PRODUCT DEVELOPMENT NEWS

In This Issuepage

Chairperson’s Corner: Where DoGreat New Product Ideas Come From?By Mark A. Milton . . . . . . . . . . . . . 1

Prescribed Statutory Interest Ratesfor the Valuation of LifeInsurance and Annuity Products—Statutory Calculationsby David G. Whittemore . . . . . . . . 1

page

ACLI Updateby A. Micheal McMahon . . . . . . . . 2

“Emerging Markets for the New SeniorCitizen” Seminar Rescheduled . . . . 2

The Underwriter’s Corner: The Valueof the Sentinel Effect (Revisited)by Richard L. Bergstrom . . . . . . . . . 3

Life Insurance Firms in the RetirementMarket: Is the News All Bad?by Paul Hoffman andAnthony M. Santomero . . . . . . . . . 6

page

New York’s Revised ExpenseLimitation Lawby Jonathan Hecht, John M.Fenton, and Douglas A. French . . 21

Ten Years Ago ... . . . . . . . . . . . . . . . . 25

Thanks to 1998 Hawaii SpringMeeting Participants . . . . . . . . . . 27

Prescribed Statutory Interest Rates for the Valuation of Life Insurance andAnnuity Products—Statutory Calculations

TABLE 1Maximum Statutory Valuation Interest Rates

Yearof Issue

Whole LifeInsurance

TypicalSingle-PremiumDeferred Annuity

Single-PremiumImmediate

Annuity

19921993199419951996199719981999

5.50%5.005.004.504.504.504.504.50

6.25%5.755.506.005.505.505.25

N/A

7.75%7.006.507.256.756.756.25

N/A

PRODUCT DEVELOPMENT NEWS

ISSUE 47 OCTOBER 1998

Chairperson’s Corner

Where Do Great NewProduct Ideas ComeFrom?

by Mark A. Milton

ccasionally, a great new productOidea will come from “out of theblue.” When this happens, youshould not ignore it but neither

should you rely on it to generate all thenew product ideas for your company. This is like finding a dollar bill in thestreet. You’re glad it’s there, and youcertainly can use it, but you wouldn’tleave your house hoping to find one topay for the groceries that day.

Good product developers typicallyhave a very deliberate process that theyuse to generate new ideas. They use abalance of reactive and proactiveapproaches. Reactive approaches includelistening to customers, agents, media, andmanagement. They also proactivelyconduct market research and in-depthcompetitive analysis.

Good innovators also know where tolook for new product ideas and theyconstantly monitor nine specific areas forchanges that can be converted into newopportunities.

1. Regulation and Tax Change. A newnonforfeiture law would have a

continued on page 5, column 1

by David G. Whittemore

Maximum Statutory ValuationInterest RatesMoody’s Investors Service has releasedits June 1998 Average Corporate BondYield Index. This index affectsmaximum interest rates under the 1980Amendments to the Standard Valuationand Nonforfeiture Laws. This articlereports the maximum statutory valuationand nonforfeiture interest rates for 1999issues of selected life insurance productsand the maximum statutory valuation

interest rates for 1998 issues of selectedannuity products.

The maximum statutory valuationinterest rates for some typical insuranceproducts are shown in Table 1.

The 1999 maximum statutoryvaluation interest rates for life insuranceproducts with guarantee durations of over20 years are the same as 1998. The ratesdropped 50 basis points for products withguarantee durations of 20 years or less.


PAGE 2 PRODUCT DEVELOPMENT NEWS OCTOBER 1998

Issue 47 October 1998 PRODUCT DEVELOPMENT NEWS

from the Individual Life Insurance andAnnuity Product Development Section

Published by theSociety of Actuaries

475 Martingale Road, Suite 800Schaumburg, IL 60173

Phone: 847–706–3500 Fax: 847–706–3599World Wide Web: http://www.soa.org

This newsletter is free to Section members. A subscription is $20.00 for nonmembers. Current-year issues are available from the Communications Department. Back issues of Section

newsletters have been placed in the Society library. Photocopies of back issues may be requested for anominal fee.

