Retirement income and other products

Saving for retirement and providing an income in retirement are different needs. Personal pensions build up a fund; annuities and income drawdown offer different ways of using it. This page also considers investment platforms, equity release, takaful and microinsurance.

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Individual personal pensions

Personal pensions are contracts which enable an individual to save for retirement.

These contracts aim to provide the policyholder with a lump sum which they may then use to provide an income in retirement (perhaps through purchase of an immediate annuity or through income drawdown). Personal pensions may be structured in the form of an endowment. In some jurisdictions, the insurer may also provide additional guarantees such as a return of fund on death and/or a guaranteed annuity at maturity.

Deferred annuities may also be used as an individual personal pension product, but these are generally unpopular. This is partly due to the need for the insurer to include prudence margins in assumptions used to calculate premiums which make the product look expensive. The need for prudence margins arises because the insurer will need to estimate at policy inception the prevailing mortality and interest rates that will apply upon retirement of the policyholder, whilst terms are fully guaranteed at policy inception.

The idea of an individual portable pension is potentially an attractive alternative to an occupational pension scheme for a job-mobile employee. This may also be suitable for a self-employed person or someone whose employer does not have an occupational pension scheme.

To meet the needs of policyholders, it is desirable for the premiums payable to be variable. This is necessary to enable policyholders to cope with employment flexibility. Changes in a policyholder's salary within the same employment may also lead to changes in the level of premium.

Within limits, policyholders can choose when they retire and thus take the benefit under the contract. Policyholders therefore also need the facility to change the retirement date under the contract.

Due to the desirable features described above, the usual vehicle for personal pensions products is either a unit-linked or accumulating with-profits contract. A conventional with-profits contract could be used, but these make it more difficult to incorporate the ability to vary premiums and retirement date. Through equitable bonus declarations, it may be possible for insurers to track the underlying asset share of a policy, whatever the pattern of premiums paid. For conventional with-profits contracts, it is difficult to alter contracts in a way that achieves equitable results for policyholders. This is because previously declared bonuses are guaranteed, which makes it difficult to respond to market changes without benefiting some policyholders and disadvantaging others.

Without-profits personal pension products are unlikely to be marketable for the following reasons:

Policyholders saving for retirement need protection against unexpectedly high inflation, which will not be provided by without-profits policies (assuming they are not index-linked).
High guarantees under without-profits policies would require high levels of fixed-interest investment, giving lower expected returns over the long-term.

Personal pension taxation, legislation, and regulation is generally designed to encourage individuals to save for retirement. However, the rules in a given jurisdiction may be complex and may differ significantly from other jurisdictions.

Examples of how legislation may impact personal pensions include restrictions on the following:

When the policyholder may take the benefits.
The form of the benefits the policyholder may receive at retirement (e.g. tax-free lump sum allowances at retirement).
The assets that may be held.
The level of charges levied on the policyholder (e.g. maximum fund management charges, preventing up-front charges to be taken, imposing maximum exit penalties, etc).
The maximum fund a policyholder may accumulate within a personal pension.
The level or form of adviser remuneration on the product.

The policyholder’s perspective

Individuals take out personal pension policies to make provision for a pension at retirement and to benefit from any favourable tax treatment associated with the product. Before taking out a personal pension product, an individual should first explore the alternatives (e.g. joining their employer's occupational pension scheme) which may provide better benefits. Policyholders will typically be self-employed or work for an employer who does not offer a company pension plan.

The risks to the policyholder prior to the benefits being taken will be similar to those applicable to the underlying fund. There is the risk of the fund value falling significantly, particularly if stock market values have been falling. This risk can be mitigated by switching to 'lifestyle' funds in the run-up to retirement (e.g. by moving progressively into fixed interest and cash funds over the previous five years). However, switching to 'lifestyle' funds may be inappropriate if the policyholder does not intend to purchase an annuity at retirement.

If, at retirement, the policyholder intends to use some or all of their pension funds to purchase an annuity then they face the risk of annuity rates being worse than expected at this time. A change in tax treatment of pension products may also pose a significant risk to policyholders. Incomplete or inaccurate understanding of the choices needed to be made at retirement (including the tax implications of various options) also poses a significant risk to policyholders. For example, policyholders will be exposed to significantly increased longevity risk if they chose not to purchase an annuity at retirement.

Where permitted by legislation, greater investment choice and flexibility within a pension product can be very attractive to investment aware policyholders. However, this increased investment freedom may come with relatively high charges. Due to the higher associated charges, this flexibility is typically more suited to higher income individuals.

