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.     

Converting retirement benefit into a life care annuity with graded benefits*

This paper deals with life care annuities, i.e. bundled products comprising a life annuity and long-term care insurance. It aims to assess the cost of converting retirement benefit into a life care annuity with graded benefits using a pre-existing public pay-as-you-go pension scheme. With this objective in mind, we present an actuarial method based on array calculus for valuing this type of life care annuity. The health dynamics of the annuitant rely on a reversible illness-death multistate framework. The paper contains a numerical example in which mortality and disability assumptions are based on data from the USA and Australia, although this should be viewed simply as an illustration. In addition, in order to check the coherence of these data, we compute life expectancy for both healthy and dependent persons, and then for dependent persons in each of the states of dependence. The effect of ruling out the recovery assumption on the annuity’s cost is also assessed. The analysis provides valuable insights into how much it would cost to introduce these annuities and enables us to make some policy recommendations to help ensure that this combined pension scheme has a good actuarial design.     

Optimal Risk Classification with an Application to Substandard Annuities

Abstract

Substandard annuities pay higher pensions to individuals with impaired health and thus require special underwriting of applicants. Although such risk classification can substantially increase a company's profitability, these products are uncommon except for the well-established U.K. market. In this paper we comprehensively analyze this issue and make several contributions to the literature. First, we describe enhanced, impaired life, and care annuities, and then we discuss the underwriting process and underwriting risk related thereto. Second, we propose a theoretical model to determine the optimal profit-maximizing risk classification system for substandard annuities. Based on the model framework and for given price-demand dependencies, we formally show the effect of classification costs and costs of underwriting risk on profitability for insurers. Risk classes are distinguished by the average mortality of contained insureds, whereby mortality heterogeneity is included by means of a frailty model. Third, we discuss key aspects regarding a practical implementation of our model as well as possible market entry barriers for substandard annuity providers.     

Immediate Annuity Pricing in the Presence of Unobserved Heterogeneity

Abstract

One of the acknowledged difficulties with pricing immediate annuities is that underwriting the annuitantis life is the exception rather than the rule. In the absence of underwriting, the price paid for a life-contingent annuity is the same for all sales at a given age. This exposes the market (insurance company and potential policyholder alike) to antiselection. The insurance company worries that only the healthiest people choose a life-contingent annuity and therefore adjust mortality accordingly. The potential policyholders worry that they are not being compensated for their relatively poor health and choose not to purchase what would otherwise be a very beneficial product.

This paper develops a model of underlying, unobserved health. Health is a state variable that follows a first-order Markov process. An individual reaches the state “death” either by accident from any health state or by progressively declining health state. Health state is one-dimensional, in the sense that health can either “improve” or “deteriorate” by moving farther from or close to the “death” state, respectively. The probability of death in a given year is a function of health state, not of age. Therefore, in this model a person is exactly as old as he or she feels.

I first demonstrate that a multistate, ageless Markov model can match the mortality patterns in the common annuity mortality tables. The model is extended to consider several types of mortality improvements: permanent through decreasing probability of deteriorating health, temporary through improved distribution of initial health state, and plateau through the effects of past health improvements.

I then construct an economic model of optimal policyholder behavior, assuming that the policyholder either knows his or her health state or has some limited information. the value of mortality risk transfer through purchasing a life-contingent annuity is estimated for each health state under various risk-aversion parameters. Given the economic model for optimal purchasing of annuities, the value of underwriting (limited information about policyholder health state) is demonstrated.     

Trading death: The implications of annuity replication for the annuity puzzle,arbitrage, speculation and portfolios

Annuities are perceived as being illiquid financial instruments, and this has limited their attractiveness to consumers and their inclusion in financial models. However, short positions in annuities can be replicated using life insurance and debt, permitting long positions in annuities to be offset, or short annuity positions to be created. The implications of this result for the annuity puzzle, arbitrage between the annuity and life insurance markets, and speculation on expected longevity are investigated. It is argued that annuity replication could help reduce the annuity puzzle, improve the price efficiency of annuity markets and promote the inclusion of annuities in household portfolios.     