Expressions of opinion stated herein are, unless expressly stated to the contrary, not necessarilythe opinion or position of the Society of Actuaries, its Sections or Committees, or the employersof the authors. The Society assumes no responsibility for statements made or opinions expressed

in the articles, criticisms, and discussions contained in this publication.The Section would like to encourage articles and papers on product development topics or subjects of

interest to product development actuaries. If you have an article or an idea for an article that you thinkmight interest Section members, please contact:

David G. Whittemore, FSAProduct Development News Editor

Tillinghast/Towers Perrin12377 Merit Drive, Suite 1200

Dallas, TX 75251

Phone: 972–701–2744 Fax: 972–701–2575 E-mail: [email protected]

Copyright 1998 Society of Actuaries.All rights reserved. Printed in the United States of America.

“Emerging Markets for the New SeniorCitizen” Seminar Rescheduled

he Product Development and Nontraditional Marketing Sections will co-Tsponsor a seminar entitled “Emerging Markets for the New Senior Citizen”designed to help actuaries and other professionals learn more about the needs,desires, demographics, and influences baby boomers and their parents have in

today’s world. Attendees will find out how insurance companies and service provid-ers might want to position themselves in the coming millennium to take advantage ofchanges in the health care system, tax reform, technological advances, and underwrit-ing protocols. Topics to be addressed include:C An overview of market demographicsC Implications of recent tax law changesC Mortality trends and underwriting issuesC Potential changes being discussed relative to valuation and nonforfeiture regula-

tionsC Distribution issues using state-of-the-art technologies C Overview of current products and services

– Life insurance– Reverse mortgages– CCRCs– Long-term care

C Insights into senior marketing.This seminar, originally scheduled for March 1–3 in Charleston, South Carolina,

has been rescheduled to November 16–17, 1998 at the Charleston Hilton Hotel. Theday-and-a-half meeting will begin on November 16, with a reception that night.

For further details, please contact Sheri Abel at 847–706–3536, or visit theContinuing Education page of the SOA web site (www.soa.org).

ACLI Updateby A. Micheal McMahon

he American Council of Life In-Tsurance (ACLI) represents the lifeinsurance business in legislativeand regulatory matters at the fed-

eral and state level of government. Sev-eral of the issues that the ACLI is cur-rently involved in affect the work ofProduct Development Section members. Three of those are:C XXX REVISION. A group of

interested industry representativespresented a proposal for amendmentto Regulation XXX to the Life andHealth Actuarial Task Force(LHATF) at the June NAIC meeting. The proposal had broad but tentativesupport within the industry. Severalissues involving adequacy and taxquestions have been raised byregulators and industryrepresentatives. Work is underwayto prepare a revised proposal that willaddress the questions forconsideration at the September NAICmeeting. It is too soon to tellwhether the effort will be successful. If it is not successful, it is likely thatthe existing Regulation XXX will beadopted by several states. BillSchreiner is the ACLI contact on thisissue.

C ZZZ SUMMARY. Actuarial GuidelineZZZ was received by the NAICLHATF in June and exposed forpublic comment. ZZZ containsreserve methodologies which wereoriginally developed by the AmericanAcademy of Actuaries. The onlycontroversial provision is a referenceto variable annuities containingguarantees in the Scope section. TheAcademy has suggested that thereference be deleted. ZZZ isexpected to be adopted in December. Vince Donnelly is the ACLI contacton this issue.

