Aging Tigers

Demographic shifts have been a driving force for change in retirement provision in Europe, but in Asia the effects of increasing life expectancy and falling fertility are even more dramatic. Could variable annuities fill the gap?

"From the level of media coverage, you would assume that western governments are the most concerned about the issue of aging and how to fund it. But in Singapore, Hong Kong, Taiwan and South Korea, the problem is much more serious."

The inexorable greying of Europe's population has seen all its major economies looking to overhaul their pension provision in recent years. But according to Mun Kurup, Hong Kong-based head of Asia Pacific Annuities for ING, the same drivers for change - increasing life expectancy and falling fertility - are not only present in Asia, but are occurring at a faster rate.

And unlike Europe, these changes are not happening against a backdrop of a comprehensive welfare state - leaving an increasingly wealthy population looking for innovative ways to fund their retirement.

"Increasing life expectancy is a very powerful phenomenon - and the next quarter century could see it occur at an even greater rate than is currently expected. When you combine this with the increasing level of affluence, it becomes a very powerful driver for retirement planning," Kurup says.

But although consumers in Asia's main four emerging economies are facing a demographic evolution more rapid than that in Europe, they have one major advantage - a much higher savings rate. Typically this stands at around 25% of earnings, against the 1.1% household savings ratio that the UK's Office of National Statistics gives for Q1 2008.

The challenge for insurers is to transform these savings into long-term investment products, and according to Kurup, it offers the potential to replicate the success of variable annuities (VAs) in Japan, North America and parts of Europe.

"As they increase in wealth, consumers are not going to settle for vanilla insurance products. They want access and they want guarantees - and that means VAs. In Japan these are focused on accumulation, with very few withdrawal products - whereas in Hong Kong, Singapore and South Korea these are the main drivers of business."

And ING is not alone in spotting this opportunity. First out of the blocks was Toronto-based Manulife, which entered the market in Hong Kong in 2007, but it has been closely followed by the top rank of global insurers such as Axa and ING, with others set to enter the market.

Dynamic demography

The figures behind the changing demographics in the region are truly startling. The phrase 'Asian Tigers' was coined to describe the rapid economic development of Hong Kong, Singapore, Taiwan and South Korea between the 1960s and the 1990s, but it could equally apply to the speed of change in their demographic make-up.

According to Globalis, a repository of development statistics compiled by the Norwegian UN Association, life expectancy at birth in the UK was 69.2 in 1955 and is predicted to increase to 83 by 2050. But for South Korea the same timeframe will see life expectancy almost double from 47.2 years to 82.2 years.

And the same is true for fertility rates - in other words, the number of children per couple. The UK is predicted to see a modest decline from 2.18 in 1955 to 1.85 halfway through the 21st century. Yet South Korea will see a precipitous fall - from 5.85 to parity with the UK - over the same time period, and this pattern is being repeated across Asia's emerged and emerging economies.

The fact that this has been accompanied by a late start in state-level retirement provision (see Box 1) gives the Asian Tigers a major advantage over their western peers, by avoiding the open-ended promise of defined benefit pension provision that has proved so toxic for corporate funds. But a culture of self-sufficiency and demand for - by European standards - low levels of taxation make a comprehensive state-led solution unlikely.

One obvious alternative is the UK model of private pension accumulation vehicles with an annuity option. Both the US and Italy have looked at this as a potential way to ensure that defined contribution-based accumulation products can provide an assured income throughout retirement (Life & Pensions, November 2007).

But according to a senior figure from a UK insurer based in Hong Kong, a combination of an absence of tax incentives and cultural differences makes annuities a difficult product to sell.

"Outside of Japan there are no countries in Asia where there are tax advantages to locking up your cash in an annuity product. But beyond this, the concept of a traditional annuity where you hand over your lifetime's savings to an insurer in exchange for a promise of cash payments for the rest of your life tests extremely badly with Asian consumers. An annuity by its very nature cannot be passed on to the next generation - and whoever controls the money, controls the family."

Currency risk

As yet, insurers have shied away from constructing VAs in local currency - with the exception of Manulife. It was the first company to launch a VA product outside of Japan, with its 2007 launch of a US dollar denominated product in Hong Kong followed by US dollar VA issues in Taiwan and Singapore. According to Cindy Forbes, the company's Hong Kong-based chief financial officer for Asia and Japan, the demand for local currency products is dependent on the particular market.

In Taiwan, for example, a long-term export-led US focus means that despite its floating exchange rate, the fortunes of the Taiwanese dollar are closely linked to those of the US currency. Even in 2007, according to figures from Taiwan's Ministry of Economic Affairs, the US still accounts for nearly 25% of the country's exports.

"The high net worth individuals in Taiwan already have US dollar assets - the challenge is whether it is possible to convert those into dollar denominated VAs," says Forbes. "The decision as to whether to offer a local currency product is a function of the capital markets - the availability of instruments to hedge the currency risk - and the demand for a local currency VA in the market. Due to customer demand, we recently issued a VA in Singapore with a local currency guarantee. We are constantly monitoring this demand, and we would consider issuing local currency products wherever there is the capability to hedge the currency risks."

Axa's two products are both Hong Kong-based US dollar denominated, though Mark Stamper, Axa Asia's regional chief actuary, says the French insurer does not feel the currency issue is a barrier to VAs becoming popular in the special economic zone. With the Hong Kong dollar pegged to its US counterpart, consumers can feel comfortable over the issue of currency risk - but the former British territory is the exception in Asia.

Stamper concedes that currency risk is an issue, but believes a lack of long-dated instruments and the illiquidity and volatility in local capital markets makes local currency denominated issues too risky in the short term - and could act as a barrier to future expansion.