Pension products with very low charges may provide policyholders with better value with regards to the contributions invested. However, if an insurer is not achieving an adequate return on a product there is the risk that they may not allocate sufficient resources to the product. This may lead to poor administration of the product and subsequently poor investment experience. The same risks may apply if an insurer does not write sufficient volumes of a product for it to be viable and subsequently withdraws the product from the market. However, it is possible that the policyholder could transfer their personal pension to another provider.

The insurer’s perspective

For insurers, personal pensions represent a large, potentially profitable, market which may offer the opportunity for cross-selling.

The main risks to an insurer posed by this type of product are the following:

Investment performance (to the extent that charges are linked to fund performance and in respect of marketability and policyholder retention).
Expenses.
Persistency.
Policyholders' facility to vary premiums and retirement date (these facilities can be controlled, but doing so may detract from the marketability of the product).
The sales and marketing process, including communications to policyholders, which may lead to accusations of mis-selling.
Adverse changes in legislation and in beneficial tax treatment.
If there is an annuity component to the product, this may give rise to longevity risk, investment risk, and expense risk.
The potential for mis-selling in relation to accepting transfers from defined benefit schemes.

Insurers have a duty to ensure that the policyholder appreciates the different ways of accessing their pension fund and the implications of each option. This remains true even where an insurer is not directly providing advice to policyholders at (or just prior to) retirement. Such implications include tax implications and issues relating to health, lifestyle choices, and marital status. Insurers are required to give relevant risk warnings and must highlight the availability of the governments 'information and guidance scheme'. They may also be required to recommend taking regulated advice. Any such communications must be done in direct and simple language.

Where there are limits imposed on the charges insurers may levy on policyholders, these may have implications for the insurer's profitability. Limits imposed on expense charges will limit policyholder contributions to the insurer's actual expenses. This may force insurers to accept a lower level of profitability than they otherwise would. They may nonetheless sell the product because. they want to be seen to support a government initiative to introduce the product. they wish to offer a full range of pension products for marketing and client-relationship reasons.

Limits imposed on charges may also give rise to mis-selling risk and systems risks. Companies may need to operate separate funds if there are different charge restrictions on each. Systems may need to be updated to ensure that charge limits are not breached.

In addition to the commercial risks of selling a sufficient volume of policies, there are issues of being able to support the associated supervisory reserves and solvency capital requirements. If legislation requires insurers to accept pension contributions of very small amounts, with no guarantee that these premiums will continue, then products with limited charges will only be viable for companies to sell in very large volumes. If legislation prevents insurers from levying up-front charges, there is likely to be higher new business strain and a longer break-even period on policies sold.

Persistency risk associated with personal pension products can be significant due to the pattern of charges taken (e.g. the risk of withdrawals prior to expenses being recouped).

Group pensions

'Group pensions' here does not mean an occupational pension scheme.

Group pensions are an arrangement such as a group personal pension plan in which an insurer offers employers a facility to set up personal pensions for each of its employees.

This may be contributory (both the employer and employee contribute) or non-contributory (only the employer contributes).

The insurer would administer the personal pensions together as one scheme, but for each individual member the contract they have would be similar to that of an individual personal pension. These contracts would be subject to personal pension legislation rather than occupational pension legislation. One key difference between individual and group personal pensions is that the latter is likely to have free cover limits (if they include life cover or similar).

The sales process for a group personal pension would either be carried out on an individual face-to-face basis or employees may apply to join on the basis of the literature sent to them, perhaps following staff meetings on the topic. The contributions paid by an employer may be a fixed percentage of employees' salaries, or may be within a specified range depending on what an employee decides to contribute.

The insurer’s perspective

Insurers offer group personal pensions to provide employers a way to fund pensions for their employees.

The insurer will administer the scheme and typically acts as investment manager (though responsibility for investment could be contracted out to an investment manager).

The key risks to the insurer posed by group personal pensions will be similar to those for individual personal pensions. There is, however, the additional risk that administration of the group scheme may be more complex and expensive than expected. This is a particular risk for smaller schemes. There may also be a greater risk of mis-selling for group personal pensions than for individual personal pensions. However, as with all products, this will only pose a direct compliance risk to the insurer if their own sales people have been involved in the sales process.

There is also a risk that the average scheme size is smaller than expected, with variable charges being too low to cover the product's share of fixed costs.

One advantage of group personal pension products to the insurer is that they can be easier to sell in high volumes and may benefit from pooling of risk. However, this may also lead to greater concentrations of risk in certain areas and industries than if the insurer had just sold individual personal pension products.

The employer’s perspective

An employer may put a group personal pension scheme in place to provide pensions to employees, which may be necessary to attract and retain employees.