C ANNUITY ILLUSTRATION MODELREGULATION. The current industryproposal emphasizes disclosurethrough a “Buyers Guide” and aseparate disclosure document. TheNAIC Life Disclosure WorkingGroup wants to split the effortbetween disclosure and illustrationstandards. The Working Group


OCTOBER 1998 PRODUCT DEVELOPMENT NEWS PAGE 3

TABLE 1Positive HIV-Antibody Rates (Per 1,000 Tested)

Serum OFT

Age $25–50K $<25K $25–50K

20–2930–3940–4950–59

0.793.622.231.64

11.7514.39

8.602.11

2.254.073.272.35

All Ages 1.70 7.67 2.88

TABLE 2Positive Cocaine Rates (Per 1,000 Tested)

Urine OFT

Age $25–50K $<25K $25–50K

20–2930–3940–4950–59

8.3616.2010.07

2.86

15.7736.8427.37

7.43

7.3618.3712.11

3.31

All Ages 5.94 19.17 10.98

TABLE 3Positive Cotinine Percentages

Urine OFT

Age $25–50K $<25K $25–50K

20–2930–3940–4950–59

21.0%27.529.526.6

30.8%41.339.734.6

29.0%36.633.725.8

All Ages 24.0% 34.8% 31.8%

UNDERWRITERS’ CORNER

The Value of the Sentinel Effect (Revisited) by Richard L. Bergstrom

he underwriting community has for OFT applicants is 70%Tknown about the Sentinel Effect greater than serum for all(SE) concept—that self-selection ages combined. But whenprocess that directs unhealthy one compares the under

insurance applicants to apply for coverage $25,000 OFT cohort to theat amounts where testing is not done, low-band serum-testedthereby minimizing the chances that their cohort, OFT prevalenceaffliction(s) will be discovered—for many rates are 4½ times greater! years. Yet accurately quantifying the Dramatic evidence of thevalue of the SE remains an illusive SE in action. To be sure,exercise at best, because we simply these differences willcannot directly measure what we cannot narrow over time, as istrack, or so it would seem. always the case as testing

However, ways to indirectly derive methodologies “mature.” surrogate measures for SE exist. This I believe this phenomenonarticle proposes one such way that should happens more because ofhelp the insurance community more fully customer awareness,appreciate the contribution SE makes to however, than changingthe cost effectiveness of one specific prevalence rates in theunderwriting protocol— laboratory insurance-buyingtesting. population—hence, the

In 1996 oral fluid testing (OFT) was further proliferation of theintroduced, its Western Blot HIV Sentinel Effect. Theconfirmatory test having finally been effect is particularlyapproved by the FDA. OFT currently enhanced by impairmentsscreens for HIV antibodies, cocaine dictated by lifestylemetabolites, and nicotine (cotinine). considerations, where theBecause the oral fluid modality easily applicant more or lesslends itself to agent collection, total test consciously chooses to liveand lab analysis-related costs can be a risky lifestyle (smoking,minimized (under $20 per applicant) drugs, etc.). Tables 2 andthereby producing dramatically low 3 show similarprotective value-testing thresholds. How comparisons for urinedoes this help us quantify the value of the versus OFT-tested cocaineSE? Let’s take a closer look. and cotinine metabolites,

Serum testing for HIV and urine respectively. “All ages”testing for cocaine and nicotine have been prevalence for cocaineavailable for many years. It is likely, detection is about two totherefore, that many insurance applicants three times higher than forare keenly aware that blood/urine profiles urine testing, and cotininespecifically target detection of these detection by OFT exceedsantibodies or metabolites. As such, it is urine tested detection bynot difficult to conclude that many such 30–45%. Significant differences! If you think the value of the Sentinelwell-informed applicants might attempt to One final, sobering thought: As more Effect is significant now, what will youplace their business in companies where and more companies begin screening at think when your company is the only onetesting is not performed at all amounts. lower testing thresholds, knowledgeably not testing?Hence, the genesis of the SE. impaired applicants seeking to secure

