Leverage in the annuity business
The recent bankruptcy filing for Lehman Brothers follows hard on the
heels of the forced takeover of Bear Stearns earlier this year. Debt played
a role in the demise of both: as with many banks and other businesses, they
used borrowed money to enhance shareholder returns, a phenomenon known as
leverage. Leverage works well when profits are made: the
shareholders reap all the rewards of the total deployed capital, both their
own and the borrowed funds. Of course, leverage also increases the downside
risk: since debt has to be repaid no matter what, shareholder funds are
first in line to be wiped out if things don't go according to plan.
The use of borrowed money is not restricted to banks and corporate
borrowers. Indeed, leverage is fundamental to the annuity business, as the
chart below shows:

On the left we have the capital requirements for an annuity policy. It
is made up of the estimated cost of the benefits (set at 100%) plus a
margin for prudence due to insurance-company regulations, plus a further
solvency margin. These funds have to come from somewhere, and this is shown
on the right. The majority of the funds come from the policyholder in the
form of the premium. The price paid is by definition greater than 100%,
since the insurer expects a profit margin on top of the expected cost of
benefits and expenses. The balance between what the policyholder pays and
what the regulator requires has to be made up by shareholder capital.
The right-hand section shows where the leverage comes in. The
shareholder capital has to make up the difference between two much larger
numbers: the total reserve and the policyholder price. If anything
should happen to raise the capital requirements on the left-hand side, then
it is the shareholders who have to provide the extra funds. Capital
requirements could rise due to an increase in the expected cost of the
benefits, a strengthening of insurance-company reserving requirements, or
an increase in the solvency margin. Whatever the cause, a 1% increase
on the left-hand side will cause a 10-15% increase in shareholder
capital.
Since annuity business is highly leveraged, shareholders demand a high
rate of return on capital. It is also the reason why a great deal of
effort is put into assessing socio-economic
group. As the most important risk factor for longevity after age
and gender, incorrectly assessing socio-economic group
can wipe out an annuity's profit margin.
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