As Warren Buffett is fond of saying about the recent financial meltdown, when the tide goes out you see who’s been swimming naked. Commonly accepted assumptions about the behavior of markets and people have been called into question. A new reality has emerged. And it’s going to take a while for things to sort out.
Nowhere is this more true than with respect to variable annuities (VAs). VAs have been made and marketed as ways to participate in the financial markets through investment portfolios diversified among stock, bonds, and other instruments, with protection against severe, sustained declines in the market. Until recently, diversification along these lines has worked pretty well.
However, as Ken Mungan and Deep Patel point out in a recent article, the VA business contains several market-sensitive elements that make them vulnerable during times like the recent past, when across-the-board declines dilute the protections of standard diversification. Clearly, if it is to succeed, the life insurance industry will have to fundamentally change the way it creates and manages variable annuities.
Although “insurers have taken many actions to address these issues . . . all of these actions assume the continuation of the existing VA business model.”
Instead, Mungan and Patel think an entirely new approach is needed—”The Sustainable Manufacturing Model”—which seeks to escape high volatility and unsustainable risk by including capital market hedges directly with VA funds, targeting volatility directly as a goal (rather than using equity allocation as a proxy for risk), and redesigning guarantees to reduce interest rate risk.
As simple as this sounds, Mungan and Patel realize that implementing the model faces many challenges—material, technical, and not the least, human. It will require, that is, a fundamental change in the way we look at assessing and assigning risk.