In 1996, as companies began using coverage at standard rates will migrate to Richard L. Bergstrom, FSA, is aOFT, statistics kept by the testing those companies that have chosen not to consulting actuary with Milliman &laboratories unveiled a dramatically reduce their testing limits. This, of Robertson, Inc., in Seattle, Washington,different profile for the cohort of course, increases the relative prevalence and a member of the Individual Lifeapplicants tested at lower amounts than of impaired risks in the markets of these Insurance and Annuity Productthat of the blood/urine tested cohort. companies, a phenomenon whose Development Section Council.Table 1 compares the prevalence of HIV- antiselection can actually lend to higherpositive applicants as tested by LabOne prevalence rates in some cells than in thefor serum versus OFT. At the $25,000 general population.amount band, the HIV+ prevalence rate


TABLE 236-Monthly Indices

July 1995 7.66%August 1995 7.81 September 1995 7.56 October 1995 7.39 November 1995 7.30 December 1995 7.11

January 1997 7.71%February 1997 7.59 March 1997 7.83 April 1997 7.99 May 1997 7.86 June 1997 7.68

January 1996 7.10 February 1996 7.27 March 1996 7.65 April 1996 7.80 May 1996 7.91 June 1996 8.00

July 1997 7.42 August 1997 7.48 September 1997 7.40 October 1997 7.26 November 1997 7.13 December 1997 7.03

July 1996 7.95 August 1996 7.76 September 1996 7.95 October 1996 7.68 November 1996 7.41 December 1996 7.50

January 1998 6.89 February 1998 6.95 March 1998 7.00 April 1998 6.99 May 1998 6.98 June 1998 6.83

Statutory Calculationscontinued from page 1

The maximum statutory valuationinterest rates for 1998 issues of annuitiesare all lower than those for 1997 issues. The reductions range from 25 to 50 basispoints.

Explanation of Interest Rate CalculationsThe maximum statutory valuation interestrates are dependent upon the values of“reference interest rates.” Referenceinterest rates vary by product type andguarantee durations. Some referenceinterest rates for annuity products arecalculated using the 12-month arithmeticmean of monthly corporate bond yieldindices published by Moody’s InvestorsService for the period ending June 1998. Reference interest rates for all lifeinsurance products and the other annuityproducts are calculated using the lesser ofthe 12-month and 36-month arithmeticmeans of those same corporate bond yieldindices.

The 36 monthly indices used tocalculate the reference interest rates areshown in Table 2.

These rates generate a 12-monthmean of 7.11% and a 36-month mean of7.47% for the period ending June 1998.

The reference interest rate is used inspecified formulas for calculating thevaluation interest rates for the variousproduct types and the resulting value isrounded to the near 0.25%. For annuityproducts, this rounded value becomes thenew maximum statutory valuation interestrate. For life insurance products, if therounded value is not at least 0.50%different than the prior year’s value, themaximum statutory valuation interest rateremains at the prior year’s level.

Maximum nonforfeiture interest ratesfor life insurance products are calculatedby multiplying the maximum statutoryvaluation interest rate by 125% androunding to the near 0.25%. There is aone-year grace period for nonforfeitureinterest rate changes—a new interest rateis optional for the following year butmandatory for the succeeding year.

Maximum Statutory ValuationInterest Rates for Future Years’IssuesThe formulas used to determinemaximum statutory valuation interestrates for life insurance products generallyrequire large swings in yield indicesbefore a change in the maximumvaluation rate will occur. As statedbefore, the maximum statutory valuationinterest rate for 1999 issues of whole lifeinsurance products will be 4.50%. Forthe whole life maximum statutoryvaluation interest rate to change for 2000issues, one of the following scenarios inTable 3 must occur.

TABLE 3

Target Maximum 12-MonthStatutory Mean for

Valuation Interest July 1998–Rate June 1999

Required

4.00% 6.21%5.00% 10.22%

Recently, Moody’s average corporatebond yields have been in the area of7.00%. If the mean yield over the next12-month period drops to 6.21%, a4.00% maximum statutory valuationinterest rate for 2000 issues of whole lifeinsurance policies would be the result.

