Beyond Age and Sex: Enhancing Annuity Pricing

This paper examines the use of more extensive risk classification and its impact on annuitisation values in consumer markets with mortality heterogeneity. Prices of U.S. retail annuities do not currently reflect buyers’ attributes other than age and sex. I qualitatively assess a number of proposed underwriting factors and show that the factors chosen can robustly predict mortality heterogeneity in a hazards framework. The relative value of annuities across demographic groups converges considerably under finer-grained pricing, but the change in consumers’ well-being is asymmetric. Shorter-lived annuitants gain about 30 per cent in financial and utility-adjusted terms, whereas longer-lived annuitants experience losses of 16 per cent.     

Private Rentenversicherung, Besteuerung und adverse Selektion

Adverse selection is commonly regarded as an important explanation for the limited size of voluntary annuity markets. Annuitants tend to be longer-lived than the population at large, thus making annuities too expensive for average individuals. Because German tax law discrimates between annuities and other forms of investment, privileged taxation of annuities might compensate for the cost of adverse selection. A major change in the taxation of annuities has been passed recently: From 2005 on, premium payments for deferred life annuities will be tax-deductible and annuities paid out will be fully taxable, if the annuitant cannot opt for an endowment. Premiums for other contracts are not tax-deductible and annuities are partly taxable. Unlike today, endowment payments won’t be tax free, anymore. We evaluate the cost of theoretical, fairly priced contracts for annuitants and non-annuitants using the money’s worth ratio. Therefore, the money’s worth concept is extended to the case of deferred annuities. Our calculations suggest that, under current legislation, average individuals have no incentive to annuitize. In contrast, under new legislation, the tax advantage of the deferred annuity without endowment option more than compensates for the cost of adverse selection. Single premium annuities will remain too expensive for average men, but may become advantageous for average women in some cases.     

On the Cost of Adverse Selection in Individual Annuity Markets: Evidence From Singapore

New evidence is presented on the cost of adverse selection in individual annuity markets using Singapore data. The Singapore annuity market is an interesting setting to examine the cost of adverse selection for three reasons. First, unlike many Western countries, the Singapore government provides very limited public financial assistance for retirees. Second, while social security contributions mandated under the Central Provident Fund (CPF) result in a high forced savings rate, a large proportion of CPF savings, are used up for housing. Third, to ensure that retirees have sufficient funds to meet basic needs, individuals who reach age 55 are required to set aside a minimum amount of their CPF savings, which can be withdrawn at age 62. The CPF Board allows various options for investing the minimum sum, but the most attractive option is to purchase an annuity. The institutional setting in Singapore in effect provides insurers with a large captive market for annuities. It is conjectured that this should be reflected in a significantly lower cost of adverse selection for annuities sold in Singapore as compared with other countries. The results herein, using data for CPF‐approved insurers, are strongly consistent with this conjecture. On average, money's worth of annuities is higher than annuities sold to a similar age‐gender mix in the United States, United Kingdom, and Australia. Adverse selection accounts for less than 13 percent of the cost of longevity insurance compared to 30–50 per‐ cent documented in many previous studies. These results suggest that one way to resolve the adverse selection problem is to adopt a universal individual defined contribution pension scheme that mandates or provides strong incentives for retirees to purchase annuities.     

Estimating International Adverse Selection in Annuities

Abstract

It is well known that purchasers of annuities have lower mortality than the general population. Less widely known is the quantitative extent of this adverse selection and how it varies across countries. This paper proposes and applies several methods for comparing alternative mortality tables and illustrates their impact on annuity valuation for men and women in the U.S. and the U.K. Our results indicate that the relatively lower mortality among older Americans who purchase annuities is equivalent to using a discount rate that is 50–100 basis points below the U.K. rate for compulsory annuitants or 10–20 basis points lower than the U.K. rate for voluntary annuitants. We then draw on the mortality experience of over half a billion lives to estimate mortality differentials due to varying degrees of adverse selection controlling for country, gender, and an allowance for mortality improvements. Results show that adverse selection associated with the purchase of individual annuities reduces mortality rates by at least 25% in the international context. We also find that the system of mortality tables used to value Japanese annuities is quite distinct from international norms.?     