The main risks to the employer are the following:

Poor staff morale and higher staff turnover arising from the inability to meet employees' expectations, especially if investment experience is worse than expected.
A negative impact on employee relations if an attractive scheme has to be replaced or employer contributions reduced because the employer can no longer afford to contribute at the level agreed at outset.

The employee’s perspective

From the employee's perspective, group personal pensions are broadly the same as individual personal pensions.

However, group personal pensions may be more attractive where contributions are also made by the employer (which is unlikely to be the case for individual personal pensions).

Annuities

Annuities are contracts which pay out regular amounts of benefit.

Immediate annuities

Immediate annuities are contracts to pay out regular amounts of benefit provided the life insured is alive at the time of payment. The word 'immediate' means that the annuity payments start immediately, without a deferral period. Payments may be made in advance or in arrears and (in the US and UK) are almost always paid monthly. These contracts will be purchased by a single premium, since the purpose of these contracts is to provide regular benefit payments to the insured. This single premium may come from the proceeds of another (regular or single premium) contract, such as from a personal pension written in the form of an endowment.

Where legislation requires individuals to use a proportion of their retirement fund to purchase an annuity, this can be a key driver of demand. Immediate annuities may be purchased on a single life or joint life basis. Joint life annuities may be written on a first death or last survivor basis. Joint life annuities written on a last survivor basis can be used to provide dependents with income following the death of the main life (though this income may be a reduced amount, such as 2/3 of the full annuity amount).

Immediate annuities may be purchased with a fixed term, making them suitable for paying liabilities such as school fees of the insured's children. The regular benefit payments made by an annuity may be level or variable. Variable payments may increase in line with an inflation index or by a fixed amount to protect the insured against the erosion of benefits by inflation. Many inflation-linked annuity increases are subject to a specified cap and floor.

Immediate annuities may have the option for the benefit payments to be made for an initial number of years irrespective of whether the life insured survives the initial period. Alternatively, the present value of the remaining payments due over the initial period may be paid up front upon death of the insured. Some insurers may offer the option for any shortfall between the single premium paid for the policy and the amounts of annuity received to date of death to be repayable as a lump sum upon death of the insured. Surrender values are generally not offered on annuities due to the risk of anti-selection.

In some countries, annuities may also be offered on a with-profits or unit-linked basis.

With-profits annuities are typically made up of two parts:

A guaranteed minimum starting income.
Bonuses added each year by the insurance company. These may be reversionary (once added, the bonus applies to all future annuity payments) or terminal (the bonus is paid only in the year in which it is declared).

The starting income is usually based on an assumed anticipated bonus rate (ABR) chosen by the policyholder at outset. The starting income is then decreased each year by the ABR and increased by the addition of bonuses. If the actual bonus rate is lower than the ABR then the annuity payments will decrease. The lower the policyholder's chosen ABR, the lower the level of starting income. For a unit-linked annuity, the policyholder will normally receive the same number of units per annuity payment, but this will be a varying monetary amount as the unit values change. The policyholder would usually be offered a choice of unit funds.

Impaired life annuities

Impaired life annuities are similar to regular annuities, but with features such as enhanced annuity rates for individuals with medical conditions expected to shorten their life expectancy. For small enhancements, rating of lives is conducted on the basis of proposal form answers and medical examinations would not normally be carried out. For lives with a severely reduced life expectancy, medical underwriting would be conducted to determine the enhanced annuity rate that could be offered.

Deferred annuities

Deferred annuities are contracts to pay a regular amount each year between the vesting date and the death of the insured. If the life insured dies prior to the vesting date, it is possible that no benefit would be paid. Alternatively, a lump sum death benefit may be payable based on the premiums paid to date or reserve value. These contracts may be paid for with a single up-front premium, or regular premiums paid up to the vesting date. Where regular premiums are payable, these may be in the form of regular single premiums to give them flexibility to vary the premium paid each year.

Surrender values would generally not be payable after the vesting date, but may be payable during the deferred period. If the deferred annuity is written under personal pension legislation then there may be restrictions on whether a lump sum surrender value can be paid.

Bulk annuities

Bulk annuities are annuities offered by an insurer to a final salary pension scheme as a way to manage their risks.

The pension scheme may hold these annuities as an asset of the scheme, or may assign these contracts to individuals in the scheme in order to wind it up. In either case, there may be difficulties in obtaining annuities that precisely match the scheme's benefit promises (e.g. where benefit amounts include a minimum or maximum, or where discretion may be applied by the scheme's members). The uncertain costs of providing the benefits promised under a defined benefit pension scheme have become a major risk and the size of the bulk annuity market has grown correspondingly.

