The Fragility of Market Risk Insurance
Variable annuities play a key role in the retail insurance market. Nowadays, they form the largest category of liabilities for life insurers, having outgrown traditional annuities and life insurance. Variable annuities combine an investment in mutual funds with a guaranteed minimum return over a long horizon.
Aside from their relevance for insurers’ books, the popularity of these products has significantly declined in the aftermath of the financial crisis. The crisis led insurers to suffer an adverse shock to risk-based capital from the increased valuation of existing liabilities. As risk-based capital regulation is an important determinant of variable annuity supply, this increased the shadow cost of capital. Insurers successively raised fees on their variable annuities and shredded the attached generosity that was guaranteed. The demand for variable annuities declined.
To interpret this evidence, Koijen and Yogo develop a supply-driven theory of insurance markets in which financial frictions (a shock) and the market power of participants (oligopolistic market) determine the price of a product, the characteristics of the entered contract, and the degree of market incompleteness.
The authors create a model which can explain a more complete theory of the supply side as financial frictions and market power not only affect pricing (which has been shown before), but also affect contract characteristics and the degree of market incompleteness.
The optimal price of a variable annuity:
- decreases in the price elasticity of demand because of market power: the less consumers can react to price changes, the more the price can be driven upwards
- increases in the shadow cost of capital and with tighter capital regulation: if capital requirements increase or if an insurer is bound by them, the marginal cost of issuing additional contracts increases and leads to higher prices.
The optimal rollup rate for a variable annuity:
- decreases in the sensitivity of the option value to the rollup rate. This is because a higher rollup rate increases the option value of the minimum return guarantee and decreases statutory capital through higher required capital.
- increases in the elasticity of demand to the rollup rate and decreases in the price elasticity of demand. This is the traditional demand channel through which the insurer optimally chooses the rollup rate to exploit market power.
- decreases in the shadow cost of capital and with tighter capital regulation. The insurer lowers the rollup rate to reduce risk exposure and required capital when statutory capital is low.
As the optimal price increases and the optimal rollup rate decreases in the reserve valuation, a negative shock to the reserve valuation leads to lower sales (less attractive conditions for buyers).
- Insurers that sold more generous guarantees prior to the financial crisis suffered larger increases in reserve valuation than those that sold less generous guarantees. Thus, changes in reserve valuation negatively relate to sales growth in the cross section of insurers.
- Insurers that suffer large increases in reserve valuation while being constrained should remove variable annuity liabilities from the balance sheet through reinsurance.
With the decline of defined benefit pension plans and Social Security around the world, life insurers are increasingly taking on the role of insuring market risk through guaranteed return products. The large size of the variable annuity market reflects its importance for household welfare, filling an important gap left by defined benefit pension plans and Social Security.
Thus, it is of high importance to understand the effects that financial frictions and market power have on the price and the characteristics of such an essential insurance product. The general insight is that contract characteristics respond to risk-based capital regulation, which could lead to market incompleteness when statutory capital is low.
This insight should help those institutions in charge of setting capital requirements to better understand the effect of their actions on the what is currently the biggest financial retail product.