Death of the General Account

CFA Institute

Death of the General AccountAuthor(s): Brian O'NeilSource: Financial Analysts Journal, Vol. 52, No. 1 (Jan. - Feb., 1996), pp. 5-7Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4479890 .

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GUEST SPEAKER

Death of the General Account

Brian O'Neil

Life insurance in the United States has traditionally been a general-account-based product. Many forces are now converg- ing to cause a major change in the fundamental nature of life insurance and annuity products-in particular, to reduce dramatically the attractiveness of the general account as an investment vehicle both to customers and to companies.

I will cover two subjects- why the general account is dying and what will take its place. In my view, the fact that the general account is a good product may not be enough to save it. The following factors are "doing in" the general account:

? product changes * company insolvencies . regulation * management's response * rating agencies . demographics * sales tactics * emergence of variable

products * breakdown of public trust

in big institutions * financial innovation

-by competitors who do not offer general accounts

-by artificial general accounts

-by improvements of general accounts

There is no villain, just actors- as in a Greek tragedy-doing what their inner logic compels.

Product Changes Whole life and participating

group annuities were the insurance industry's major product line until the late 1970s. The participating nature of these products allowed for a diversified asset mix and a pass-through of investment results to the customer. Long-term total return was what counted, and the effects of a bad investment year could be managed over time.

Many companies introduced universal life, single premium deferred annuities, and guaran- teed investment contracts (GICs) in the late 1970s, leading to an "unbundling" of the product. In particular, they sepa- rated out the investment fea- tures and made them explicit, which in turn led to a focus on crediting rates as the primary determinant of product value. This unbundling led to more ag- gressive investment strategies, particularly at some companies, and a general decline in industry margins and profitability. It also brought about a major change in the way products were sold.

The bottom line: The 1980s generation of products poses greater risks to companies because they are unable to pass through poor investment returns to policyholders; instead, they eat them. Industry adop- tion of these products set in mo- tion a chain of events that no one could have foreseen.

Company Insolvencies Company insolvencies

marked the turning point. The collapses of First Executive, Fi-

delity Bankers Life, and most of all, Mutual Benefit sent shock waves through the life insurance industry and its system of regulation. This development was an echo of the S & L crisis, but without the benefit of Fed- eral Deposit Insurance, these failures meant people could and did lose money. The system of state guaranty funds is not understood by the public and therefore has little credibility.

These insolvencies taught a new generation of Americans that life insurance companies can go belly-up. Although the public appears to have recov- ered from the initial shock, our customers today look at life insurance companies in a differ- ent way than in the past.

Regulation The regulatory response

was-and is-to say "never again." Insolvency of companies causes political problems, raises concerns that the state regulators are not doing their jobs, and leads to talk of federal regulation. In response, regulators have vowed to create an environment in which these types of insolvencies can never happen again (which is a wor- thy goal), with little, if any, re- gard for the secondary effects of their actions.

Most of this regulation falls on investment portfolios. Risk- based capital is as much an investment regulation as a balance sheet regulation. The strongest proponents of the proposed "Model Investment Law" are the industry's regulators.

The long-run effect of the

Brian O'Neil was chief investment offi- cer at the Equitable Life Assurance So- ciety of the United States when he gave this speech. He is currently in a senior investment position at AXA Asset Management in Paris.

Financial Analysts Joumal / January-February 1996 5



regulators' efforts to eliminate investment risk may be to so reduce the attractiveness of the general account that it will become extinct. If that happens, the next generation of products may be safer for the issuing companies by leaving more of the investment risk with the customer. Although this solution would be fine for the most sophisticated life insurance consumers, it may not be right for others.

Management's Response

Company managements have also responded to the changing environment. Capital levels are up, portfolio risk is down. Companies are reducing noncore business exposures. In- dustrywide, companies are fo- cusing on profitability and ex- pense control.

Most of these steps were taken at the initiative of managements rather than the regulators, but risk reduction is a shared agenda. At bottom, however, the general account business is a risk-taking business. Excessive regulation will not eliminate risk taking, only drive it underground. There is no substitute for management accountability, and regulation must recognize that fact.

Rating Agencies The rating agencies are ap-

plying similar pressures. In many ways, they are more in- fluential than regulators, particularly with companies that are financially strong. The regulators concentrate primarily on weak companies, but the rating agencies look at everybody. They focus mainly on reducing asset and interest rate risk, and they have become more de- manding on company profitability. This approach is on the whole a good thing for the industry because rating-agency

pressure substitutes for market pressure at mutual companies.

The rating agencies, however, appear to be uncomfort- able with the overall level of ratings for the industry and to be ratcheting it down. The AAA rating is becoming a Platonic ideal, something not found in nature. Although the agencies' message, less risk and more profits, is a good one, taking risk reduction to an extreme under- mines the competitive nature of the product.

Demographics Demographic pressures are

changing the landscape. Annu- ity sales are up, life insurance sales are flat or down. This phe- nomenon should not be a mys- tery. The fear has shifted from dying too soon to living too long, even for Baby Boomers, and annuities are the remedy. When Equitable did research for an ad campaign, the hot but- ton question was, "What is going to happen to me when I'm old?"

The annuity product is easy to explain, and it is so much like other investment products that it attracts hosts of eager competitors and cannot, even today, support a high commission. Be- cause annuities are more explic- itly financial products, asset/li- ability management is crucial and interest rate risk taking is potentially more tempting- also more dangerous.