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.     

Application of Relational Models in Mortality Immunization

The prediction of future mortality rates by any existing mortality models is hardly exact, which causes an exposure to mortality (longevity) risk for life insurers (annuity providers). Since a change in mortality rates has opposite impacts on the surpluses of life insurance and annuity, hedging strategies of mortality and longevity risks can be implemented by creating an insurance portfolio of both life insurance and annuity products. In this article, we apply relational models to capture the mortality movements by assuming that the realized mortality sequence is a proportional change and/or a constant shift of the expected one, and the size of the changes varies in the length of the sequences. Then we create a variety of non-size-free matching strategies to determine the weights of life insurance and annuity products in an insurance portfolio for mortality immunization, where the weights depend on the sizes of the proportional and/or constant changes. Comparing the hedging performances of four non-size-free matching strategies with corresponding size-free ones proposed by Lin and Tsai, we demonstrate with simulation illustrations that the non-size-free matching strategies can hedge against mortality and longevity risks more effectively than the size-free ones.     

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.     

Optimal rate classification for enhanced annuities

For a given premium, enhanced annuities pay higher pensions to policyholders with impaired health. Even though risk classification is a common concept in the insurance sector and should allow insurers to increase their profitability, enhanced annuities are rarely offered outside of the United Kingdom. The paper provides a general method of determining an optimal risk classification system for enhanced annuities that will maximize an insurance company’s profits. The cost of risk classification, as well as that incurred when insureds are assigned to inappropriate risk classes (a chief component of underwriting risk), are explicitly considered.     

Longevity Risk Management in Singapore's National Pension System

Although annuities are a theoretically appealing way to manage longevity risk, in the real world relatively few consumers purchase them at retirement. To counteract the possibility of retirees outliving their assets, Singapore's Central Provident Fund, a national defined contribution pension scheme, has recently mandated annuitization of workers’ retirement assets. More significantly, the government has entered the insurance market as a public‐sector provider for such annuities. This article evaluates the money's worth of life annuities and discusses the impact of the government mandate and its role as an annuity provider on the insurance market.     

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.     

Factors Affecting Retirement Mortality

Abstract

As many countries consider mandatory individual retirement accounts as their answer to a secure social security system, the question arises as to whether all workers can get true “market value” annuities when they retire. It is clear today that private-sector life annuities are priced assuming that the applicant is healthy—very healthy. Very little underwriting or risk classification now exists in the individual annuity marketplace. However, if a large percentage of the population were looking to annuitize their social security accounts upon retirement, there would be strong pressure for more risk classes in the annuity-pricing structure.

Even without the advent of individual accounts for social security, the authors of this paper feel there may be real market opportunities for more risk classification in the individual annuity market and the offering of “impaired life annuities.” Given that this pressure does or might soon exist, this paper reviews 45 recent research papers that look at factors that affect mortality after retirement. In particular, factors that seem to be important in predicting retirement mortality include age, gender, race and ethnicity, education, income, occupation, marital status, religion, health behaviors, smoking, alcohol, and obesity. for each factor, this paper gives highlights relative to the named factor of the impact expected from that variable as described in the 45 reviewed research papers.

The authors believe there is a wealth of information contained in the summaries that follow, and it is our sincere hope that this paper will cause an increased interest in a more broadly based risk classification structure for individual annuities.

Summaries of the 45 papers can be found at www.soa.org/sections/farm/farm.html.     

The Impact of Disability Insurance on a Portfolio of Life Insurances

The aim of this article is to study the impact of disability insurance on an insurer's risk situation for a portfolio that also consists of annuity and term life contracts. We provide a model framework using discrete time nonhomogeneous bivariate Markov renewal processes and in a simulation study focus on diversification benefits as well as potential natural hedging effects (risk-minimizing or risk-immunizing portfolio compositions) that may arise within the portfolio because of the different types of biometric risks. Our analyses emphasize that disability insurances are a less efficient tool to hedge shocks to mortality and that their high sensitivity toward shocks to disability risks cannot be easily counterbalanced by other life insurance products. However, the addition of disability insurance can still considerably lower the overall company risk.     