Bulk annuity contracts usually take two different forms: buy in or buy out. A buy-out contract involves the pension scheme transferring the entirety of their risk to the insurer. Members of the scheme become policyholders with the insurer. This is the more traditional form of a bulk annuity transaction.

A buy-in contract is a bulk annuity contract held by a pension scheme to insure a specified tranche of their pension liabilities. These contracts may be used by schemes that are very large or cannot afford to undertake a buy-out. Members of the scheme remain members of the scheme. These contracts are often viewed as a short-term risk management tool before progressing to a full buy-out in the future.

The policyholder’s perspective

Immediate annuities

The main purpose of an immediate annuity is for the consumer to convert capital into a lifetime income and remove the uncertainty of how quickly capital should be spent to provide income over the consumer's remaining lifetime.

Deferred annuities

Deferred annuities enable consumers to build up a pension that becomes payable upon retirement from gainful employment. At the vesting date, an alternative lump sum may be offered in lieu of part or all of the pension, thus meeting any need for a cash sum at that point (e.g. to pay off a mortgage). In practice, the same aims as a deferred annuity can be achieved (potentially in a more flexible way) by combining an endowment assurance with an immediate annuity starting at the maturity date of the endowment.

A deferred annuity may be purchased at the point of retirement to provide a guaranteed minimum income from an advanced age, with withdrawals taken from the remaining fund to provide an income until that age.

Bulk annuities

The main purpose of a bulk annuity contract is to remove or reduce the risks relating to the payment of benefits from the pension scheme (particularly longevity and investment risks). Employees may also benefit from the increased security of benefits achieved by the transfer of these risks. Bulk annuities can also be used to reduce the administrative burden on a pension scheme.

The insurer’s perspective

Immediate annuities

Risks posed to insurers by immediate annuities include the following:

The main risk with immediate annuities is longevity risk and, in particular, the risk of underestimating the rate of mortality improvement.
Similarly to mortality risk, there is an anti-selection risk. The extent of this will depend on the level of free choice policyholders had in purchasing the contract.
Investment and expense risks will also be present. The nature of any investment risk will depend on the extent to which annuity liabilities are backed by appropriate matching assets.

Annuities give rise to significant capital requirements for the insurer. Guaranteed annuity rates (e.g. for policyholders of personal pensions written as endowments) are now less common than they were in the past, due to an increasing awareness of how onerous these guarantees can be.

Deferred annuities

The risks to the insurer of a deferred annuity are effectively the sum of those posed by an equivalent combination of an endowment assurance and an immediate annuity, but with the following additional risks:

A particular issue with deferred annuities is that the insurer may be attempting to estimate future mortality over a very long period, which creates additional uncertainty.
Additional investment and mortality risks will be present at the vesting date if the terms for converting from a lump sum to an annuity are guaranteed at outset.

Bulk annuities

Relative to immediate annuities, bulk annuities pose additional risks to insurers:

There may be additional concentration of risk if, for example, the individuals covered by the policy are concentrated in one area or industry.
There may also be issues in obtaining accurate data for pricing and administering policies.

Income drawdown

Where legislation allows it, policyholders may take regular withdrawals from their accumulated pension fund after retirement, rather than purchasing an annuity, to provide them with an income. Income drawdown products were introduced to provide consumers with this facility.

On death, the remaining value of an income drawdown fund is payable to a nominated beneficiary (or, alternatively, the beneficiary may choose to continue with the existing drawdown arrangement).

In some jurisdictions, there may be limits on the level of withdrawals that may be made from the fund. In such cases, insurers may be required to conduct regular reviews to ensure that withdrawals remain within these limits. In other cases, individuals may be permitted to make unlimited withdrawals provided that they can demonstrate that they have sufficient alternative pension income.

Drawdown of capital amounts from a fund can blur the distinction between pre and post retirement. As such, products may be offered which combine a drawdown phase and a post-retirement investment with a guaranteed deferred annuity which becomes payable at an advanced age (provided the insured is still alive at that age).

Alternatively, 'phased' annuity products may be offered. For example:

The individual's fund may be split into segments.
They may start to withdraw an income from one segment of their pension fund, leaving the rest of the fund intact.
To increase their income at a later date, the policyholder could either increase their rate of withdrawal or start to draw an income from a further segment of their pension fund.
At various stages, the withdrawals could be used to purchase lifetime annuities in order to gain an increasing level of longevity protection.

