Guaranteed death and living benefits combined with equity-linked products provide good protection to consumers in the event of poor market performance, but they represent a risk to the industry that must be adequately priced and prudently reserved. By Michael W Pado.

In many parts of the developed world, equity-linked financial products contain elements of insurance in which the issuer guarantees that the policyholder (or their beneficiary) will have access to a minimum benefit level should one or more insurable events occur. The insurable events can relate to death, disability, critical illness or unemployment. Other guarantees sold in the market are more financial in nature, but nonetheless are still considered to be insurance from the policyholders' perspective. These products provide protection against market under-performance over time. All but death benefits are, of course, considered as living benefits. They are often referred to as guaranteed minimum death benefits (GMDBs) or guaranteed minimum living benefits (GMLBs).

These guaranteed benefits do not exist in and of themselves. In the US they are most often designed into tax-advantaged insurance contracts known as variable annuities. The market for variable annuity contracts is large, structurally sound and generally growing. It grew by nearly 23% per annum to $137.1bn during the 1990s before losing ground in 2001 due to poor global equity performance.

Such contracts have an accumulation phase during which policyholders save money for retirement and an optional payout phase when policyholders can convert their future cash value into a lifetime income annuity.

During the accumulation phase, GMDBs are designed into each and every contract sold, while GMLBs are typically offered on an optional basis for an additional premium. The most basic GMDB provides the beneficiary with the shortfall between the initial premium deposited and the current account value upon death; it is known as the return of premium GMDB. There are, of course, variations on the theme. Typically, the insurer is on the risk for long periods as the average issue age is late 50s to early 60s and the contracts remain in force until the policyholder terminates his or her contract by virtue of surrender, death or annuitization.

This is not just a US phenomenon. In Canada, these types of guarantees are included within regulated products known as segregated fund contracts. These require that the contract provides for a minimum death benefit and a guaranteed maturity benefit over the ten-year horizon following contract issuance. In France, they exist within equity-linked contracts known as guarantie planche.

The costs associated with providing these guarantees tend to vary with the type and richness of guaranteed benefit being offered. In most cases, the charge within the retail product is expressed in terms of basis points and is usually applied to the policyholders' account value. It is perhaps beneficial from the consumer's perspective but tends to be somewhat problematic for the insurer as the revenue structure is at odds with the risk amount. The risk amount is generally defined as the difference between the guarantee and the account value. It starts at zero upon policy issuance and then varies over time depending upon the level of the guarantee as compared to the level of the account value: should the account value drop (due to poor market performance), the revenue decreases while the risk amount increases.

The reinsurance market for such risks is somewhat small as the risk taker must be willing to accept a commingled risk comprising policyholder behaviour (death, surrender annuitization) and capital markets performance. The risks associated with policyholder behaviour are diversifiable, while those related to capital markets performance generally are not. Those that tend to reinsure the risk have specialized underwriting and risk management teams dedicated to the business and tend to do so on a non-proportional basis involving claim and capacity limits.

At AXA Corporate Solutions Life Reinsurance Co (AXA CS Life), the process tends to start during the client's product design phase when the risk/reward trade-offs between various benefit designs and other contract features are discussed. It concludes with an agreement that provides for risk sharing within certain bounds. Risk sharing ensures that both parties have an alignment of interests and encourages full disclosure.

The systematic nature of the capital markets risk component tends to suggest that various forms of hedging are appropriate to help manage the risk and thus limit the amount of capital deployed to support the business. In order to manage the business, one must first be able to monitor the business. Hence, the importance of the timely receipt of credible policyholder data and fund data cannot be over-emphasized.

Guaranteed death and living benefits added to equity-linked products provide good protection to consumers in the event of poor market performance. At the same time, they represent a risk to the direct writers and/or their reinsurers that must be adequately priced and prudently reserved for in order for the guarantees to be of any value.

Breaking with tradition
As competition in the life markets continues to grow a number of players are increasing, exploring niche life and health markets. Across the US and Canada, AXA CS Life now provides risk management solutions to a select group of life and health niche markets, including group life and disability, critical illness, medical, corporate/bank owned life insurance COLI/BOLI and individual life.

