Product Trends in Life Insurance

Product Trends in Life Insurance
by Mike Brown and Keith Dall

A discussion about the trends and changes affecting the life insurance industry by impacting product growth. Read how today's ideas can become tomorrow's successes.

Product trends are of considerable interest to actuaries. One company's innovation can become tomorrow's top-selling product. About 25 years ago, a product called "universal life" was just being introduced. Perhaps we are about to see the next wave of product creativity as we work through the implications of principles–based reserving. These are exciting times for life actuaries and the pace of change is continuing to accelerate. Are we ready for these changes? Are we moving forward, or could we be on the verge of creating a horrible legacy by not considering the implications of our efforts? All risks need to be understood. As actuaries, we have the tools and abilities to assure that our current actions are in the best interest of the life insurance industry and our profession. This is why we need to focus on both emerging and emerged issues and lead the way today through the changes of tomorrow.

Sources Scanned
Numerous sources have been scanned to prepare this discussion. These sources include articles written in A. M. Best Review/Preview, the National Underwriter, Best's Review, Contingencies, the Wall Street Journal and discussions with various actuaries.

Results of Scanning Activity
The material that follows is a summary of the scanning that was obtained from these sources.

New life reserving structures
This timely topic is one of the most frequently discussed among life actuaries. The implications are immense and will likely include new and revised life and annuity products. Revisions to our modeling practices and technology are also expected. For these reasons it is important for actuaries to stay informed and participate in this area of emerging change.

The restrictions imposed by our current statutory reserving standards are leading to product innovation. Examples of this innovation include securitization and principles–based reserving. The immediate goal of these new ideas is to produce statutory reserves that are adequate and appropriate. It is anticipated that these new structures will have far–reaching impacts on future product designs. Numerous issues need to be addressed to achieve a complete solution. Is it possible that GAAP reserves will change as we open the door to investigate these new structures? At this time we have seen no such trend for this type of event.

Releasing the redundancy in our current statutory reserves involves time–consuming calculations. Will smaller companies be able to benefit from these new approaches? Currently, securitizations are too costly for small companies to benefit from reduced reserves and principles–based reserves will require a large amount of resources to calculate, document and certify. Inherent in these new reserving structures is the usage of current company experience. Are we prepared to spend the time and effort to quantify our experience? Can we defend it? Could a sudden deterioration of experience lead to a reserve increase that causes insolvency or a reduction in financial ratings?

Tax reserves are currently highly dependent on a formula–based approach for calculation. Is it possible that adverse tax consequences will come from these new statutory reserving approaches? Historically, the IRS has used numerous opportunities to increase taxation of life insurance companies and its customers. Given the recent communications from the U.S. Treasury that there is interest in current taxation of interest earned by life insurance policies, we need to use caution as we move forward.

It is logical to conclude that these new approaches to statutory reserving will affect the Standard Nonforfeiture Law and policy cash values as we know them. The disturbing issue is that we may be postponing this topic, but should instead be dealing with it.

The reinsurance quick fix for reducing redundant reserves has been statutory reserve credits. Under this strategy, direct business is placed offshore where NAIC reserve regulations have less strength. In return, direct writers take relief on their statutory statements with letters of credit. These letters are generally short term (i.e., one year in length) and therefore price volatility is an issue. Increasing demand for these letters has led to higher pricing and concerns over available capacity. Rating agencies, stock analysts and regulators are monitoring companies that are dependent on these letters. It is best if multi–year letters in a laddered approach with respect to maturity are purchased. New reinsurance alternatives to letters of credit are reinsurance trusts and funds deposited by reinsurers. A relatively new strategy for mitigating redundant statutory reserves is securitization. A U.S. captive is created for the purpose of accessing the capital markets to fund the growing reserve requirements. The advantage of securitization over letters of credit is that securitization provides a more permanent solution. The disadvantage is that Wall Street requires a minimum transaction size for securitization, although there is an opportunity for pooled securitization that covers a pool of insurers. It may be difficult for the investment banking community to get comfortable with the underwriting expertise of a pool of carriers.

These new reserving structures will require careful monitoring by the state insurance departments. Are they ready for this more demanding reserve strategy? Will companies be treated similarly and fairly? What will we do if different states adopt different reserving requirements? How frequently will the state demonstrations of compliance occur? Will disapproval by one state mean the immediate suspension of new sales? AG38 has led to inadequate reserves held by some insurers. Will new reserve requirements be mandated retroactively?

Innovative payout options
Life insurers are driven by fund accumulation and the interest–rate spreads that are earned on these funds. Unfortunately, we often see death benefit proceeds and deferred annuities that are cashed–out in lump–sum payments. Thus, there is considerable interest and opportunity for product actuaries to develop more attractive payout options.

