Japan’s variable annuity market is starting to feel the pinch of the financial crisis. This segment of individual pension provisioning, also known as ‘unit-linked’, has experienced tremendous growth since banks were allowed to sell these products in October 2002. With JPY 16.4 trillion (approximately USD 155bln) of assets invested as of September 2008, the success of this product reflects the increased awareness by Japanese households for the need to additionally save for retirement on top of any public- or occupational pension arrangement. Typically the product runs for a long term, such as 10 years, and contains insurance- as well as investment features where policyholders will receive at least their money back at maturity or in case of mortality and the pay-out at maturity depends on the performance of a predetermined mutual fund or combination of mutual funds. The fact that policyholders bear investment risks meant Japanese insurers initially were hesitant to offer VA products fearing claims from a client base used to fixed annuities with guaranteed pay-outs. Foreign players however recognized the potential of the market based on the growth in this segment seen in the USA and foreign insurers such as Hartford, MetLife (in a joint venture with Sumitomo Mitsui Insurance) and ING now dominate the market although the local players are starting to catch up.

Part of the success undoubtedly lies in the appealing product features the most prominent of which is the guarantee that the policyholder will at least get back his/her investment principal at the maturity of the policy. This feature is currently causing the pinch to the insurance companies that have provided the guarantee. Because the investments supporting the policy have substantial allocations to equity markets, insurance companies are forced to make reservations for the increased possibility that the guarantees will end-up in the money. These risks can be - and, on many occasions, have been - hedged but hedging-costs have become prohibitively expensive leading to insurance companies ceasing their VA offering altogether. Those who have not hedged might find themselves in the position Hartford has been finding itself lately: having booked a USD 2.7bln loss for 2008 to reflect potential losses from guarantees, it saw its credit rating downgraded to BBB; its shareholders now attach a negative value to its USD 248bln of life-insurance business and its management is reportedly looking to dispose of the business. Allianz, another player operating in this market, announced to suspend the structuring and launch of new VA products in Japan until further notice citing the cost-of-guarantee-issue as the main reason. This leaves the distributing banks with the problem of not being able to offer their clients products that remain in high demand in the current market environment due to their guaranteed nature.

A solution seemed to have been found by T&D Asset Management, the investment manager linked to Taiyo and Daido, two medium-sized insurance companies. T&D structured a VA product which, through its investment policy, was able to guarantee the investment principal for policy holders at maturity. By managing the assets of the policy such that, at all times, enough money remains available to buy a zero-coupon bond that grows to the amount of the guaranteed principal, T&D was able to alleviate the risk to insurers and topped the rankings for collecting new VA assets in the first half of 2008 raising JPY 320bln in 6 months. The constant proportion portfolio insurance (CPPI) mechanism by which the product was managed however has shown its drawbacks: with rapidly falling markets the fund managers were forced to sell out of the risky asset part of the portfolio and buy into the zero-coupon bond necessary to protect the principal at maturity causing a so-called cash-out where no money is left to invest in equity markets and the product is left only holding the zero-coupon. This is the more problematic because only about a year has passed from what would be a 10 year period until maturity at which the principal guarantee is valid. Bank of Tokyo-Mitsubishi UFJ, the main distributor of this VA policy, has subsequently announced ceasing the sale of this product.

The industry is now frantically looking for a solution that is risk-light to insurance companies whilst maintaining the attractive features such as principal guarantee at maturity and -after the CPPI methodology proved to be too much of a wild-card for a long-term product such as this- a responsible investment policy that does not cash-out even after a substantial draw-down in equity markets. It seems clear that the investment principal needs to be safeguarded within the investment policy because in today’s environment the capital required to guarantee investment risks is simply unavailable. The positive news is that if the safeguard occurs within the investment policy, the insurance company can also abstain from charging a guarantee fee opening the way for a lower total expense ratio from what has traditionally been a fee-heavy product. Further, the cash-out risk must be managed by not putting all of the money available after purchasing the safeguarding zero-coupon, at risk, but rather by keeping a part of this money in reserve to redeploy at sufficiently long time intervals to benefit from lower equity market valuations. Lastly, the money that is actually put at risk should be invested aggressively in order to maintain a sufficiently attractive expected return. The combination of an aggressive policy for a small part of the portfolio and an ultra safe investment for a large part, results in a barbelled investment strategy that can maintain an attractive expected return whilst limiting unacceptable downside risks.

If such next-generation VA product would see the light of day in Japan, the industry can resume the growth path as if no credit crisis occurred.