Chapter 3 Life insurance products (3) - Annuity

Question 1

Describe in detail the core structure of an immediate annuity contract (7)

List ‘other/additional features’ which one might find with such annuities (5)

Answer 1

1. Pays regular benefit, provided insured alive at time of pmt
2. Payments start immediately, no deferred period
3. Purchased by single premium, may actually be proceeds of another policy (e.g. endowment policy)
4. Customer needs
   convert capital into lifetime income e.g. pension
   protect level of future income
5. Normally no surrender value (but can be sold to secondary market in some jurisdictions)
6. Group version can be used by employer to provide pensions
7. Other features:
   May be in advance or arrears
   May be single, joint-life first death, last survivor
   May be level or variable e.g. fixed increase or inflation link
   May have guaranteed period
   Can be payable for temporary periods only e.g. pay school fees

Question 2

State key risks to an insurance company that arise from immediate annuities

Answer 2

1. Longevity risk
   including rate of improvement of life expectancy
2. Anti-selection risk: extent depends on extent of free choice available regarding purchase
3. Investment risk
   extent depends on extent of matching of annuity payments with suitable assets in market
   shortage of appropriate securities to match/meet liabilities
4. Expense risk
   higher than expected inflation
   inability of management to manage expenses
   higher than expected initial expenses when selling
5. Withdrawal/persistency risk may arise if withdrawal is permitted

Question 3

Comment on the capital requirements surrounding immediate annuities

Answer 3

Can be quite significant, as will need to set aside capital to meet a very long term liability purchased with a single premium
Depends on relationship between reserving/pricing basis
Capital strain if insurer needs to set up reserves and solvency margins higher than single premium received

Question 4

Describe in detail the core structure of a deferred annuity contract (7)

List ‘other/additional features’ which one might find with such annuities (5)

Answer 4

1. Pays regular benefit, provided life insured is alive at time of pmt
2. Benefit payments start at end of deferred period,
3. Funded by regular or single premiums
4. Customer needs
   Can be used to buid up to pension in retirement
   Lump sum instead of part/all of the annuity, meeting need for cash sum at that point (e.g. to pay home loan)
5. Typically surrender value payable during deferred period, but not normally once benefit starts/is in payment
6. Group version exists (employers for their employees)
7. Annuity choices as for immediate annuity i.e
   advance/arrears
   single/joint
   level/variable
   guarantee period
   less flexible than endowment assurance (savings vehicle) with immediate annuity starting at maturity date

Question 5

State the risks to an insurance company that arise from deferred annuities

Answer 5

1. Pre-vesting: as for endowment
   investment
   mortality
   (depending on death benefit)
   withdrawal/persistency
   expenses
2. Post-vesting: as for immediate annuity
   longevity
   investment
   expenses

Question 6

Comment on the capital requirements surrounding deferred annuities

Answer 6

1. Frequency of premium pmts
   more upfront = less capital intensive
2. Initial expenses
   higher initial expenses increase capital requirement if premium doesn’t increase
   Solvency capital requirements
   need assets to cover supervisory and required solvency capital
3. Contract design
   whether contract design allows reserves/solvency margin to remain low
   lower initial reseves = lower initial capital requirement
   slower increase in reserves over contract term, faster invested capital is release
4. Reserving basis (level of prudence)
   reserving basis stronger, requires more capital than would be required under pricing basis
5. Guaranteed terms (for converting between lump sum and pension - requires additional capital