There is a void to be filled to offer new settlement alternatives that provide value to both insurers and their policyholders. This is especially acute with the aging of the "baby boom" generation and their limited assets. Perhaps insurers need to develop a better process for merging multiple funds or annuities into one payout annuity. Could insurers offer an annual return that competes with mutual funds? Perhaps life insurance policies could be designed to provide enhanced payout annuities, including the development of two–tiered life insurance. Expanded opportunities for substandard, underwritten annuities seem to be very likely. A very plausible extension to the "hot" equity indexed annuity marketplace is equity indexed payout annuities.

Current barriers to success in this marketplace include liquidity since there is a tremendous reluctance by potential buyers to purchase an annuity that has no liquidity or cash value. Greater competitiveness with other financial instruments is needed. It is easy to structure regular distributions from alternative investments that meet the current needs of potential annuitants (although the guarantees are often weak or non–existent). Greater flexibility is needed to allow more customer choices regarding the direction of the underlying investments. Credited rates that are much closer to current market rates (including the choice of receiving equity market returns) are also needed.

Some progress in meeting the needs of consumers has recently occurred. The guaranteed minimum withdrawal benefit (GMWB) attached to variable annuities provides an income stream that doesn't require clients to give up asset control. Three key attractions of the GMWB are (1) client maintains equity exposure, (2) client retains control of the investments and (3) the longevity risk is mitigated via the guaranteed minimum benefit. Drawbacks of the GMWB include (1) age is not reflected in the income payment and (2) payments are taxed first on the gain received. "Next generation lifetime income" on variable annuities offers the tax advantages of traditional payout annuities, but still provide the control, access and flexibility of GMWBs. The drawback is the lower guaranteed lifetime income relative to the GMWB.

Products for seniors
Inter–generational wealth transfer can be a huge opportunity for life insurers. As product actuaries, we have the tools and skills for creating products that benefit both consumers and life insurers. However, we need to remember that this marketplace has unique needs that must be served.

Seniors (consumers who are age 65 and above) want guarantees, liquidity of principal, choices, reasonable underwriting and competitive products. These potential customers have many different needs, but very few products have been developed specifically for them. In addition, they have considerable means to spend on life insurance products. If the 2001 CSO extends to age 120, why do we set issue age 80 as the maximum issue age? What kind of mortality improvement do we expect to see? What are the correct mortality rates to apply to these older applicants? Can we perform successful underwriting at these ages?

Our customers have high expectations that must be met to successfully sell products in this marketplace. In addition, it is logical to conclude that regulatory–based changes will occur to assure that we appropriately meet these needs.

The financial marketplace is rearranging itself along demographic parameters–creating what may be called the "Retirement Industry" out of the "Life and Financial Services Industry" of the 1990s. We are beginning to see concepts, products and solutions being developed that support people living in retirement for 20, 30 or more years. Life insurance fits this market via policy loans, withdrawals, acceleration riders, geriatric underwriting, no–lapse guarantees and more. Success is possible as long as we remember that the customer needs are varied.

The H5N1 avian flu virus
As practicing actuaries, we have not encountered widespread illnesses that have produced mortality so severe as to jeopardize company solvency. We now have a wake–up call and its name is H5N1–the avian flu virus. This timely topic is of interest and concern to many life insurers (and life actuaries).

Some of the predictions we now hear link H5N1 to the Spanish flu of 1918 to 1919 that killed 500,000 people in the United States. The equivalent of 1918 in current dollars would cause a $100 billion loss event. This equals half the surplus of the entire life insurance industry at year–end 2002. Unlike flu epidemics we have seen in our lifetime, there is the potential for H5N1 to turn the body's own immune system against itself, killing quickly and hitting the healthiest people hardest. This "fear of the flu" will paralyze economies (it is already occurring on a limited scale). As a result, product availability may become limited. Rate increases (including reinsurance) may become widespread. Travel may become a key underwriting criteria. Re–insurance may become unavailable. Insurers could fail and go into state receivership. Reinsurers now seem to be especially vulnerable, although rate increases can readily be passed on to the direct writers. State guaranty funds would have to kick in if insurers failed.

New combinations of insurance products and benefits
Product actuaries are increasingly being asked to apply innovation when developing new life insurance products. What is often occurring is that product features found in health insurance and annuity products are being added to life insurance products. The consequences of this process are not yet known and certainly deserve further analysis.