Sales Tactics Industry sales tactics do not

help. The market conduct scan- dals, heralded by a press eager to report bad news, are a big negative, but the problems are deeper than that. The two biggest problems with life insurance sales are that customers do not know why they are buying it and that commissions are too high. High commissions attract some quick-buck artists (which

makes it tough on the rest of us) and are out of line for a world going to "no-load" or "low- load" products.

The result: Whole life has a limited future. Example: North- western Mutual and the Guard- ian are introducting a variable life product. Those companies are two of the last bastions of whole life, and both carry AAA ratings. Like large computer makers dealing with the per- sonal computer, the companies recognize that the future be- longs to a new product but are reluctant to undermine a suc- cessful past and present.

In the future, the kind of one- on-one selling and advice giv- ing that career agents can provide has to add real value. Sell- ing the highest credited rate, as has been the recent habit, does not add value. The obvious move is to reduce up-front commssions in return for a longer stream of payments to the agent, but no major company wants to be the first to try this solution.

Variable Products The emergence in recent

years of variable products will accelerate these trends. Variable life represents a further unbundling of the product and creates more visibility for the investment component. The long- term nature of life insurance al- lows for an increasingly long- term (and equity-oriented) investment strategy. At Equita- ble, more than 85 percent of new life premiums are going to separate accounts. Many financial experts have kind words for variable life-few will say any- thing positive for whole life. Over time, this kind of rein- forcement from independent advice givers should stimulate sales of variable life at the ex- pense of whole life.

The shifting of investment risk to clients is very beneficial from a company risk and capi-

6 Financial Analysts Joural! January-February 1996



tal-adequacy perspective. Also, common stock separate accounts have outperformed the typical general account over just about any period of time since the introduction of variable life, so the customer benefit is clear. There is an ongoing debate over the ideal asset mix for preretirees; the concensus view is that people are underinvested in equities. Variable products allow customers to control their asset allocations and to take a common stock strategy if they wish. I believe the general account is still needed within our array of investment options; many customers, particularly older ones, still want "fixed."

Breakdown of Public Trust

The breakdown of public trust in big institutions has also had an impact. I do not quite know whether life insurance companies have been affected by this loss of trust in recent years or whether we have always had a poor image. Whole life is a bun- dled product, requiring customer trust, which is not in keeping with the times. The increasing visibility of commissions, which seems to be the trend, will probably reduce either sales or commission levels.

Financial Innovation Financial innovation is al-

ready having an impact in al- lowing noninsurance competitors to take market share in product areas traditionally con- sidered to be life insurance ter- ritory. Although many 401(k) customers like the general account option, that has not stopped mutual fund companies from invading the market. These companies offer money- market funds or GIC funds as their equivalent to the general account. They are increasing market share because they are perceived to provide better

overall service at lower cost. The variable annuity busi-

ness is also becoming the play- ing field of mutual fund companies, using insurance companies only as providers of wrap- pers, again because they can sell at lower costs or through differ- ent channels than we do.

The next step is the artificial general account. This development is taking place in the GIC business with what are known as synthetic GICs. Corporate sponsors are asking themselves, "If insurance companies only buy bonds, why not buy bonds ourselves?" The cost of a money manager and a "wrapper" can be less than the profit margin to the insurance company. Syn- thetic GICs allow greater diver- sification, selection of an investment manager, and the oppor- tunity to boost performance, all very appealing to corporate pension trustees. Right now, the product is very complicated and difficult for most people to understand. That situation may change, however.

The synthetic general account can be offered to individuals, as well as corporations. Again, the biggest obstacle is ex- plaining how the product works. The investment technology already exists, and the systems technology will evolve; in- dividual "accounts" are what many customers want, and someday they will be able to get them from a nonlife insurance provider.

The general account can be improved upon. Because general accounts do not have a clear identity, they are not necessar- ily what sophisticated investors want. What types of securities can provide tailor-made investment returns? Derivatives! Once they recover from their image problems, derivatives may become very popular with individuals. As an example, a contract offering 80 percent or more of the S&P 500 return, but

with no possibility of loss, could be very attractive to individuals looking for a home for their re- tirement savings.

The industry could "inter- mediate" all of these contracts, and some companies have. Regulators and rating-agency capital constraints, however, may not permit large intermedi- ated general accounts. Separate accounts that buy their own contracts will probably prove to have a better risk-return trade- off both for companies and for customers.

What will take the place of the general account? Variable life and annuities, of course, are doing so right now. The ongoing debate as to whether individuals should invest their savings in debt or equities will also play a role. If the Baby Boomers get comfortable with equities, that will really hurt the general account. The growing use of annuities and synthetic general accounts will allow nonlife insurance companies to compete on an equal footing. The investment technology exists, and the no-load companies will learn how to explain it to individuals. Some customers will move out of the general account, and others will put their money into synthetic general accounts offered by nonlife companies. The ability of providers of other financial services to replicate the general account in their product portfolios will be a major chal- lenge to the life insurance industry as a whole.

What to do about it? Start a variable life and annuity business. That is easier said than done, however, because it takes substantial agent retraining. In- vest in systems, and manage costs carefully. Hook up with a good money manager. Or pos- sibly, merge with a company that has already done so. The long-heralded " consolidation" of the industry appears finally about to begin.

Financial Analysts Joumal / January-February 1996 7



Death of the General Account

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