Benefits of phased annuity products include the following:

Any tax-free lump sum allowances can be spread over time to provide an income, thus reducing the tax liability for a given level of income.
The balance of the pension fund not used for drawdown pension continues to be invested, thus providing the possibility of higher future income.
As the policyholder ages, there is the possibility of annuity rates rising and thus providing a higher income due to shorter life expectancy.
They give flexibility to vary the profile of retirement income to reflect personal circumstances in the future. For example, better annuity rates may be obtainable due to any deterioration in health over time. It may also be possible to choose whether to include any dependents' pensions until a lifetime annuity is purchased. This could be valuable to someone whose dependent is in poor health. Any remaining pension that is unused can be returned to beneficiaries as a lump sum (possibly free of income tax and inheritance tax) upon the policyholder's death.

The policyholder’s perspective

From the policyholder's perspective, the main risks are similar to those associated with personal pension products, particularly in relation to investment performance. Income drawdown products may, however, enable policyholders to invest in higher yielding assets for longer, enabling them to achieve a higher income in retirement than possible through an annuity. However, the policyholder will also assume greater investment risk due to uncertainty in future investment returns. This could lead to more variable income in retirement than under an annuity. Policyholders may, therefore, need to retain specialist investment advice whilst in income drawdown. This will come at a cost.

Income drawdown products are generally better suited to more financially sophisticated policyholders. There are significant risks to the policyholder if they do not adequately understand the choices they need to make at retirement and the tax implications of each option. There will be significantly increased longevity risk if no annuity is purchased and funds are withdrawn too quickly from the pension fund.

The insurer’s perspective

The main risks to the insurer are similar to those for personal pensions (e.g. investment performance and expenses). Additionally, the rate at which income is drawn down will affect the charges received by the insurer. There are also risks of future changes to legislation and taxation, and of potential mis-selling. Tax implications may be too complex for policyholders to understand and manage. The policyholder may not understand fully the type of product or the inherent risks (e.g. the risk of drawing funds down too quickly and failing to provision for longevity).

Wraps

A wrap account is an investment account which enables investors to view all of their financial assets on one platform.

These are often technology-based and are typically provided as a web-based application enabling an individual (or their adviser) to view all of their financial assets (and often liabilities) in one place. The aggregation of information has made wrap accounts popular with financial advisers, since it makes it easier for them to offer appropriate advice.

Within a wrap account, an individual's whole portfolio can be analysed and quantified in terms of monetary value, tax treatment, product type, and asset allocation. The key problem is in consolidating all of an individual's investments within the wrap. To the extent that this is not possible (e.g. due to inadequate technology or a lack of engagement between different providers), the more the key selling point of the wrap account is compromised.

In addition to bringing together shares, bonds, cash, investment trusts, unit trusts, and pensions within one platform, these products may also contain tax wrappers. Tax wrappers are arrangements that shelter investments from tax (e.g. through a personal pension or tax-exempt collective investment scheme).

Wrap accounts are used in markets including the UK, Australia and the USA.

The charges for wrap accounts are usually broken down into separate charges for the different services provided (e.g. admin, access to the platform functionality, fund management charges according to the funds chosen). These are usually levied as a percentage of funds held on the platform. The cost of any investment advice provided is usually covered by a fee directly negotiated between the investor and their adviser.

A wrap account is not itself an insurance product but life insurance products may be contained within it. Similarly, contracts sold through the wrap will not necessarily be those of the insurer - they may instead be the products of another asset manager.

The investor’s perspective

From an investor's perspective, the benefits of a wrap account include the following:

They may allow the account holder to consolidate a range of assets they have on one platform. This may also allow them to benefit from reduced charges. This will also make completion of tax returns much easier.
They are available online, giving instant information at any time.
They enable investors to adjust their investment goals at a low cost as income and lifestyle needs change.
They have simple and transparent charging structures.
They can offer considerable flexibility (e.g. whole families can organise their affairs together).

The insurer’s perspective

Wrap accounts will be attractive to insurers either because the wrap account itself is profitable, or because it enables the insurer to sell more life contracts. Investment advisers may encourage their customer base to convert to wrap accounts en masse, so insurers may develop wrap accounts in order to retain the revenue stream from existing clients serviced by such advisers (and to benefit from getting access to their entire client base). Wrap accounts may improve an insurer's persistency experience if it results in stronger relationships with customers and better meeting their needs.

Where a client consolidates their assets in the insurer's wrap account, this may lead to higher levels of charges being received than if the client had not consolidated their assets.

The risks posed to the insurer by these products will be similar to those posed by the individual products contained within the wrap. There will also be additional operational risks, especially those relating to computer systems and related customer services. The development costs of building and launching a wrap platform are significant, so there is the risk to new entrants of not achieving sufficient business volumes to make an adequate return. One of the main features on which wrap accounts compete is charges, so margins may be tight.