The distinctions between the product lines and product types are narrowing. One example includes individual life products sold to small groups. Long–term care riders and waiver of specified premium benefits attached to life insurance can be looked upon as either a life insurance benefit or a health insurance benefit (or both). A guaranteed minimum death benefit (GMDB) is now commonly offered on variable annuity products. The GMWB is a variable annuity concept that will likely soon be attached to variable life insurance. It is easy to visualize other potential applications, such as major surgical riders attached to life insurance (which is now sold today outside the United States). Are we thinking through the risks that result from these new combinations of benefits? Are the regulators ready to deal with this? Do we understand the risks?

It is easy to drill deeper into this topic to find more new combinations. For example, the equity–indexed annuity provides the principal protection of a fixed annuity plus the potential upside of participation in the equity markets. The use of "fixed bucket" funds within a variable annuity allows fixed–income accumulation within an equity–based product. Secondary guarantees on variable annuities allow investment risk sharing between the policyholder and the insurer. This "hot" feature in today's retirement marketplace includes a GMDB that insures the contract holder, a Guaranteed Minimum Accumulation Benefit (GMAB) that is available at the end of a period elected by the policyholder, a Guaranteed Minimum Income Benefit (GMIB) to convert the guaranteed account value (via guaranteed annuitization rates stated in the policy) into a future income stream, and a GMWB to withdraw funds from the account up to the initial guarantee amount, subject to an annual maximum set at election of the benefit.

Competitive/survival strategies
This discussion reveals the connection between our life insurance products and the survival of our employers. While this may seem obvious, there are numerous opportunities for success and failure. Product actuaries have an opportunity and responsibility to help their employers make the right decisions. Failure is easy, but success is the real challenge.

Growth is a serious concern for every insurance carrier. Too slow growth leads to criticism by Wall Street and may lead to inefficiency through not reaching critical mass. Too rapid growth may be a symptom of poorly priced products and lead to an immediate strain on earnings. The products we provide are instrumental in the growth we ultimately achieve. Non–insurance competitors include mutual funds, brokers and banks. The strengths provided by non–insurance competitors include strong balance sheets, exceptional financial flexibility, broad distribution and branding. Survival strategies for life insurers include delivering product innovation, achieving scale to be low–cost providers, negotiating preferred relationships with other product manufacturers, working with unaffiliated distribution networks, increasing the use of branding, improving customer service and applying technology to provide tools and information to producers and customers.

The life insurance industry has done a poor job in several of these areas. Retention of deferred annuity assets rarely occurs once the owner reaches retirement. Product innovation that leads to retaining these assets (and earning the associated spread on these investments) is clearly one of these survival strategies. It is believed that the down side of some of the above survival strategies is that products will become relatively commoditized.

Life settlements and LILACs
The life settlement marketplace (where life insurance policyholders are selling ownership of their policies on the secondary market) is a perceived threat to some, and an opportunity to others. Insurable interest is clearly replaced with speculation. New lapse and mortality rate patterns will emerge. Alternatives are needed within life policies to provide attractive, flexible options for policyholders. Insurance carriers want the ability to require insurable interest at the time of transfer, including the legal right to refuse the transfer. A noteworthy trend is that expanded regulatory controls are being aggressively requested by life insurance companies. IRS answers still are unclear regarding tax deductibility, 7702 and 7702A compliance. Will life insurers adapt by providing greater liquidity of death benefits for catastrophic and/or chronic conditions to help retain their policies? Will these policies retain the tax deferral of interest earned on policy values?

LILACs (life insurance and life annuity combinations) occur when immediate annuities are purchased and the periodic annuity benefits are applied to pay life insurance premiums. Profitability concerns and the arbitrage potential are significant. Should we be concerned that investment groups are placing capital into these insurance products?

Equity indexed life insurance (EILI) is growing
Equity indexed annuities are growing in popularity, and this will extend to EILI, now being sold by a few life insurers. It is likely that this relatively new product design will lead to variations not yet contemplated by our industry. Are we ready for the accounting and reserving issues and the investment alternatives produced by this innovation? Will these products ultimately be considered to be securities subject to the jurisdiction of the SEC? What are the risks being absorbed by life insurers? Do we understand these risks?

Product simplification
Insurance contracts are too complicated for most consumers. The potential for policyholder misunderstanding and misuse of insurance products can easily result. Courts are continuing to interpret ambiguous provisions in favor of policyholders. Legal stakes are high since we live in an increasingly lawsuit prone society. Would product simplification help increase our sales and/or improve persistency? Lead to a higher rate of repeat sales? Perhaps this is a lawsuit we can avoid if we become proactive with the suitability and design of our insurance products.