"We are looking further afield - both China and India are potentially very interesting, but both would require us to be innovative and overcome a challenging regulatory environment." Stamper says its first GMIB product - a rider designed to give policyholders a guaranteed minimum income if the investment does poorly - was not a great success; although the second, distributed via Citibank, has proved more popular. But he says the main aim currently is the strategic advantage of establishing Axa in Hong Kong as retirement provision, and establishing its risk management capability in the region made it a worthwhile exercise.

"There are serious issues over the availability of local currency interest rate hedges, and at Axa we need to be hedging the key risks - we are not interested in taking a gamble. Another issue is the availability of underlying funds - you want to offer a diversified range of funds but this simply isn't available many countries, and this is a key challenge for any future product development in China or India."

Hedging dilemmas

Axa's dislike of taking a gamble with its VA products has led it to establish a Singapore-based addition to its existing European and US hedging centres. In future all the company's Asian business will go through this office, which will offer the same comprehensive hedging capability.

"We are at the forefront of risk management. We hedge the same number of greeks as our US operations - there is nothing in the US that we couldn't offer here." Stamper identifies delta and rho as the key risks that Axa needs to keep on top of, and despite the "perfect timing" of launching its second product just as the credit crunch bit, the chief actuary is happy about the programme's performance so far.

Where Stamper does see a difference between the Asian market - ex-Japan - and the US experience is that the choice of underlying funds is narrower. "You want to be able to offer a diversified range of funds to your customers, and they simply are not yet available in these markets."

The narrow choice of local capital markets is behind ING's decision to offer only euro or US dollar denominated products in the near term. As a result, Kurup says, the Dutch insurer has no plans to set up a hedging platform in Asia, as the company is happy to use its existing resources. But this may change in the long term.

"Twenty years ago some professionals thought a GMAB-type rider - which guarantees policyholders that their investment will be annuitised at a set rate - was a free benefit that you don't need to charge for, but we are aware of its value and the need to have hedging in place.

"Currently our target market is the mass affluent group, who already have a fair amount of savings in US dollars as well, so it should be relatively easy to capture that money. But to expand into the mass market companies, we will need to find ways of offering guarantees in local currencies. The main challenge in the near term are market volatilities and the depth of the securities markets, including the derivatives market, to enable a proper hedging and risk management program. Some markets in Asia are more ready than others, but for the near future, euro and US$ denominated products will remain the focus for sophisticated VA products."

Liquid capital markets are a prerequisite for an economic hedging programme, but in Kurup's view these markets must also work within certain volatility boundaries for insurers to offer products that are reasonable priced and at the same time present a strong customer value proposition.

Asian stock markets - ex-Japan - are presently a long way from these levels of volatility. The Shanghai Stock Exchange, for example, is the fifth largest in the world, with assets of over US$3 trillion, and its composite index has fallen by nearly 50% in the first six months of 2008, following stratospheric gains of 97% in 2007.

The danger of this volatility is readily apparent to HSBC Insurance - it was the distributor for the Asian business of Old Mutual which experienced serious problems when its hedging programme was caught short (see news story on p11), which is currently being touted around by investment bankers as a textbook case of how not to manage VA guarantees.

Unsurprisingly HSBC Insurance was quite hesitant to discuss the details of its US dollar VAs. David Fried, group general manager and regional head of insurance for the insurer's Asia-Pacific division, declined to give details other than to confirm it was now preparing to hedge all its future VA risks on its balance sheet.

"Our intention is to ensure an appropriate hedging programme is in place before any product launch. Depending on market conditions and sophistication, hedging programmes may vary in different markets."

Minding the GAAP

Manulife is a trailblazer in Asian VAs, outside of Japan, but unlike some of its later-arriving rivals it has yet to hedge the risks resulting from this book of business. While Forbes says that hedging is a key risk management tool, Manulife has only employed it in its US subsidiary, John Hancock - the sixth largest seller of VAs in the US - since 2007. When VA volumes grow in Asia to a material size, Forbes expects Manulife would extend its hedging to this block as well.

But this is not the result of a cavalier approach to risk management, it instead reflects the realities of the domestic accounting regime - CGAAP - which does not value liabilities on a mark-to-market basis.

So VA writers whose primary reporting basis is US GAAP have a greater incentive to hedge given its higher volatility. Canadian GAAP also marks VA liabilities to market but does not allow gains, when the guarantees are out of the money, to be counted as earnings making the P&L less volatile. So a company using CGAAP will see losses on assets amortised over time, whereas US GAAP will result in an immediate impact on the balance sheet.

Instead of offloading risks via the capital markets, Forbes argues that product design is the most important aspect of risk management. By extending the time at which a policyholder can benefit from guarantees, and ensuring the underlying funds are not too volatile, the Manulife CFO argues that risks can be reduced to an acceptable level.

Manulife's approach to product design leaves it clear of the longevity risk that is the driver behind VA growth, and while Hong Kong has life expectancy tables in existence, other governments are lagging behind - though this is expected to change.

For ING's Kurup this presents a problem - designing products with longevity risk without the data needed to underpin it leaves insurers open to making mistakes that could haunt them in future years. ING has reached its pricing assumptions for the Taiwan VA by applying data from its US product to its existing knowledge of the local market.

"We don't simply apply a mortality experience from one society to another, but instead approach it from a base principle - where does it start from? In any case, mortality has several drivers - and while there isn't a lot of state sponsored data on mortality, life insurance has been active in the region for a while, which can be used."

This approach is echoed by Axa, which uses data from abroad - especially Japan - that is then referenced against the existing Hong Kong data, but in any case longevity is not its overwhelming concern. "The design of the product is that longevity is a risk, but not a main one. The whole point is the upside - this is the target, not the minimum guarantee. So while withdrawal riders are a key benefit, they are not a key risk - instead, the main risk is financial."