There is also the risk that the amount invested in a wrap account becomes so small that it is no longer cost effective for the insurer to run.

Variable annuities

Variable annuities originated in the USA as a tax-favoured savings accumulation vehicle. Despite their name, variable annuities are more similar to endowment assurances (or deferred annuities) than immediate annuities.

A variable annuity (VA) is a basic unit-linked product offering access to several funds and containing a variety of explicit guarantees, which are often referred to as Guaranteed Minimum Benefits (GMBs).

These GMBs can be either linked to the funds underlying the VA, or independent. Charges for the GMBs are taken from the unit-linked funds (along with the investment management charges).

There are four distinct types of GMB:

Guaranteed minimum death benefit (GMDB): This offers a guaranteed value on death of the policyholder. These guarantees can be quite simple. For example, they may constitute a minimum return equal to premiums paid to date (with or without being rolled up as a pre-specified rate of interest). Alternatively, these guarantees can be quite complex. For example, a minimum guarantee of the highest point the fund reached during the term of the policy or the average fund value over the past few policy anniversaries.
Guaranteed minimum accumulation benefit (GMAB): This offers a guarantee on the value of the fund, usually at a specified future date. Again, these guarantees can be quite simple (e.g. the value of premiums paid to date, rolled up at a pre-specified interest rate) or quite complex (e.g. the highest value reached by the fund over the policy's term). A common feature of a GMAB is a 'ratchet' whereby the guarantee increases each year in line with the larger of either a proportion of the fund's actual real return and a guaranteed minimum amount.
Guaranteed minimum income benefit (GMIB): This guarantee involves an accumulation phase and an income phase. The income levels are guaranteed at outset (using minimum conversion rates) regardless of movements in financial markets and mortality during the accumulation phase. These benefits are usually marketed to the retirement market.
Guaranteed minimum withdrawal benefit (GMWB): This guarantees regular income from the fund during a defined period. For example, a policyholder may be allowed to withdraw 7% of the guaranteed level (which might be the initial investment with bonuses added based on fund performance) each year for 15 years. Alternatively, a policyholder aged 60 may be allowed to withdraw 5% of their initial investment for the remainder of their life (with any remaining fund on death being paid as a death/surrender benefit to their dependents).

The policyholder’s perspective

Variable annuities potentially offer a combination of equity-based returns and underpinning guarantees. A variable annuity could be a middle ground between the customer purchasing an immediate annuity at retirement (where investment freedom is limited, but certainty over future income is greater) and income drawdown (where certainty over future income is limited, but investment freedom is greater).

However, VAs have been criticised for their high expense loadings relative to other investment products. Expense loadings are close to 3% (with rider costs) for some USA products. By contrast, VA-style withdrawal benefit guarantees on a standard index tracker fund can have charges of less than 1% (e.g. 0.4% for fund management plus 0.6% for the guarantee).

The insurer’s perspective

Variable annuities will be attractive to insurers either because the product itself is profitable or because it enables the insurer to sell/retain a greater volume of business.

Pricing and managing VA-style products can be challenging due to the interplay between different investment and insurance risks (e.g. the relationship between investment performance and policyholder behaviour). For example, policyholders may be more likely to lapse when their guarantees are significantly out of the money, leading to the loss of future charges for the insurer. Insurers may allow for policyholder actions by assuming that policyholders exercise their options at a time that maximises the expected loss to the insurer. However, this would likely significantly overstate the insurer's losses from these options. Most policyholders will not have the detailed knowledge to optimally select against the insurer and their actions will instead be driven by personal circumstances.

VAs can be capital intensive for insurers. This is due to the reserves and capital requirements needed to cover the high level of guarantees and the associated risks. Hedging and other investment strategies such as constant proportion portfolio insurance (CPPI) may be used to reduce investment risks. However, the extent of selective behaviour by policyholders is hard to predict and can have a significant impact on profits.

CPPI is a trading strategy that allows an investor to maintain an exposure to the upside potential of a risky asset whilst protecting against a fall in the value of the asset. This is achieved by actively managing the proportion of assets held in risky and low-risk investments. As guarantees on a contract get closer to biting, an insurer would increase the proportion of safe assets and reduce the proportion of risky assets to reduce the risk of the guarantee biting. A significant risk to the investor is that the risky assets fall in value too quickly for them to rebalance the assets held to maintain the capital protection.

Equity release products

The aim of equity release products is to unlock equity held in domestic homes without the need for the individual to move out of the property.

These products are particularly appealing to older people who are asset rich and cash poor. However, these products can also be useful in areas such as inheritance and tax planning.

There are two main types of equity release product: home reversions and lifetime mortgages.