Author’s Reply: Statistical Independence and Fractional Age Assumptions - Discussion by Cecil Nesbitt; Elias S. W. Shiu; Serena Tiong,January 1997

Abstract

This paper addresses the problem of the sharing of longevity risk between an annuity provider and a group of annuitants. An appropriate longevity index is designed in order to adapt the amount of the periodic payments in life annuity contracts. This accounts for unexpected longevity improvements experienced by a given reference population. The approach described in the present paper is in contrast with group self-annuitization, where annuitants bear their own risk. Here the annuitants bear only the nondiversifiable risk that the future mortality trend departs from that of the reference forecast. In that respect, the life annuities discussed in this paper are substitutes for reinsurance and securitization of longevity risk.     

Enhanced Annuities – Produktinnovation als Lösungsstrategie für das Annuity Puzzle?

The private annuity markets are traditionally small even though annuity products have many favorable properties from a theoretical point of view. In this paper, the discussed approaches to the so-called annuity puzzle are examined and evaluated. In particular, adverse selection has been repeatedly held responsible for the annuity puzzle. Thus, it is investigated if enhanced annuities can eliminate or reduce problems on the annuity markets caused by adverse selection. It is shown by a modeling approach that – depending on the superior knowledge of the insured – a first-best-solution can be implemented by offering enhanced annuities.     

Mandatory Pensions and the Intensity of Adverse Selection in Life Insurance Markets

This article examines the impact of varying mandatory pensions on saving, life insurance, and annuity markets in an adverse selection economy. Under reasonable restrictions, we find unambiguous effects on market size, participation rates, and equilibrium prices. The degree of adverse selection, whether a market is active or inactive, and social welfare are analyzed.     

Structured settlement annuities, part 1: overview and the underwriting process

Structured settlement underwriting is the underwriting of medically impaired lives for the purchase of an annuity to fund the settlement. Other than risk assessment, structured settlement (SS) underwriting has little in common with traditional life insurance underwriting. Most noteworthy of these differences is the relative lack of actuarial data on which to base decisions about mortality and the necessity for prospective thinking about risk assessment. The purpose of this paper is to provide a foundation for understanding the structured settlement business and to contrast the underwriting of structured settlements with that of traditional life insurance. This is the first part of a two-part article on SS annuities. Part 2 deals with the mortality experience in SS annuitants and the life-table methodology used to calculate life expectancy for annuitants at increased mortality risk.     

The Simple Analytics of a Pooled Annuity Fund

This article provides a formal analysis of payout adjustments from a longevity risk‐pooling fund, an arrangement we refer to as group self‐annuitization (GSA). The distinguishing risk diffusion characteristic of GSAs in the family of longevity insurance instruments is that the annuitants bear their systematic risk, but the pool shares idiosyncratic risk. This obviates the need for an insurance company, although such instruments could be sold through a corporate insurer. We begin by deriving the payout adjustment for a single entry group with a single annuity factor and constant expectations. We then show that under weak requirements a unique solution to payout paths exists when multiple cohorts combine into a single pool. This relies on the harmonic mean of the ratio of realized to expected survivorship rates across cohorts. The case of evolving expectations is also analyzed. In all cases, we demonstrate that the periodic‐benefit payment in a pooled annuity fund is determined based on the previous payment adjusted for any deviations in mortality and interest from expectations. GSA may have considerable appeal in countries which have adopted national defined contribution schemes and/or in which the life insurance industry is noncompetitive or poorly developed.     

