From my perspective, this unprecedented environment is emphasizing two previously-obscure concepts which lead to diametrically opposed effects. Let me explain.
First, any financial advisor that shunned GMWB-type products in the last few years simply because they were expensive or charged an extra 100 basis points in fees is looking pretty foolish after a 40% drop in equity prices. For their sake, I hope clients don’t remember the conversation in which that particular product was dismissed.
You see, here is some simple arithmetic to illustrate just how deep in-the-money (i.e. valuable) these “FinSurance” options have now become.
A single premium life annuity that pays $5,000 per year for life, issued to a 65 year-old buyer, would cost approximately $67,000, based on recent prices from any garden variety insurance company. Obviously, if you invested $100,000 in a GMWB product last year, that promised 5% for life, your put option was out-of-the-money by about $33,000. Indeed, many have scoffed at the meager guaranteed $5,000 for life, since you could secure this guaranteed income for much less in the pure SPIA market.
But, remember, the $100,000 bought you some upside potential in the market and some bonuses on the guaranteed base. Let’s assume you bought the GMWB and allocated your deposit to the aggressive 80/20 equity/bond fund, which was exactly the way to maximize the value of the guarantee, ex ante.
Now, say, your portfolio is down 40% and your account is only worth $60,000. This is quite painful and I sympathize deeply with these investors. But now it’s important to remember that your put option is in-the-money. This is precisely why you paid for protection; a mere 100 or so basis points in addition to management fees. Your quarterly statement might only say $60,0000, but the economic value of your contract is $67,000 since the value of the guaranteed life annuity is $67,000. And, if you were younger when you purchased the GMWB and/or were credited with a bonus for the last year or two, the in-the-money value is even greater. I repeat, your $60,000 account might now be worth as much as $80,000 in economic value.
Just make sure NOT to lapse or surrender the contract and then exercise the lifetime income option. Events have vindicated those who allocated wealth to GMWB products. You bought home insurance. You had a fire. Put in a claim.
But now I start to worry about the other side of this equation…
If – and this is a big if – insurance companies have properly hedged these put options by either buying their own offsetting equity puts, or reinsuring themselves, then theoretically those hedges should be showing a profit which offset the loss on their GMWB products. Even if they have experienced some hedging mismatch (i.e. basis risk) this is likely just a rounding error on a large and diversified insurance business.
However, and this is what worries me, if they didn’t hedge a substantial portion of this exposure, and instead relied on the traditional actuarial method of reserving against this risk, the situation is messier and potentially fatal. At the end of each quarter, and especially the most recent one, they will be forced to take some money from a so-called “capital bucket” and move the funds to a “reserve bucket”. Both of these metaphorical buckets sit deep in the bowels of the insurance company’s general account.
The amount of money they move from the capital bucket into the reserve bucket depends on the exact magnitude by which markets have declined in relation to the in-the-money value I discussed above. To those of your in the derivatives business, this is (well, sort of) the equivalent of delta hedging put options by shorting stock only when the option is in the money, and ignoring the liability when it’s far-out of the money. This kind of insurance thinking makes sense when you are exposing yourself to traditional law-of-large-number liabilities, such as life annuities and life insurance. It doesn’t quite work for FinSurance guarantees.
Now, to the outside observer this whole discussion of buckets and numbers might not mean very much, especially since insurance companies are constantly moving money back and forth from one internal pot to another. However – and this is the crux of my fear – at some point they may have to move so much money into the reserve bucket, they might get close to emptying the capital bucket. And, to make it worse, if both buckets are leaking because of the heavy mortgage-back securities that poked holes inside, they might be forced to tap new shareholders (or possible government) for an infusion of new capital. This can lead to bigger problems, to put it mildly.
Of course, mere mortals don’t get to see these buckets, ever – we are just told about them in very general, obscure and historical terms.
Ok, so, what’s going to happen from here?
First, this market has completely halted any innovation or enhancements within the GLWB business. Companies that were considering adding a step-up or increasing a guarantee have shelved those plans for now, and for good reason. The next step might be to-step back from actively promoting their GLWB, and perhaps even placing some (severe) asset allocation restrictions on the account going forward. They might also increase fees on existing business – which they are allowed to do – although I’m not sure it will reduce their risk profile. It might make things worse at this point since all their policyholders will become annuitized by default. Something will have to give, soon.
Bottom line. For GMWBs it has become the best of times and possibly the worst of times.