In collaboration with New Jersey-based health risk analytics firm, Continental Underwriters Ltd, AXA CS Life moved away from participating in traditional reinsurance programs such as excess or first dollar medical programs or specific and aggregate stop-loss programs, to concentrate on developing aggregate reinsurance programs for HMOs, health insurance companies and other entities that provide healthcare insurance. The risks covered include the cost of provision of care for insureds within the covered population with a particular disease, or the costs of providing a series of services such as imaging or orthopaedic services to a large covered population.

The market for this type of reinsurance coverage is ever expanding as entities that provide healthcare insurance develop new ways of delivering care and managing its costs. The main driver for the desire to reinsure these risks is to limit the potential volatility associated with medical costs. Each program is specifically tailored to meet the structure of the arrangement and the client's protection needs.

Programs such as the one AXA CS Life and Continental Underwriters are working on often takes longer to develop than traditional aggregate excess programs due to customization, the number of parties involved (the transactions often include medical or disease management companies as well as the underlying reinsured) and the extensive due diligence, verification of data and actuarial analysis that must be performed. Ongoing monitoring of claim incidence and cost trends, however, is still just as important. The resulting reinsurance contracts have lasted for many years. Besides hard work, a key underwriting factor is that all parties involved have aligned incentives.

The outlook for this type of reinsurance coverage is very promising, but there are still very few reinsurers that currently provide this type of coverage.

Situation critical
Critical illness products now hitting the marketplace are at the cutting-edge and fill a serious coverage gap existing in established health insurance products. Most health plans in the US are forms of `indemnity insurance' which reimburse a `reasonable and customary' portion of cash outlays made to pay for medical services. These plans typically do not cover substantial short-term indirect costs associated with severe illnesses such as treatments viewed as "experimental", the cost of travel and lodging while receiving care, housekeeping and childcare assistance, or home-modification. In terms of long-run financial security there is substantial economic damage to the family of a patient which survives a critical illness - lost future earnings due to a disrupted career path, interruption and permanent reduction in the funding of college and retirement goals, and ongoing special expenses to accommodate an altered lifestyle. Critical illness insurance fills these gaps.

Competing successfully in a new market, however, requires cutting-edge expertise, particularly when there isn't a well-established statistical database on which to make underwriting and pricing decisions. This is even more relevant to critical illness insurance, since the incidence of various medical conditions is dependent on local factors. Pricing US-based risks using foreign data or stale information can turn an opportunistic product offering into a gamble or worse. Research of the most up-to-date US clinical statistics for various conditions and developed appropriate pricing and underwriting for the US marketplace, in combination with analysis of various channels and designs such as worksite-marketed, `true group', individual stand-alone, and life insurance benefit acceleration, tailoring the results to each market, is the only way to avoid this.

Past slow sales of critical illness insurance are an artifact of several historical factors. The first is a lack of awareness on the part of both the general public and insurance advisors as to the large financial risks associated with surviving a critical illness. The second has been the recent surge in medical advances - certain diseases were fatal so one only really needed life insurance. Furthermore, reliance on out-of-date or foreign data has required direct carriers and reinsurers to price critical illness conservatively, making early product offerings unattractive. The variety and disparity in `disease definitions' has made the product confusing.

As the critical illness product has now stabilized around relatively standard disease definitions, advances in medical technology make surviving a critical illness more likely, and as the baby-boomers have aged, the key remaining factors to the success of the critical illness product are education and appropriate US-based research data.

By Michael W Pado

Michael W Pado, FSA, MAAA, MBA is president and CUO of AXA Corporate Solutions Life Reinsurance Co in New York; Donna R Jarvis, FSA, is vice president of Reinsurance Solutions Life & Health at AXA Corporate Solutions Life Reinsurance Co in New York, and Leonard Mangini, ASA, MAAA, CLU is assistant vice president of Reinsurance Solutions Life & Health at AXA Corporate Solutions Life Reinsurance Co in New York.