Fixed-rate annuities exposed to higher/lower IR?

CFA Level III Portfolio Management
#1

Hi Brave Ones,

From what I read on LIFE INSURANCE COMPANIES I am tried to do this comment on FIXED-RATE ANNUITIES (need your help please):

  1. if IR go UP than we have DISINTERMEDIATION EFFECT

  2. if IR go DOWN than the insurance company is exposed to REINVESTMENT RISK as it is not reinvesting the cash-inflows from policyholders’ contributions at the same rate that is making disbursements to ‘other’ policyholders

I am not sure about 2)…

MANY THANKS

#2

They set their policyholder reseve rate most likely based on long term capital market expectations (so long term bond yields if that is what they are primarily investing in). In the event rates decrease, as their old, higher yielding paper begins to mature, they must reinvest it in lower yielding assets. However, they are still crediting the policyholders at the higher interest rate specified in the contract.

#3

thank you Mark,

so how can these kind of products be a good bet for the life insurance’s product mix (if they have risks associated with both IR rising and IR dropping)?

#4

It’s just like any other ALM focused IPS, you have to match durations. Too long and you risk market value risk, too short and your risk reinvestment risk.

#5

I had not looked at CFAI AM exam 2007 answers yet , but there was a question on the Insurance company selling a whole life business and buying a fixed annuity business . Given what you’re saying , I guess the increase in risk should be coming from a situation where rates drop over the life of the annuities leading to unprofitable crediting rates on the fixed annuities.

#6

Yes, but they also mention the higher liquidity needs coming from a rise in IR. So they explore both ways (disintermediation and reinvestment).