Last Wednesday, Prudential Financial Inc. (Baa1 stable) announced that it would take a “below-the-line” GAAP pre-tax charge of $1.7 billion, predominantly because of lower-than-expected lapses on its variable annuity block. The charge is credit negative for the company because lower lapses will lead to higher economic costs on its guaranteed benefits.
Under GAAP accounting, the value of a guaranteed minimum withdrawal (GMWB) uses market assumptions, much the way financial options are valued. Given the low interest rate environment, this results in Prudential using a very low long-term account growth assumption to value its variable annuity-related guarantees. Although lower lapses in a rising market environment may end up providing greater profitability than higher lapses would, this is not the case in a declining market environment. Lower-than-expected lapse rates during adverse equity markets and low interest rate environments — when the GMWB benefits are most valuable for contract holders and most costly for insurers — will meaningfully hurt insurers’ variable annuity product profitability.
US life insurers’ experience since the global financial crisis highlights the inherent challenge of estimating policyholder behavior regarding options embedded in variable annuity contracts with guaranteed living benefits. Although insurers regard equity market declines as the biggest risk in variable annuity contracts with living benefits such as GMWBs, most insurers effectively hedge equity market risk via derivatives. That leaves the less easily hedged and more unpredictable policyholder behavior, including lapses, being a key driver of the profitability of these popular products.
Data has shown that insurers priced many of these products with lapse and utilization assumptions that were less conservative than actual experience so far. In addition to Prudential, AXA Equitable Life Insurance Company (insurance financial strength Aa3 negative) and ING US Inc.’s life insurance companies (whose insurance financial strength ratings are A3 stable) incurred reserve charges of more than $1 billion each for adverse policyholder behavior. At AXA Equitable, lapses and partial withdrawals were lower than the company expected. At ING, lapse rates overall were lower than the company expected, resulting in additional reserves. Other insurers have taken charges of lesser amounts because of policyholder behavior that deviated from their expectations, including MetLife, Inc. (insurance financial strength Aa3 negative).