Annuity maximum statutory valuationinterest rates are more volatile than thosefor life insurance. If the Moody’s indicesremain at current levels or drop slightly,an additional 25 basis point reduction inthe maximum statutory valuation interestrates can be expected for 1999 issues ofmany annuities. If the Moody’s indicesincrease, on average, by 25 basis points,maximum statutory valuation interestrates will increase for some annuities in1999.

A complete listing of maximumstatutory valuation interest rates for alllife and annuity classifications is availablefrom the editor of Product DevelopmentNews. David G. Whittemore, FSA, is withTillinghast-Towers Perrin in Dallas,Texas and editor of Product DevelopmentNews.


Chairperson’s Cornercontinued from page 1

significant immediate impact as well as and group insurance and that inflationimplementation of XXX. The illustration affects permanent cash-value insurance.regulation has also had some effect. How will you design attractive fixed

In the taxation area, you are quite annuities and universal life policies foraware of the government’s occasional today’s low interest environment? Thethreats to tax the cash value buildup of stock market’s impressive performanceordinary life insurance policies. You also has certainly helped support the dramaticare aware of how government has increase in variable products being sold.expanded the IRA market. Any of thesechanges could create exciting new product 4. Competitor Analysis. As forideas. competition, your company must define

2. Social and Demographic Change. on any marketing activity—not justHow dramatic is demographic change? A product development.man who is married to his first wife, who Field force and industry sources areis the sole breadwinner in his family, and particularly useful in assessing yourwho has two children and a house in the competitive environment.suburbs, now represents less than 4% of Good industry sources are tradethe population. journals such as the SOA’s North

If a company attempts to anticipate American Actuarial Journal (NAAJ),the demographic changes that will occur Best’s Review, the National Underwriterin its customer base of the future, it’s and meetings sponsored by the SOA,bound to find opportunity. Four LIMRA, LOMA, and other industrycategories of demographic changes need groups. In addition, the Internet alsoto be monitored in a firm’s end provides much useful information.customers: income, age, education, andmix. 5. New Technologies. There have been

The right question is, “What a number of developments on thedemographic changes are happening or technology side. In computer technology,will happen in our customers in these four new developments have affected theareas, and how can we convert these into services we offer to both agents andnew product or market opportunities?” clients and the manner in which we offer

Here are some questions about them. New underwriting technologies aredemographics your firm can be asking: helping us better assess life insurance

risks.C How is the age distribution of yourcustomers changing?

C How will the education level of yourcustomers change in the next fewyears?

C How will the income distribution ofyour customers change in the nextfew years?

C How might the geographicdistribution of your customers changein the next few years?

C How might the buying habits of yourcustomers change in the next fewyears?

C What are the customer demographicsthat might change in the next fewyears?

C How will the mix of your customerschange in the next few years?

3. Financial and Economic Changes. On the financial and economic front, weknow recession affects health insurance

who its competitors are before embarking

6. Unexpected Successes. Mostorganizations accept success readilyenough, however, relatively fewcompanies make the key determinationthat allows them to build still further onthis success. Unexpected success canhappen to both your own organization andthose of your competitors. Most people,unfortunately, explain away unexpectedsuccesses as temporary aberrations thatwill soon disappear.

Here are some questions that may beuseful to help mine opportunity fromunexpected successes. By asking yourselfthese questions and by formalizing themas part of your company’ work routine,you will tend not to overlook someunexpected successes, whether they bethose of your peers or your own.C What unexpected product successes

have you recently had?C In which geographic areas have you

recently experienced unexpectedsuccesses?

C What customer segments haverecently provided unexpectedsuccesses?

C What unexpected successes haveyour suppliers recently had?

C What unexpected successes haveyour competitors recently had?

C What unexpected customer groupshave recently bought from you?

7. Unexpected Failures. Everyorganization has had new products thathave failed. In some cases, people tendto spend the rest of their careersdefending the failure. Instead, theyshould be asking, “what caused thisfailure and how can we turn it into anopportunity the next time?”