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.     

降低企业基本养老保险政策缴费率能促进年金发展吗?北大核心

构建有效的多层次养老保障体系是积极应对我国人口老龄化的重要举措。本文基于税收调查数据,利用政策缴费率的差异,识别企业基本养老保险缴费负担对企业年金发展的影响。研究发现,企业基本养老保险缴费负担抑制了企业年金发展,其中政策缴费率每提高1个百分点,企业建立年金的概率会下降0.29个百分点,年金缴费率会减少0.06个百分点。使用上市公司数据进行分析,基本结论依然成立。进一步分析表明,基本养老保险会通过利润分享渠道、缴费能力渠道和缴费动机渠道影响企业年金发展。此外,企业基本养老保险对年金的影响,在企业产品定价能力较弱或小规模企业中更大,也会随地区经济增速的差异而不同,且仅在非国有企业中显著存在。依据本文估计的结果可以推算,企业基本养老保险政策缴费率降低4个百分点,能使年金覆盖率增加1.2个百分点,这同目前5.7%的覆盖率相比,是一个较大幅度的提升,但也应注意到6.9%的覆盖率依然偏低,年金发展需要更为积极的支持政策。     

Health and Mortality Delta: Assessing the Welfare Cost of Household Insurance Choice

We develop a pair of risk measures, health and mortality delta, for the universe of life and health insurance products. A life‐cycle model of insurance choice simplifies to replicating the optimal health and mortality delta through a portfolio of insurance products. We estimate the model to explain the observed variation in health and mortality delta implied by the ownership of life insurance, annuities including private pensions, and long‐term care insurance in the Health and Retirement Study. For the median household aged 51 to 57, the lifetime welfare cost of market incompleteness and suboptimal choice is 3.2% of total wealth.     

The Poisson Log-Bilinear Lee-Carter Model

Abstract

Life insurance companies deal with two fundamental types of risks when issuing annuity contracts: financial risk and demographic risk. Recent work on the latter has focused on modeling the trend in mortality as a stochastic process. A popular method for modeling death rates is the Lee-Carter model. This methodology has become widely used, and various extensions and modifications have been proposed to obtain a broader interpretation and to capture the main features of the dynamics of mortality rates. In order to improve the measurement of uncertainty in survival probability estimates, in particular for older ages, the paper proposes an extension based on simulation procedures and on the bootstrap methodology. It aims to obtain more reliable and accurate mortality projections, based on the idea of obtaining an acceptable accuracy of the estimate by means of variance reducing techniques. In this way the forecasting procedure becomes more efficient. The longevity question constitutes a critical element in the solvency appraisal of pension annuities. The demographic models used for the cash flow distributions in a portfolio impact on the mathematical reserve and surplus calculations and affect the risk management choices for a pension plan. The paper extends the investigation of the impact of survival uncertainty for life annuity portfolios and for a guaranteed annuity option in the case where interest rates are stochastic. In a framework in which insurance companies need to use internal models for risk management purposes and for determining their solvency capital requirement, the authors consider the surplus value, calculated as the ratio between the market value of the projected assets to that of the liabilities, as a meaningful measure of the company’s financial position, expressing the degree to which the liabilities are covered by the assets.     

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.     

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.     

Life insurance companies as investment managers: New implications for consumers

This paper examines the attractiveness of the equity portfolios of life insurance companies as an alternative investment to mutual funds. In particular, this study analyzes the risk-adjusted investment performance of the stock portfolios of life insurance companies, attributable to their stock selection and market timing abilities. Using conventional measures of risk-adjusted portfolio performance, we find that life insurance companies exhibit performance similar to mutual funds. The evidence suggests that the life insurance companies, like their mutual fund counterparts, fail to exhibit differential stock selection or market timing abilities that are statistically significant. While the risk-adjusted investment performance of the two investment vehicles is similar, the variable annuity contracts of life insurance companies may offer an edge over mutual funds due to their ability to defer taxes.