort and entrepreneurship to pioneer this market and make it a success.

So, what were the reasons behind the rapid growth of the Japanese VA market?

Well, the fundamental driver was, of course, the demographics. The vast Japanese baby boomer generation was in their 50s at the beginning of this new millennium, approaching their retirement age. Meanwhile, with one of the highest saving rates in the world, the Japanese baby boomers accumulated a huge amount of wealth as their retirement savings, looking for financial products to meet their needs including savings, investment, protection, estate planning and retirement income, all of which could be provided through a simple variable annuity policy.

In addition, the Japanese economic environment in the early 2000s further spurred the growth of the variable annuity market. Adversities within the financial markets as the legacy of the burst bubble completely shattered investors' confidence with a 10–year bear market, while zero interest rate monetary policies left individual investors with no safe alternatives. At the right moment, variable annuity products came to the rescue with principal–guarantees for safety that allowed policyholders to get into a better asset allocation for their investment with confidence.

For the same reasons, the distributors, Japanese banks and security firms, were driven to partner with VA manufacturers to promote sales as they had been combating the urgent need for positive cash flows to strengthen their balance sheets and get rid of bad loans accumulated over the bubble time. Additional revenue sources are crucial to the Japanese banks, as loan business has been shrinking since the mid–1990s with very narrow margins, if positive at all. While VA commissions, front and tail, are the main sources of revenue, most of the larger banks and securities firms are able to keep the variable annuity funds in their own asset management arms and earn a handsome fee from the assets, making VA an even more attractive sell.

Japanese Variable Annuity Market: Update
The success of the variable annuity in Japan (See Chart B), as I alluded to before, was championed by a number of foreign companies, who came into the market early and dominated the market by product innovation, strong distribution relations and proactive wholesale support. It has become extremely hard for newcomers to get into the market as distribution relations and networks have been almost fully established with very limited additional shelf space, although competition within this limited group of players did not stop and actually intensified over time. To get a better idea where the market stands now, let's take a detailed look at the following three areas: product and risk management, distribution and regulatory environment.

Product and Risk Management
Guarantee is the key element of variable annuity products, especially to the more risk–averse Japanese investors. On the other hand, guarantee is also the central topic on risk management. In the past five years since variable annuity was introduced to Japan, the market went through the whole span of evolution on guarantees which took 15 years in the United States. VA carriers introduced return–of–principal GMDB, later on ratcheting GMDB and the more recent living benefits such as GMIB and GMAB. Fees charged for these guarantees varied widely, ranging from 20 to 60 bps. Living benefits became a must–have for marketing, just like the popular GMWB designs in the United States. Some of the latecomers to the market recently came up with more aggressive guarantees, such as 10–year GMAB and ratcheting GMIB, heating up the competition on the guarantees.

One thing that is different in Japan that helps insurers afford (or at least get closer to affording) offering such guarantees is forced asset allocation. Before 2003, Japanese VA products were similar to those in the United States–free selection of separate account fund choices. However, in 2003, Hartford Life first introduced balance–fund–backed variable annuity products with forced asset allocation. Apparently this measure was more of a risk management tool. Nevertheless, the product concept turned into a great marketing advantage as it simplified the sales process, allowed a much better historical illustration and gave the policyholders a sense of safety, simplicity and professional investment management. As different living benefit guarantees hit the market, companies have put more of their focus on testing and finding the right investment mixes that suit their guarantees and risk management parameters the best.

While having the control over asset allocation is definitely a big positive, insurers may sometimes find it a very different challenge. For example, variable annuity risk management in the United States is mainly about managing equity market risk. But with guarantees on the diversified asset portfolios in Japan, insurers need to assess, manage and mitigate types of market risks other than just equity risks. When compared at "face value," guarantees offered in the Japanese market are actually less aggressive than those in the United States. Additionally, the Japanese keep the upper hand in controlled asset allocation. However, the low interest rate environment in Japan makes the theoretical value of these guarantees much pricier, which brings another interesting challenge for different VA carriers to manage their risks properly.

Distribution is always one of the keys to an insurer's success. Almost all the VA products in Japan have been sold through banks and securities firms with a top–down approach– the head–offices have much more decision–making power than the local branch offices in terms of product selection and promotion. Meanwhile, shelf space has become quite limited as the existing VA writers are signing–on most of the distributors. The preferences and needs of the distributors become equally important, if not more important, than the actual consumers' needs, which makes product innovations and marketing strategies more demanding. Products are required to clear hurdles for both the consumers and the distributors and insurers have to spend time and resources to educate both at the same time about the VA products.

Regulatory Environment
There was a real–life example at the end of 2004 that illustrated how big of an impact regulatory change could make on the VA market. The Financial Services Agency (FSA), the Japanese regulatory body of financial industries, issued new regulations and standards, particularly on variable annuity reserving and solvency margin (RBC–like) requirements. The new reserving methodology requires insurers to valuate statutory reserves for any VA guarantees written after March 31, 2005, including both death and living benefits, using risk–neutral scenarios, while lapse assumption is not allowed and utilization is set at 100 percent. On top of the statutory reserves, for any VA guarantees, regardless of the issue date or the guarantee type, minimum risk–based capital has to be 2 percent of the guaranteed amount. Even though a CARVM–type of allowance is granted when calculating total surplus for solvency, for a typical VA product currently on the market that offers both GMDB and GMIB at return–of–principal, the insurer has to put up, at three times the minimum risk capital, at least 5 percent (6 percent for GMDB + 6 percent for GMIB-7 percent of surrender charge credit) of the premium to issue the policy–on top of the heavy statutory reserve requirement. The capital requirement increases as the surrender charge credit goes away. Insurers scrambled in late 2004 to find solutions, and most of the foreign companies eventually had to send these guarantees offshore through reinsurance. This new regulation also has a significant impact on product designs going forward, as the product guarantees are now all subject to local accounting and statutory requirements in the country where they are reinsured. This adds another layer of complexity to product design, development and pricing.

Japanese Variable Annuity Market: Outlook
On a long term and macro basis, as we discussed earlier, the growth of variable annuity, or more broadly, insurance products for retirement planning, will be phenomenal. As the variable annuity products have earned more media exposure, insurers will continue to educate the consumers and distributors and cultivate the market. On a shorter horizon, for example 2006, the current trend of high growth, I believe, will remain strong, although the Japanese VA industry could very well experience some adversities due to external factors, such as the stability of the financial markets and regulatory environment.

We have already seen insurers' quick and effective response to the recent regulatory change on capital and reserve, but financial markets have been performing well, both domestic and international, for the past three years. A shock in the stock or bond markets, which we know from past experience is coming sooner or later, could well be the ultimate stress test of all the VA products on the market. The different risk strategies deployed by the different carriers will eventually separate the players and determine the winners of this potentially trillion–dollar market.

Liang (Jason) Zhang, FSA, CFA, FRM, MAAA, is actuary, risk management for Hartford Life International in Simsbury, CT. He can be reached at