Variable Annuity Guaranteed Minimum Withdrawal Benefit (GMWB) Features in a Challenging Market

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The economic crisis has led to major challenges in the pricing of new variable annuity (VA) business. To help VA writers navigate the evolving market, the current issue of Pricing Variable Annuities — Insights provides a broad overview of pricing methodology in VA living benefit riders with particular focus on the GMWB feature, as well as key findings from Towers Watson’s 2009 Variable Annuity GMWB Rider Pricing Methodology Survey* and Life Insurance CFO Survey #23.* Following are some of the highlights.

Impact of Financial Crisis

The economic crisis led to a VA sales downturn in the latter part of 2008, with further declines in 2009 annualized sales amounting to 20%. Historically, sales growth has always returned after a slowdown, and there is already some evidence that VA sales are stabilizing.

However, as VA sales declined, the GMWB rider became more critical, and companies faced the challenge of reflecting a provision for hedging in pricing.

Pricing Approaches

In general, the rider’s hedge cost is calculated using risk-neutral (sometimes referred to as market-consistent) scenarios:

• Most commonly, the cost is expressed on an annual basis as either a percentage of the benefit base or the account value.
• A few companies attempt to more closely reflect the actual incidence of hedge timing.
• Some companies try to mimic the impact of hedging on specific adverse scenarios, applicable primarily in tail measures.
• The provision for hedging is then incorporated into the base product pricing using real-world scenarios.
• A few companies — generally those that employ a market-consistent framework to manage their business — fully price the product using risk-neutral scenarios.

Types of Hedging

Our GMWB Survey showed that the majority of companies price assuming three-Greek hedging (delta, rho and vega). In general, companies determine hedging cost based on their own hedging strategy, i.e.:

• Companies that price assuming full three-Greek hedging often execute a full three-Greek hedging strategy.
• Exceptions include cases in which companies actually hedge less than three Greeks but assume that more Greeks will be hedged in the future.

Risk-Neutral Scenarios

The primary approaches to generating risk-neutral scenarios are as follows:

• Using current market conditions
• Using long-term estimates

Half the survey respondents set pricing assumptions based on “then current” market conditions; the other half use either long-term estimates or a blend of these two approaches.

However, since economic conditions change daily, and hedging costs generally are not locked in over the lifetime of the product, profitability projections for business priced today can be stale by tomorrow. Consequently, companies need to perform multiple sensitivity tests under various market conditions.

Given that market conditions frequently change, companies need to consider:

• Developing a company position on the long-term economic assumptions on which risk-neutral scenarios are created
• Pricing their products to meet targeted profitability levels with long-term estimate assumptions
• Assessing profitability periodically (e.g., monthly) at current market conditions

Risk-neutral scenarios for full three-Greek hedging are based on implied volatility; however, these levels are not observable past certain tenors.

Current methods companies use to set implied volatility at later tenors include:

• Grading from longest-credible market-observable tenor to a target value (the most common)
• Holding level at the longest-credible market-observable tenor
• Using level volatility throughout

Setting Capital

Ideally, companies would use the same methodology for setting capital levels in GMWB pricing that they use for point-in-time valuations: a stochastic-on-stochastic framework. However, this approach is not yet prevalent, primarily due to lack of computing power. For now, most companies employ factor-based approaches:

• Common industry practice leverages off C3 Phase II results, using either a multiple of CTE(90) or the CTE(98) value.
• Some companies use their internal economic capital formula.
• The level of sophistication varies, with some companies using factors that vary by key drivers such as duration, “in the money” level and issue age.

A further consideration is whether the capital charge is based on:

• A stand-alone product
• All new VA business issued  
• Combination with a larger block of business (i.e., all GMWB in force)

Finally, the degree of diversification benefit versus other risks must be considered. Most companies surveyed indicated they hold an average of between 1.0% and 1.9%, or 2.0% and 2.9%, of account value in pricing.

Hedge Effectiveness

Nearly half the companies surveyed assume 100% hedge effectiveness for mean pricing; however, we find this overly optimistic and recommend hedging effectiveness assumptions of no more than 85% to 90%. For capital, half the respondents indicated an assumed level of hedge effectiveness of less than 75%.

We expect companies to continue monitoring the level of hedge effectiveness and to use recent results to determine whether they should update pricing assumptions.

Industry Response

During the economic downturn, many companies altered their products dramatically. Many new product releases involved de-risking through:

• Significant fee increases
• Removing or scaling back costly features, often the roll-up benefit
• Modifying features such as the minimum age for 5% lifetime withdrawals
• Adding or enhancing asset allocation restrictions
• Not allowing allocations to overly volatile funds or those not tracking well to selected hedging indices

Despite these changes, however, GMWB features remain fairly rich and continue to expose companies to some equity market risk, albeit at lower levels than earlier products.

Going Forward

We see several areas of activity industry-wide:

• Product redesign on a de-risking theme
• Probable continuation of de-risking, though favorable economic conditions could tempt the industry to move back toward offering richer features
• Focus on total fee and charge levels — finding the right benefit/cost mix to keep products accessible to a broad range of customers  

In general, companies are now doing more complete market-based analyses of the key factors underlying VA rider pricing — which enables them to better understand risk versus reward trade-offs.

*Originally published by Towers Perrin, © 2009