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As longevity increases ensuring that people have sufficient finances in later life has become a greater challenge for governments, whether that funding provision involves the public or private sector, or a mix of both. Joël Wagner’s research focuses largely on the topics of risk management and insurance including recent work on long term investment products like life insurance savings contracts.
5 min read
Here he discusses how consumers are not always well placed to assess the relative merits of an insurance product, in particular of endowment policies, common in Germany, Austria and Switzerland. And, at the same time, questions whether insurance companies that offer such product are capturing the total value it offers clients in their pricing.
What kinds of financial products is your work concerned with?
Our research focuses on a type of life insurance savings product that is found mostly in Germany, Austria and Switzerland – the German speaking part of the world. It is a particular type of long term savings product offered by many insurers. There is a life insurance element and a savings element. The key features of the product are that it provides a capital guarantee or a guaranteed annual rate of interest, as well as participation in a share of any surplus profits. Ultimately the accumulated capital is typically converted into an annuity.
And your research shows that customers might not be correctly evaluating which of these type of products offer them the best value over the long term? What are the issues involved?
Insurers have faced a number of challenges in recent years. Difficult market conditions have made it more difficult to earn the required return on investments to serve their customers. Nevertheless companies have strived to offer the highest possible guarantees allowed by the regulator. At the same time regulatory interventions have introduced new solvency requirements to mandate the levels of capital held by insurers. The intention is to provide a sound level of financial safety for the customers.
That seems sensible? Especially if interest rates are falling or very low as they are in many economies at the moment.
The problem is that the competition to attract customers means that insurers are still under pressure to offer the maximum amount level of guarantee that is allowed. So in Switzerland and Germany you have had interest rates from government bonds at close to zero or even negative interest rates. But the maximum interest permitted was about 1 or 1.5%, even though net interest rates in the economy were significantly lower.
Customers looking for the best possible product on the market are often persuaded by higher guaranteed rates. However, our research shows that this investment strategy is not in the interests of customers in the long term. As our work shows there are alternative approaches with products including lower guarantees that can produce better returns for customers in the long term.
Why is that?
The difficulty for the insurers (and their customers) is that the offer of guaranteed interest at relatively high levels is tied to restrictions regarding the levels of capital that the insurers hold and the types of investment that they can make to keep their safety level. The regulatory idea is to protect customers, limit risk taking, and try to reduce the chances of the financial failure of the insurers.
A company that offers a higher guaranteed return will be more limited in the way that it invests its assets in an attempt to realize the promised returns. For example, the provider may have to balance its investments towards less risky government bonds rather towards shares which would provide a better (if riskier) return.
In theory if the investments are not as risky, they will not provide as good returns relative to other investment approaches. The insurer will make less profit and there will be less profit shared out in any distribution of profits.
In addition, such a low risk approach will make the insurance company less attractive to investors, who in turn will be less inclined to invest in such firms, and this will cause problems in the industry as a whole.
And low risk investments are not necessarily low risk either?
No. It is worth remembering that government bonds are not always without risk, for example, as the financial problems in Greece have shown. Indeed if the result of the regulator’s actions is to have all insurers act in similar manner then this also carries some risk. If regulatory measures encourage all organizations to invest in government bonds, there could be a bubble on the bond market, for example. So while regulation is necessary there still needs to be sufficient freedom for organizations to diversify. You don’t want to create one set of risks by trying to avoid another set of risks.
Also, as far as the customer is concerned, there are transaction costs. These types of costs are under scrutiny for example in the EU and there is a lot of pressure for greater transparency. But if a sophisticated customer is paying transaction costs for low risk investment in government bonds they might as well invest directly in the underlying asset and avoid the transaction costs.
So what did your modelling suggest was the best investment approach for customers in these types of products?
The main finding was that if an insurer promised less in terms of guaranteed interest rates, it then had lower liabilities, and had more investment freedom. By taking greater risks with its investments it was able to offer customers a relatively better return overall, when the profit sharing at the end of the year was taken into account.
Importantly, there is a safety net for the customer as there is still a guaranteed interest rate return, as well as participation in the profit that the insurer makes.
It also makes the insurer more attractive to investors and so benefits the industry.
What other issues have emerged from your research work?
One issue was that the companies need to be more aware about the financial value of the products that they are providing. What is the cost of capital of the benefits that they are providing?
When there was a significant gap between the return on capital that the insurers could obtain and the amount that is guaranteed to the customer, there was little incentive to accurately calculate the value or price the benefit of having a guaranteed return over a period of time. Or to calculate the value of the terms under which the product is offered, such as the right to have a payment break, for example.
However, in a low interest rate environment the industry must more correctly price the benefits included in the products offered. On the one hand, they have to get rewarded for the benefits offered. On the other hand, the competitive environment does not allow for (over)pricing with large margins any more.
You work with many companies in this industry. What are your main messages to the insurers at the moment?
They need to be attentive in the next years, to refining and developing the best product with the right elements. The combination of life insurance and savings in a single product is quite an USP. With the right guarantee offering insurers will be able to still attract customers.
And also they need to really understand the financial value of the product that they are selling. Currently, it is still something of a black box situation, with aggregate numbers not offering sufficient visibility on costs and pricing.
Related research paper: Policy Characteristics and Stakeholder Returns in Participating Life Insurance: Which Contracts Can Lead to a Win-Win? (2016). HEC-DSA Working Paper. By Joël Wagner, Professor of Actuarial Sciences, HEC Lausanne and Charbel Mirza, HEC Lausanne.