The Annuity Puzzle and an Outline of Its Solution

In his seminal 1965 paper, Yaari showed that, assuming actuarially fair annuity prices, uncertain lifetimes, and no bequest motives, utility-maximizing retirees should annuitize all of their wealth on retirement. Nevertheless, the markets for individual immediate life annuities in the United States, the United Kingdom, and several other developed countries have been small relative to other financial investment outlets competing for retirement savings. Researchers have found this situation puzzling, hence the so-called “annuity puzzle.” There are many possible explanations for the annuity puzzle, including “rational” explanations such as adverse selection, bequest motives, and incomplete markets; and “behaviorial” explanations, such as mental accounting, cumulative prospect theory, and mortality salience. We review the literature on the various plausible explanations given for the existence of the annuity puzzle, suggest ways of stimulating the demand for annuities, and suggest a few of the ingredients needed for further development of hybrid annuity products that may provide a solution to the puzzle.     

Adverse selection and the market for annuities

Adverse selection is often blamed for the malfunctioning of the annuities market. We simulate the impact of adverse selection on the consumption allocation of annuitants under alternative parameter values, and explore the resulting welfare implications. We show that, for most parameter values, the welfare losses associated with equilibriums that are subject to adverse selection correspond to a loss of wealth of around one percent in a first-best equilibrium. These losses are smaller than the corresponding losses associated with equilibriums with no access to an annuity market by an order of magnitude of ten. The existence of substitutes for annuities such as a bequest motive or a social security system intensifies the adverse selection but reduces its welfare impact.

A Computationally Efficient Algorithm for Estimating the Distribution of Future Annuity Values Under Interest-Rate and Longevity Risks

Abstract

This paper proposes a computationally efficient algorithm for quantifying the impact of interestrate risk and longevity risk on the distribution of annuity values in the distant future. The algorithm simulates the state variables out to the end of the horizon period and then uses a Taylor series approximation to compute approximate annuity values at the end of that period, thereby avoiding a computationally expensive “simulation-within-simulation” problem. Illustrative results suggest that annuity values are likely to rise considerably but are also quite uncertain. These findings have some unpleasant implications both for defined contribution pension plans and for defined benefit plan sponsors considering using annuities to hedge their exposure to these risks at some point in the future.     

Experimental Tests of Self-Selection and Screening in Insurance Decisions

A major characteristic of insurance markets is information asymmetry that may lead to phenomena such as adverse selection and moral hazard. Another aspect of markets with asymmetric information is self-selection, which refers to the pattern of choices that individuals with different personal characteristics make when facing a menu of contracts or options. To combat problems of asymmetric information, insurance firms can use screening. That is, they can offer the clients a menu of choices and infer their characteristics from their choices.This article reports the results of several studies that examined the degree to which people behave according to the notions of self-selection and screening. Subjects played the role of either insurance buyers or sellers. The results of these studies provide partial support for the hypothesis that subjects use self-selection and screening in insurance markets. Our study also points at the importance of learning in experimental studies. In one-stage experiments where subjects did not get feedback, screening was not detected. When multistage experiments were conducted, and the subjects learned from experience and were also taught the relevant theories, their decisions were more aligned with screening.     

Explaining Low Annuity Demand: An Optimal Portfolio Application to Japan

Using an optimizing financial planning model in the tradition of Merton and Richard we explore how individuals should determine their life insurance and annuity choices, given uncertainty about investment returns and mortality. Both consumption and bequests appear as arguments in the individual's preference function. The model explicitly recognizes the existence of social security in retirement, and of loadings on insurance premiums, due to administration costs in the life insurance and annuities markets. The model sheds light on the reasons for the thinness of voluntary life annuity markets worldwide. The relative importance of pre‐existing annuitization through social security, the role of bequests, and premium loadings are quantitatively assessed within a single optimizing framework. Results are presented for a model specification calibrated to Japan.     

The predictive power of the implied volatility of options traded OTC and on exchanges

This paper investigates the efficiency of stock index options traded over-the-counter (OTC) and on the exchanges in Hong Kong and Japan. Our findings suggest that implied volatility is superior to either historical volatility or a GARCH-type volatility forecast in predicting future volatility in both the OTC and exchange markets. This paper is also one of the first to compare the predictive power of the implied volatility of stock index options traded OTC to that of exchange-traded stock index options. Our evidence suggests that the OTC market is more efficient than the exchanges in Japan, but that the opposite is true in Hong Kong.     