Ask yourself the same type ofquestions that you would for anunexpected success. Maybe you reallycan learn more from your failures thansuccesses.

8. New Knowledge. Obviously,discoveries or new knowledge will alwayslead to opportunities in the form of newproducts or markets.

The true innovator finds distinctapplications of new knowledge that canbenefit his or her business. Newmortality research or investment vehiclesare clear examples driving some of ournew products today.

Some questions about new knowledgeone can ask are:C What new knowledge has recently

become known about your business?C What combinations of knowledge

have created new insights into yourbusiness?

9. Your Customers. One last source ofproduct ideas too often forgotten is thecustomers themselves. Pay attention tothe messages they send through theiragents or your company complaintsystem. Get involved in consumer panelsand surveys.

As you know, idea generation is animportant step of the product developmentprocess. It can be managed as a



Life Insurance Firms in theRetirement Market: Is the NewsAll Bad?

Chairperson’s Cornercontinued from page 5

process so you can systematicallygenerate new product ideas.

It is also always important to haveseveral ideas “in the bullpen.” You neverknow when yesterday’s crazy idea maybecome tomorrow’s wildly successfulproduct.

By systematically managing the ideageneration process, you will never bewithout ideas—and it is almost guaranteedthat you and your company will benefitdramatically.

Mark A. Milton, FSA, is Vice Presidentand Associate Actuary at Kansas City LifeInsurance Company in Kansas City,Missouri, and Chairperson of theIndividual Life Insurance and AnnuityProduct Development Section.

ACLI Updatecontinued from page 2

would like to accomplish the disclosureportion as soon as possible so companiescan start implementing it. Theillustrations standards, which wouldinclude a “supportability” component,would be defined later. The industry willmake another proposal on the disclosuredraft at the September NAIC meeting. Julie Spezio is the ACLI contact.

A. Micheal McMahon, FSA, is SecondVice President and Actuary at ThePrincipal Financial Group in Des Moines,Iowa, and a member of the Individual LifeInsurance and Annuity ProductDevelopment Section Council.

by Paul Hoffman

and Anthony M. Santomero, Ph.D.

EDITOR’S NOTE: Reprinted withpermission, from the Journal of theAmerican Society of CLU & ChFC, Vol.LII, No. 4 (July 1998). Copyright 1998by the Journal of the American Society ofCLU & ChFC, 270 Bryn Mawr Avenue,Bryn Mawr, PA 19010. Distributionprohibited without publisher’s writtenpermission.

� �

ABSTRACT

The role of the life insurance industry inthe retirement assets market is examined. General trends found include: the massiveincrease in total retirement assets, both inabsolute levels and relative to totalwealth; the decline in corporate pensionsincluding a shift from defined-benefitplans to defined-contribution plans, drivenby increasing investment in 401(k)s; therise in total IRA assets; and the relativedecline of insurance annuities. Thesetrends, and the increasing dependence ofinsurance companies on annuity premiumincome, presage a difficult competitivefuture for life insurance companies in theretirement market.

� �

The Popular Image: The DyingInsurance DragonThe popular view of the role of insurancecompanies in the private retirementmarket is that of a dominant player that israpidly fading in prominence. Mutualfunds are rightfully perceived as havingattracted both the general investor andthose who are planning for retirement. Banks are also seen as a threat, though toa much lesser degree. Bank entry into theinsurance market is much feared but, thusfar, greatly exaggerated. While clearly anew competitor, the bank threat is merelyone more piece of bad news—one morecombatant in the war for retirementassets.

In this article, the authors take anobjective look at where insurancecompanies and their products fit in theretirement asset market. The articlesurveys the literature and available dataon the products that make up this growingsegment of the financial landscape inorder to help professionals bothunderstand the trends and identifyopportunities.