New York attorney general investigation of certain insurance practices
What will be the outcome(s)? Commission disclosure? The restricted use of reinsurance? Increased state regulation of product development? Will the federal government stay on the sidelines? Recent activity regarding finite–risk reinsurance includes the U.S. accounting rule makers considering tougher standards. Regu–lators are also arguing that in some cases the transfer of risk is really loans. Transfer of risk is under review by the NAIC, the London–based International Accounting Standards Board (IASB) and the SEC. The rule of thumb "risk is transferred when there is a 10 percent chance of a 10 percent loss" is frowned upon as being arbitrary and subject to abuse. FASB–related developments include voting unanimously to add a project to clarify when transfer of risk occurs, showing interest in defining basic concepts like "insurance contract" and "insurance risk, enhancing disclosure, adding new Q&A guidance and amending FASB 113."

Terrorism and natural disasters–are we ready?
What limitations and/or protections are needed in our policies? Are stop–loss and catastrophic covers needed and available? What are the capital market implications and are there opportunities for immunization? Perhaps this is beyond insurance and should be ignored.

Underwriting that utilizes genetic testing
How will genetic testing change the expected mortality tables? Will it be cost effective? Will the regulators and the public allow it? How will the courts rule if policyholders sue insurers for relying on this information? Are we morally and legally obligated to share the results with the applicants?

Conclusions
Numerous conclusions can be drawn from this information. In general, we have many more questions than we have answers. More specifically:

• Greater representation by and for smaller companies is needed as we work through the issues associated with principles–based reserving.
• There is a clear potential for principles–based reserving to lead to adverse tax consequences. Open discussions and negotiations with the IRS are needed now.
• The implications of principles-based reserving on the Standard Nonforfeiture Law have been ignored. We need to work closely with our regulators to demonstrate our responsibility in this area.
• Innovation is needed and is occurring for payout annuities. Numerous product ideas are being developed for achieving this result. We must remember the consumers' needs, which are key to future success.
• Products for seniors are expected to receive increasing attention by the life insurance industry. Our success is dependent on recognizing the unique needs of this affluent customer segment.
• H5N1 may have a dramatic impact on the financial wellbeing of the life insurance industry. Several changes may occur that impact our products, including reinsurance rates and availability. If H5N1 becomes a pandemic, as is feared, we will have little time to react.
• Product innovation by actuaries is leading to the development of new combinations of benefits. The implications of these combinations may not be fully understood by actuaries, regulators and the life insurance industry.
• The success of our employers is not to be taken for granted. Our competitors reach well beyond the limits of the insurance industry. Product innovation is one of the key opportunities for our employers. As product actuaries we are positioned to help meet this need.
• The life settlement marketplace is undergoing rapid change. This uncontrolled change has led to lawsuits, unhappy customers and bad press for the life insurance industry. Resolution of outstanding issues is needed quickly to assure no such additional developments will occur.
• Product simplification deserves additional focus by the life insurance industry. Legal stakes takes are high for life insurers.

Need to Continue Scanning
In summary, the expectations associated with these emerging and emerged product trends are:

• Principles–based reserving will lead to reinsurance evolution. In fact, it is safe to assume this will lead to a greater need for actuaries in all areas of expertise. This deserves additional monitoring during 2006.
• Further blurring of the distinctions between life insurance, annuities and other financial instruments is expected, including the borrowing of features that have been successful. Much opportunity exists here for life insurers. No further scanning of this topic is expected in 2006 unless new developments are noted.
• It is likely that the seniors–based marketplace will experience regulatory–based changes to assure that we appropriately meet the needs of our customers. Considerable opportunity for both success and failure exists for life insurers. No further scanning of this topic is expected in 2006 unless new developments are noted.
• Advance thought and preparation will be given to the potential H5N1 pandemic, such as the purchase of catastrophic reinsurance. Further scanning of this topic is expected in 2006.
• Product innovation is expected to become a growing concern for the industry and regulators. It is also expected that the trend toward new combinations of insurance products and benefits will continue and probably accelerate. Further scanning of this topic is expected in 2006 as new developments are noted.
• Product innovation that leads to retaining policy assets (and earning the associated spread on these investments) is clearly one of the life insurance industry's survival strategies.
• The secondary marketplace for life insurance has many forms and will grow with considerable force. We are not moving quickly enough to resolve the underlying issues that may erupt at any time.
• Product simplification will not be important to many life insurers. Not listening to our customers will serve to further reduce customer satisfaction.

Mike Brown is a senior actuary for AEGON USA Inc. He can be contacted at mjbrown@aegonusa.com.

Keith Dall is a consulting actuary for Milliman Inc. He can be contacted at keith.dall@milliman.com.

Disclaimer: The material presented was obtained from various sources documented in this article and may not represent the views of our employers.