Question from Ross Johnstone
Could we please have informed comment on the (in)security of purchased annuities? It seems to me there is unjustified belief that they are a safe investment for those who seek them, however, nobody can be assured that the many assumptions made by actuaries, auditors and managers of vendor companies will turn out to be correct. They are very risky especially as the payouts will cover many years with many unknowns.
Response from Jeremy Cooper, Chairman, Retirement Income, Challenger
In Australia, annuities can only be issued by life insurance companies that are prudentially supervised by APRA, the Australian Prudential Regulatory Authority.
While no investment is ever completely risk-free, life insurance products, including guaranteed annuities, are highly secure investments because of a robust framework of legislation and prudential standards, an effective and targeted supervisory process and a strengthened and well-resourced regulator with appropriate interventionist powers.
Most recently, these investor safeguards have been supplemented with the introduction of a regulatory capital regime tougher than that imposed in North America and Europe, post GFC.
Capital is the cornerstone of a life company’s strength and the adequacy and sustainability of this capital is the focus of APRA’s regulatory framework. Currently, APRA requires life companies to hold enough capital to withstand a 1 in 200-year shock event, which represents a 99.5% margin of safety over a 12-month period. That is, life companies must keep aside enough capital to withstand the events of the next year with only a 0.5% chance of default.
It is generally accepted that the GFC was around a 1 in 70 year event, and no annuity provider in Australia was required to raise equity capital to achieve regulatory minimums.
So the safety of an annuitant’s claim on the issuing life company does not depend on any assumption by actuaries, auditors or anyone else. The safety for policy holders actually comes from being compulsorily prepared for events to be very wrong (the 1 in 200-year event). When the bad event doesn’t occur, the life company’s shareholders will get a return, and they provide the capital buffer in case it does.
An under-appreciated safety valve for lifetime annuitants is the buffer of shareholder capital that sits between them and the underlying investments of the life company.
The Life Insurance Act 1995 expressly deals with the possibility of failure of the life company by requiring that the premiums paid for annuities and additional capital are ‘ring-fenced’ in a separate account called a ‘statutory fund’ held by the life company. The statutory fund is specifically intended to outlive the life company in the event of it encountering financial difficulties.
When annuities are issued, extra capital must be put in as a buffer to protect policyholders. This capital is provided by the life company (i.e. its own shareholders’ equity) and any claim the life company has on this capital ranks behind the policyholders.
This is a unique feature of annuities: shareholder capital is there to protect policyholders in the event of a fall in the value of the assets backing the annuity.
APRA can even direct a life company to raise more of its own capital to contribute to the statutory fund under expanded powers given to it by legislation in 2010.
If a life company wishes to hold riskier assets than the usual government and investment grade corporate bonds, APRA requires more capital to be held against those assets under its risk-weighted approach. This approach takes into account a range of risk factors that might adversely impact a life company’s ability to meet its obligations and includes: insurance risk (e.g. increasing longevity); asset risk (e.g. adverse market movements); asset concentration risk (e.g. too much exposure to a particular asset or counterparty); and operational risk (e.g. exposure to loss from internal processes or external events). In addition, APRA can impose a ‘supervisory adjustment’ requiring even more capital to be held if it is of the view that there are prudential reasons for doing so.
While necessary to give the complete picture, this discussion of riskier assets is probably misleading. The assets backing annuities are typically conservative: investment grade bonds, high quality property assets with long-term leases to creditworthy tenants and a small amount of infrastructure creating inflation-adjusted cash flows. In fact, the fixed income portfolio of Australia’s leading annuity provider includes more investment grade debt than do the balance sheets of the nation’s big four banks.
Lifetime annuities are by nature long-dated liabilities, allowing a life company to invest in financial assets with long-term cash flows and longer tenor, making them one of the few institutional investors capable of earning duration, or illiquidity premia. These assets are typically held to maturity, so while market movements can impact their market value in the short term, short term fluctuations do not impact the underlying cash flows available to policyholders.
In fact, the short-term fluctuations in the value of assets and liabilities which are sometimes visible through the statutory income statement of life companies are another safeguard for policyholders and demonstrate life companies’ unique position to make and honour very long-term financial promises.
Life companies’ mark to market accounting requirements gives an annuitant better transparency than available to bank term depositors. While a life office must regularly value its financial investments at their fair value, a bank can hold an identical financial asset at par, its purchase price.
In the event that an Australian annuity provider did run into problems due to a market downturn, you could only imagine what a typical 70/30 managed fund/super investment option would look like: burnt toast.
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