The news is not all disheartening. The industry is clearly a central part ofthe burgeoning retirement asset marketwith a major share of the assetsaccumulated so far. Its position over thelast several years has been exaggeratedand/or misrepresented by snippets of datathat have led to an incomplete picture ofthe retirement asset market and theinsurance industry’s role within it.

Specifically, a broad overview of theprivate retirement asset market suggeststhat:1. The market itself is growing rapidly asbaby-boomers appear to be saving morerapidly than the preceding generation.2. The retirement products used by thisnew generation have shifted substantiallyover the past decade, such that:a. pensions assets are not growing as

quickly as other forms of retirementassets

b. defined-benefit plans are decliningboth as a percentage of wealth and asa percentage of retirement assets

c. corporate pensions are declining infavor of individual retirement assets

d. annuities, offered by insurance firms,have grown in importance relative towealth and have remained stable as apercentage of retirement assets.

3. The observed growth in mutual fundmarket share has been primarily at theexpense of depository institutions, mostnotably in IRA and 401(k) assets.



The charts for this article are not available on line.Please contact Susan Martz at [email protected]

or (847) 706–3543 for a hard copy.

TABLE 1Retirement Asset Reserves

(% of Total Wealth)

Life Insurance Firmscontinued from page 6

This market overview suggestscertain requirements for the future growthand profitability of insurance firms in theretirement market. The challenges are:a. maintaining dominance of the annuity

marketb. recognizing that the defined-benefit

and defined-contribution pensioncategories are aged markets, subjectto relative, if not absolute, decline

c. competing effectively in the 401(k)and IRA segments of the retirementarena.Make no mistake about it, however;

the retirement market as a whole isgrowing and as such is an extraordinarilyattractive segment of the financial market. By year-end 1996, private retirementassets were nearly $5.1 trillion.[1] Retirement assets have increased theirproportion of wealth from 10.6 percent in1983 to 13.6 percent at year-end 1996(see Table 1). It is therefore possible,given the scenario of an increasingmarket, for an industry segment to losemarket share and yet increase sales andprofits. Since 1990, this has been thecase for insurance firms. Prior to 1990,the insurance industry market share wasincreasing. Subsequently, however, itsshare has dramatically shifted asconsumers changed the asset categoriesselected.

Life insurance companies were neverable to achieve a significant market sharein the fastest growing retirement assetmarkets such as 401(k)s and IRAs. Thislost share can and should be viewed as alost opportunity. Offsetting this loss isthe industry’s annuity market dominance. It has been projected, based uponhistorical trends and economic forecasts,that the market for individual annuities isexpected to increase annually at an 8percent rate.[2] Therefore, it is wise totake some of the dire predictions with agrain of salt.

Many data services and consultingfirms track the retirement asset market,and their data are often the source ofpredictions of a collapse of the insuranceindustry’s market share. In the past,headlines such as “Insurers Lose Groundto Competitors in IRA Market,”“Insurers Losing the Retirement AssetBattle,” or, to take a specific example,“Insurers Lose 401(k) Market Share toMutual Funds,”[3] have beencommonplace. The last of these articleswas based upon data reporting that the

insurance company’s share of the 401(k) institutions.market slipped from 34 percent to 30 The traditional stronghold of lifepercent in the two-year period from 1992 insurers, the annuity market, is notto 1994. Mutual funds were declared immune to gloomy reports andvictorious because they were able to projections. In thriving areas such asincrease their share from 26 percent to 37 variable annuities, direct insurancepercent. company sales are slipping. The Variable

Industry pundits do make some Annuity Research and Data Service [5]important points. For example, well- reports that direct sales of variableknown publications such as Best’s Review annuities decreased to 43 percent in 1995[4] cite fundamental weaknesses that and are projected to further decline to 30impair insurance companies from percent by the year 2000. Banks arecompeting effectively in the retirement identified as the primary culprit in thisasset market. Life insurance products sales decline. The insurance industry canhave been contrasted with those offered passively watch further erosion in thisby mutual funds and are frequently found market, or it can fight to keep the secondwanting. Some of the citations are well largest segment of the market.worth repeating. Through all of these assessments, the

