It should come as no surprise that increasing longevity poses challenges in countries with strong public pension systems. Spain, my native country, provides an excellent case study: streamlining the Spanish public pension system will be critical to safeguard its sustainability – and to provide much-needed supplemental income.
Life annuities present one answer, yet demand for annuities in Spain is lagging. In fact, the majority of insurers are unwilling to generate sufficient life annuity supply, both due to the challenges of longevity risk management and the high capital requirements under the Solvency II framework.
The traditional sales model also contributes to this stagnation. Put simply, to succeed, the process for selling life annuities must change in countries such as Spain. Life annuities should be offered only within a broader advisory process and as part of package of solutions. Instead, too many insurers present life annuities alone and push the sale of a product that, in itself, is difficult to market.
Success also requires greater education. Insurance customers must recognize that saving for retirement is a long-term commitment. It is necessary to diversify income sources, combining the public pension with private capitalization products, to generate replacement income when we are no longer active in the economy.
Meeting the Regulatory Challenge
The market for annuities has become more hospitable as state-sponsored measures seek to make public pension systems more sustainable in an aging world. Consider recent reforms to the Spanish public pension system, including the introduction of a sustainability factor (SF), the initial consequences of which will be visible starting in 2019. The SF adds two new variables to the calculation of the public pension – the intergenerational equity factor and the annual revaluation factor – to current considerations (retirement age, years of paying dues, and dues base).
These reforms acknowledge an unfortunate reality: the public pensions today's Spanish wage-earners can expect to receive will be lower than those of our parents. Therefore, if we want to maintain our standard of living, it will be necessary to save more during our working years to increase income in retirement.
The state has provided a favorable tax system to encourage purchase of life annuities. For example, starting at age 70, annuitants can expect a tax bonus of 92% in IRPF (individual income tax); the taxable base to be consolidated is 8% of the annuity received, reducing the actual tax rate to very low levels. The Spanish public pension system also offers a tax benefit on accumulated capital gains in the pension plans, with an exclusion of up to €240,000 for taxpayers over 65 as long as they reinvest those capital gains in a life annuity.
Classifications of permitted life annuities can be very extensive and flexible, and depend on payment frequency, beginning date of the annuity (deferred or immediate), and the number of people covered. Enhanced annuities are also possible; to qualify, the purchaser's state of health or medical history must be such that their life expectancy is lower than that of other annuity purchasers.
Meeting the Demand Challenge
So, why then isn’t there higher demand for life annuities in Spain? There are three causes: lack of a savings culture, lack of an advisory process that emphasizes educating the consumer as well as selling the product, and lack of competitive offers from the insurance companies themselves.
The objective of this article is not to study, in depth, the absence of a savings culture in my native country; however, I do want to highlight the need to develop a basic understanding of finance and a culture of preventative savings. From my point of view, companies should place the sale of life annuities within a process of advice to the customer. It is necessary to sell life annuities as an answer to a need, complementing the income of a future public pension. It also will be vital to understand if the client is close to accessing funds saved throughout his or her working life.
The advisor must understand each client's financial situation and goals. Does he or she expect an immediate predetermined future income? Or does the client plan to build savings in order to receive that additional income in the future, either through a deferred annuity or the combination of savings products with an immediate life annuity on the retirement date? In any case, it is always important to ask the client what level of net income he or she expects to enjoy in the future.
Additionally, there is a general perception that life annuities are purely actuarial, a financial strategy that cannot enable an earner to leave capital to heirs as inheritance. Nothing could be further from the truth. It is important to dispel this myth by asking insureds about funds they wish to leave to their heirs, and then to select the recommended annuity accordingly.
Such advice also should be based on an investment advisory service protocol (published by the CNMV in 2010) or a MIFID advisory protocol for investment funds. This way, the client will perceive the insurer as an adviser and financial partner, helping secure a strong financial future. Many institutions do not operate within this process.
Meeting the Economic Capital Challenge
Another very important consideration is the lack of annuities available in the Spanish market. Very few direct insurers in Spain are really active in the sale of life annuities; in fact, existing offers have very high amounts of capital to be inherited by the insured’s family. Additionally, Solvency II imposes through the standard formula a shock that generates a lot of economic capital and raises the risk margin (which reduces the own funds of the S-II economic balance sheet). Spanish law requires specific assets backing specific liabilities, in such a way that these assets also generate economic capital due to market risk. This makes life annuities, from the viewpoint of economic capital and of the return on risk-adjusted capital (RORAC), less attractive.
How can we optimize this economic capital? There are several alternatives, among which reinsurance has an important role:
- Design the product so that the income is similar to a financial income instead of an actuarial one.
- Develop a highly diversified risk portfolio, so that the impact of correlation reduces the capital charge as much as possible.
- Execute a longevity swap with a reinsurer, which reduces the longevity risk SCR to a maximum and has a positive impact, reducing the risk margin.
- Utilize asset-intensive reinsurance in such a way that it is possible to eliminate a material part of the longevity and market S-II required capital .
- Turn to another reinsurance product, in the form of stop loss, which is centered on the exclusive elimination of the S-II required capital derived from the longevity risk. In this solution, there is no total transference of the longevity risk (full risk); only a material part of the remote longevity risk inherent in the Solvency II shock is transferred. It has a much lower cost than a longevity swap, and is effective from the viewpoint of cost and capital reduction.
It is important to note that, in Spain, given the different perception of longevity assumptions between direct insurance and reinsurance, the viability of the reinsurance solutions for life annuities is not the best when we speak of in force portfolios. However, reinsurance can help design an efficient new business income product that helps cedants to reduce volatility in the future income statement and optimizes the impact of the Solvency II required capital – all without any negative impact on the calculation of technical provisions, which in turn would affect the profit and loss account. From my point of view there is space for new business as there is high elasticity price in the annuity products in Spain as there are no insurance aggregators or any other type of tool to compare annuity prices for policyholders.
In conclusion, given the reforms in Spanish public pensions, it is necessary to increase long-term savings in a diversified manner if we want to maintain at least the same purchasing power as our parents. One of the most effective ways is to encourage payment in the form of a life annuity as a protection against longevity risk.
However, the life annuities offer has to be improved and expanded in Spain, emphasizing the process of advising the insured and optimizing the capital requirement of Solvency II. Adequate information and risk coverage instruments must be developed to facilitate the treatment of longevity risk. Many solutions exist to improve life annuities, with the development of new business via reinsurance being one of the best.