Home reversion

Home reversion is where the client sells all or part of their home in return for a cash lump sum, a regular income, or both.

The individual is allowed to continue living in the home until they die or choose to move. A nominal rent is usually payable by the individual to the insurer whilst they live in the home. Alternatively, the insurer may pay the individual less than the full value of the home, but allows the individual to continue living in it.

Lifetime mortgages

Lifetime mortgages provide the policyholder with a loan secured on their home which is only repaid when the home is eventually sold (which will typically be upon the policyholder dying or moving into long-term care) or upon the policy being surrendered.

This is by far the most common type of new equity release contract being sold. The amount of the loan will typically be restricted to a percentage of the current house value. There are various types of lifetime mortgage, including those under which the repayment amount rolls up with fixed or variable interest, interest-only loans (where the policyholder pays regular interest during the term of the loan), and fixed repayment loans (where the lender receives a higher agreed amount on redemption).

Home income plans are another form of lifetime mortgage under which the money released from the property is used to purchase an immediate annuity payable for life. This income covers the interest on the mortgage, leaving some excess to provide an income to the policyholder. Some lifetime mortgage policies also offer a drawdown facility to offer the policyholder flexibility in the amounts and timings of the amounts of future cash loans.

In some countries, the insurer may guarantee that the amount of the loan to be repaid will not exceed the value of the house at the time of sale, known as a 'no negative equity guarantee' or 'NNEG'. This protects the policyholder or their estate against a fall in house prices. This guarantee will be more expensive for roll-up mortgages than interest only mortgages, since interest added to the loan will increase the probability of the guarantee biting.

These loans may generally be repaid at any time. However, there will typically be a penalty for doing so (either at a fixed cost or varying by duration).

The policyholder’s perspective

Equity release products allow individuals to release money from their property without the need to move house or downsize. This may help with retirement planning or to provide a windfall payment for house repairs, holidays, or large purchases.

Disadvantages of equity release products include the following:

The main downside is that, since the loan is not normally repaid until death of the policyholder, the cost is met by the estate of the policyholder, thus reducing payments to dependents.
Lenders will require policyholders to maintain the house in good condition, which may be costly.
Taking out an equity release product may impact the policyholder's income tax position, eligibility for State benefits, and inheritance tax.
Under home income plans, the amount of income receivable after interest could be perceived as very low at any age other than very old ages.

The insurer’s perspective

The main benefit of equity release products to insurers is the ability to utilise the equity tied up in domestic property. Demand for equity release products has grown in recent years due to an ageing population and a reduction in the financial support provided by pensions. Capital requirements for equity release products reflect the risks that impact their value on the insurer’s regulatory balance sheet.

Risks associated with equity release products (the relative significance of which will depend on the type and conditions of the particular product) include the following:

The main risk to insurers posed by equity release products is a fall in domestic property prices so that the property value is less than the loan balance at the time of its sale.
Longevity also poses a significant risk to some equity release products, particularly when combined with large falls (or sustained stagnation) in property prices.
Mortality risk can also arise under some market conditions and/or product designs. Losses may arise from high mortality at times when property prices are low. Profits may be lost due to high mortality where profits are gained from margins in the interest rate charged.
There may also be significant interest rate risk, persistency risk (e.g. from re-financing when interest rates fall significantly or higher early repayments when interest rates rise), and expense risk.
Reputational risk should also be considered. There has been bad press in the past about home reversions with high house prices benefiting the insurance company (rather than the policyholder's estate) as being perceived as unfair. Early repayment charges can also cause confusion for policyholders and may also result in bad press.

Takaful

Takaful is a form of insurance product that is compliant with Sharia. It originated in the late 1970s and has become increasingly important in the Middle East, Asia, and Africa. Takaful principles may apply to life insurance, non-life insurance, and reinsurance.

Takaful is similar in many ways to conventional mutual insurance: policyholders co-operate by pooling premiums (generally referred to as 'donations') with profits/losses being shared and liabilities being spread according to an agreed pooling system.

However, the application of Sharia principles means that Takaful differs from conventional insurance in three main respects:

Usury (Riba, the payment of interest) is forbidden: Conventional products and the investments underlying them generally contain an element of Riba, meaning that alternative financing arrangements and investment strategies are needed to ensure compliance with Sharia.
Uncertainty (Gharar) is forbidden: The uncertainty about the amounts and timing of payments (and the retention of premiums by the insurer if no claims are made) is forbidden, so there is a need for specific pooling methods and separation of risk pools from operator or management companies. Any profits after claims and management expenses should be returned to policyholders.
Gambling (Maisir) is forbidden: This means that the payment of a small premium in the hope of gaining a larger sum is forbidden. This is dealt with by reference to Takaful principles of mutual assistance in which premiums are defined as 'donations'.

