Share / Print
Research Highlights

Do Variable Annuities Make for Fragile Insurance Markets?

KoijenBody

The persistent underfunding of pension funds may foreshadow similar problems for life insurers in the future, and the fact that life insurers are publicly traded and subject to market discipline could lead to additional challenges.

One of the less headline-grabbing effects of the 2008 financial crisis was the decline in sales and rise in fees of variable annuities, which are mutual funds with long-dated minimum return guarantees. New research from NYU Stern Professor Ralph S.J. Koijen studies the evolution of the variable annuities market and highlights the importance of financial and regulatory frictions in the pricing and design of variable annuities following the financial crisis.
 
In “The Fragility of Market Risk Insurance,” Professor Koijen and Princeton’s Motohiro Yogo plumb the phenomenon of minimum return guarantees in variable annuities and show how these guarantees ended up backfiring on insurers after 2008. They analyzed relevant contract-level data collected from 1999 through 2015, combined with annual financial statements of insurers from 2005 through 2015. Insurance companies that experience larger losses increase fees and reduce the level of guarantees. In addition, those companies whose liabilities increased the most resorted to affiliated reinsurance (i.e., shadow insurance) to move them off the balance sheet, which relaxes regulatory capital constraints.
 
As the authors point out, the variable annuity market is a relatively unsung powerhouse for insurance companies, accounting for $1.5 trillion or 34 percent of US life insurer liabilities in 2015. But sales peaked in the fourth quarter of 2007 at $41 billion, just before the crisis, subsequently shrinking to $27 billion by the second quarter of 2009. During that period, the average fee on minimum return guarantees almost doubled and insurers reduced, and in some cases stopped offering, such guarantees.
 
A key message is that the risk profile of modern life insurance companies changed as a result of offering long-dated minimum return guarantees instead of traditional life and annuity products. Consequently, modern life insurance companies more closely resemble defined-benefit pension plans. The authors furthermore write that “The persistent underfunding of pension funds may foreshadow similar problems for life insurers in the future, and the fact that life insurers are publicly traded and subject to market discipline could lead to additional challenges.”