Optimal Annuitization Policies

Abstract

At, or about, the age of retirement, most individuals must decide what additional fraction of their marketable wealth, if any, should be annuitized. Annuitization means purchasing a nonrefundable life annuity from an insurance company, which then guarantees a lifelong consumption stream that cannot be outlived. The decision of whether or not to annuitize additional liquid assets is a difficult one, since it is clearly irreversible and can prove costly in hindsight. Obviously, for a large group of people, the bulk of financial wealth is forcefully annuitized, for example, company pensions and social security. For others, especially as it pertains to personal pension plans, such as 401(k), 403(b), and IRA plans as well as variable annuity contracts, there is much discretion in the matter.

The purpose of this paper is to focus on the question of when and if to annuitize. Specifically, my objective is to provide practical advice aimed at individual retirees and their advisors. My main conclusions are as follows:

? Annuitization of assets provides unique and valuable longevity insurance and should be actively encouraged at higher ages. Standard microeconomic utility-based arguments indicate that consumers would be willing to pay a substantial “loading” in order to gain access to a life annuity.

? The large adverse selection costs associated with life annuities, which range from 10% to 20%, might serve as a strong deterrent to full annuitization.

? Retirees with a (strong) bequest motive might be inclined to self-annuitize during the early stages of retirement. Indeed, it appears that most individuals—faced with expensive annuity products—can effectively “beat” the rate of return from a fixed immediate annuity until age 75?80. I call this strategy consume term and invest the difference.

? Variable immediate annuities (VIAs) combine equity market participation together with longevity insurance. This financial product is currently underutilized (and not available in certain jurisdictions) and can only grow in popularity.     

Adverse selection in the annuity market with sequential and simultaneous insurance demand

This paper investigates the effect of adverse selection on the private annuity market in a model with two periods of retirement and two types of individuals, who differ in their life expectancy. In order to introduce the existence of time-limited pension insurance, we consider a model where for each period of retirement separate contracts can be purchased. Demand for the two periods can be decided sequentially or simultaneously. We show that only a situation where all risk types choose sequential contracts is an equilibrium and that this outcome is favourable for the long-living, but is unfavourable for the short-living individuals. JEL Classification D82 · D91 · G22     

Ripples through markets: Inter-market impacts generated by large trades

This paper uses a sample of large trades executed on the London Stock Exchange's SEAQ-I market for European cross-traded firms to investigate their impact on home market prices when parallel markets suffer from information frictions. I find that (a) large London trades produce price impacts in home markets even though no timely information is published, (b) market makers appear to pre- and post-position their inventories by splitting orders across markets, and (c) the price discovery process across markets changes significantly around large trades with the foreign market making a significantly bigger contribution to price discovery at this time, even though information opaqueness exists.     

Are options redundant? Further evidence from currency futures markets

This paper investigates the impact of the introduction of options on the underlying asset's price formation process, using Geweke feedback measures. We derive the feedback measures from the Deutsche Mark, British Pound, Swiss Franc, Japanese Yen and Canadian Dollar futures and spot prices, before and after the introduction of options for these currency futures. While each currency market maintains some distinct characteristics in the post-option period, a common theme is found: after the option introduction, the instantaneous feedback between spot and futures markets improves drastically. The feedback from the spot to the futures market tends to decrease and remains small. The feedback from the futures market to the spot market tends to decrease as well. These results confirm the dominance of options markets, probably due to their smaller transaction costs. When made available, options assume a leading role for information transmission in currency markets.     

Global financial services and a global single currency

The purpose of this paper is to highlight the evolution of financial institutions in the context of increasingly volatile foreign exchange markets. The paper discusses the importance of the formation of a single currency in the US in the 19th century and the formation of the Euro in the 20th century for reducing volatility in foreign exchange markets that have assisted financial institutions’ international business expansion. The paper also considers some of the key assumptions of an optimal currency theorem such as labour mobility and argues that in the 21st century, more comprehensive financial market integration and a single global currency could emerge, provided that capital mobility and hence foreign capital flows continue meeting labour in the host countries for production rather than the other way round.