A key aim of Takaful is to ensure that no party to a financial contract can take advantage of another. Traditional life insurance products violate this principle, since they could lead to large profits or losses for the insurer and corresponding profits/losses for some policyholders.

Under a Takaful life insurance policy, policyholders make 'donations' to a fund which then makes payments to policyholders in times of need.

This fund must be well capitalised to avoid losses for the insurer. Surpluses are then shared between the insurer and the remaining policyholders (often as a return of a proportion of the premium) by a formula agreed at outset. In this way, the policies act as a collective undertaking between all policyholders and the insurer.

Takaful insurers are prohibited from investing in conventional fixed interest stocks, or investing in businesses involved in armaments, gambling, pork products, or alcohol.

Sukuk bonds are securities that comply with Sharia principles. They are structured to pay out profit rather than interest.

Microinsurance

Microinsurance is insurance that is targeted towards those who are working, but with low incomes. It is defined by the International Labour Organisation as '...a mechanism to protect poor people against risk (accident, illness, death in family, natural disasters, etc)' in exchange for insurance payments tailored to their needs, income, and level of risk'.

It is characterised by limited benefits and very low premiums (for reasons of affordability). It is not a product type in itself, but rather the market it is targeted at, which makes it microinsurance.

Microinsurance is often sold alongside microfinance. For example, an individual may borrow a small sum (e.g. to help set up a business) and may then insure the repayments against death or sickness. Banks may only be willing to offer such loans if insurance is in place.

Microinsurance is generally based on a pooling or a community rating approach and, in some countries, may be compulsory.

Although microinsurance may not be sold in an insurer's home market, the concept may be of interest to insurers with existing overseas operations.

The policyholder’s perspective

Microinsurance offers some degree of financial protection to individuals who might otherwise be unable to afford it. This helps such individuals to avoid the need to rely on money-lenders, who may be expensive and unscrupulous. Those on lower incomes are more vulnerable to adverse events (e.g. due to lower savings), so some provision of health cover can be particularly reassuring to families - particularly where the provision of state welfare is limited.

The main issue for policyholders is the ability to continue paying premiums, since their income may be low and irregular. This is particularly true for those working in an informal economy. Policyholders may also have no access to bank accounts (or, even if they do, may not bank their income). Such individuals typically have short planning horizons and manage their risks through informal means such as social networks.

Policyholders may also have limited familiarity with formal insurance. There is thus the risk that they misunderstand the nature of the contract, perhaps expecting more than is provided by the limited benefits. Financial literacy is often low within microinsurance target markets so, in some cases, insurers may collaborate with regulators and other organisations in the country to deliver financial education. This can be particularly difficult in areas with low basic literacy rates, in which case pictures and acting may be used to depict how insurance works.

In addition to not understanding how insurance works, some individuals may not understand how it compares to other personal risk management tools such as savings. Such individuals may view insurance as being only for the rich, or may not trust insurers' motives.

The insurer’s perspective

Reasons why an insurer may offer microinsurance include the following:

Microinsurance can provide an insurer with the opportunity to break into a new market (e.g. emerging markets) and hence increase profits.
There is also a wider social benefit in providing access to insurance cover for such socio-economic groups. This might form part of an insurer's ethical strategy.
There may be grants available from development funds and governments to support microinsurance initiatives in order to generate an insurance culture within the lower income sector.

Issues relating to offering microinsurance include the following:

The main issue will relate to pricing and profitability. Risks may be very specific to the target market and pricing needs to reflect this. However, since it is a relatively new market, data is generally limited. This can make it difficult to set premium and benefit levels accurately.
Due to the low premium nature of microinsurance, margins are also generally low so high sales volumes are needed. This may be difficult to achieve, particularly as trust in insurers may be limited in some countries.
Distribution of products and collection of premiums can be more difficult and expensive than for traditional insurance. This means that having a low-cost operating model is vital in order to achieve adequate profitability levels.

Other challenges in designing, pricing, and monitoring microinsurance include the following:

Difficulty in recording member and claims information, and thus in performing experience monitoring.
'Normal' insurance definitions (e.g. the definition of a household) may not be applicable, so new definitions and designs need to evolve to suit the circumstances of the microinsurance policyholders.
Coping with potentially huge volumes of small policies.

Some jurisdictions (e.g. South Africa) have reduced the barriers to entry for new microinsurers (e.g. reduced regulatory requirements combined with increased use of technology), which may make writing microinsurance more attractive to some insurers.