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Two researchers have posted a major new working paper on variable annuity contracts that come with minimum return guarantees.

The researchers — Ralph S.J. Koijen, an economist who teaches at New York University’s Stern School of Business, and Motohiro Yogo, an economist at Princeton University — wrote the paper to fill what they see as a major gap in the economic literature: a lack of research on variable annuity contract guarantees.

Researchers have published many papers about mutual funds that offer no guarantees, and they have also published papers about insurance products that protect the insureds against “idiosyncratic risk,” such as the risk of illness, or the risk of death, the economists write in their paper.

Those papers fail to reflect how life insurers’ business has changed, the economists write.

“The main business of life insurers is now savings products that insure market risk through minimum return guarantees,” Koijen and Yogo conclude.

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Return guarantees account for a major share of life insurer liabilities in Austria, Denmark, France, Germany, the Netherlands and Sweden as well as in the United States, the economists say.

The economists have published their working paper, or early version of the paper, behind a paywall on the website of the National Bureau of Economic Research.

The paper is likely to get attention from other academic economists, and from economists involved in policymaking, because Koijen and Yogo are widely published, frequently cited scholars.

A paper on “shadow insurance” that Koijen and Yogo published in Econometrica in 2016 has been cited by other scholars 58 times. A paper on life insurers’ “financial friction” that they published in the American Economic Review in 2015 has been cited 85 times.

 A link to a full version of the paper is available here.

Here’s a look at five highlights from the paper that might be of interest to life insurance agents and brokers.

1. Koijen and Yogo assume their readers know almost nothing about variable annuities.

The economists assume that their readers understand terms such as “financial friction,” “market incompleteness,” and “strictly positive stochastic discount factor” without any explanation.

Dollar puzzle (Image: Thinkstock)

(Image: Thinkstock)

They assume that the readers need explanations of terms such as the National Association of Insurance Commissioners, A.M. Best and risk-based capital ratio.

“Insurance regulators and rating agencies use risk-based capital as an important metric of an insurer’s financial strength,” the economists tell their economist readers.

One implication of that approach is that, in some cases, the economists reading the Koijen-Yogo paper may be seeing the term “variable annuity” for the first time. Even if the readers have heard of variable annuities, Koijen and Yogo may be giving them the vocabulary and definitions they will use to think about the products in the future.

2. Koijen and Yogo describe variable annuity guarantees in terms of the options market.

From the perspective of an economist, to a life insurer, “minimum return guarantees are long-dated put options on market risk.”

That means that the consumer gets the right, but not the obligation, to sell the assets in the variable annuity contract at a specified price within a specified time.

3. Koijen and Yogo assume that other economists will wonder why life insurers don’t just use financial derivatives contracts or other arrangements to “hedge,” or reduce, their own guarantee risk.

Koijen and Yogo write that insurers have kept much of their guarantee-related risk on their own books for a number of economic institutional reasons.

Limits on their liability, and access to state guaranty associations, reduce life insurers’ incentive to hedge.

Because life insurers tend to have their assets locked in better than other players, they may be better at supporting the guarantees than the other players that could, theoretically, assume the guarantee risk.

Variable annuity guarantee periods often last longer than standard financial derivatives contracts, and mismatch in time periods leads to uncertainty.

Differences between statutory accounting rules and the Generally Accepted Accounting Principles (GAAP) rules that public companies use may make a hedging arrangement that looks good under one set of rules look bad under the other set of rules.

Life insurers can use reinsurance arrangements to get guarantee obligations off their books for statutory accounting purposes.

4. The Great Recession had a big effect on what life insurers think about their guarantee obligations.

Koijen and Yogo use large data sets to document and flesh out the argument that life insurers pulled back from offering guarantees, and increased the cost of the guarantees they still offered, after the 2008 financial crisis.

From 1999 through 2008, for example, variable annuity sales increased roughly in sync with mutual fund sales.

From 2008 to 2014, variable annuity sales fell even as mutual fund sales rose.

The average fee on the guarantees available increased from 0.59% of account value in late 2007 to 0.96% in mid-2009, and to 1.08% in late 2015, the economists write.

5. Economists can develop, and test, formulas to show how changes in variable annuity reserves, rollup rates and contract values interact.

Koijen and Yogo came up with a model that seems to show, for example, that fees and guaranteed death benefits have a much bigger effect on variable annuity demand than the number of investment options available.

—Read Fed Bank Fearful of Insurance Risks on ThinkAdvisor.

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