Most insurance companies offer a reader is cautioned to keep one caveat inlimited selection of investment choices. mind: Data in the retirement market canIf they do offer mutual funds, they tend to be misleading and at times extremelybe conservatively managed, not unlike the opaque. Some segments of the financialpattern exhibited with their general funds. sector do not clearly report assets held forThis has lead to relatively poor retirement in such vehicles as 401(k) orinvestment results or, at least, IRA accounts. Others do not indicate thesignificantly less appreciation than purpose for which purchases areaverages achieved elsewhere during the earmarked. For example, annuity figuresrecent stock market boom. Returns from are most certainly higher than areinsurance products are often further reported. Many annuities do not qualifydiminished by front- or back-end fees, or for tax advantaged status, and therefore,deferred sales charges that are generally are not reported as being higher than those of competitors. Inaggregate, these factors predispose poor continued on page 8, column 1performance and will lead the public tomove to other better-performing



retirement assets. A further example is ensure acceptable living standards at case, the problem is compounded by thecontained in the Pension and Welfare retirement. An Organization for differing percentage in post- retirementBenefits Administration’s report on Economic Cooperation and Development income needs demonstrated by differentdefined-benefit and defined-contribution (OECD) comparison of savings rates in income levels. [14] The poor definitelyplans; a total of $128.5 billion is reported Canada, France, and Great Britain reveals need a higher fraction of preretirementas being held in insurance company that the United States has the lowest earnings, known here as the replacementgeneral accounts. A significant portion of savings rate and the highest percentage of rate. Generally, whatever examinationthis is most certainly earmarked for its population entering the retirement tool is used, the conclusion reached is thatannuities. [6] portion of their life cycle. [8] While the current level of aggregate savings is

Nonetheless, extrapolating from providing a relative picture, this ranking inadequate for a clear majority of theavailable data, with all its pitfalls, the begs the questions of what is adequate and general public. In addition, futurebottom line is that the insurance whether U.S. retirement asset changes to the Social Security system,industry’s portion of the retirement asset accumulation is sufficient in light of this which put the onus on individualmarket is huge. Life insurance company generation’s expectations and existing responsibility, will deepen the need forassets and reserves of annuities alone government social programs. increased saving. [15]have increased from $172.0 billion in A major hindrance to past research There is extensive literature on1980 to $1.315 trillion in 1996 [7] (these has been the lack of adequate data. The governmental measures to remedy thistotals include nontax-advantaged annuities situation has improved with the advent of situation and their efficacy in stimulatingas is the practice of the Federal Reserve). the Health and Retirement Survey (HRS). saving. [16] Despite a great deal ofThese figures represented 2.06 percent of Beginning in 1995, commentators have contention, the general view is that tax1980 wealth and 3.52 percent of 1996 shifted their views about wealth adequacy advantaged programs can induce greaterwealth, respectively, and reveal a based upon the data provided in the HRS, saving but not nearly at the proportionsrelatively healthy insurance industry which offers evidence that wealth is being desired. One pair of analysts suggestssector. accumulated at a faster pace than has been that retirement accounts that are rolled

The Contest: The RetirementAsset MarketAny discussion of the competitive positionof insurers in the retirement asset marketmust begin with an understanding of themarket itself and its trends. Theretirement asset market consists of multi-year assets established to facilitate theaccumulation of wealth in anticipation ofdecumulation upon retirement. Suchassets are usually tax advantaged, with thetax liability of either principal and interest(or both) deferred until withdrawal. Because of this feature, the category itselfis imprecise, as some may attempt to savefor retirement beyond tax-advantagedproducts while others may use theproducts’ tax-advantaged status for multi-year nonretirement savings. It is for thisreason that the numbers produced bydifferent reporting entities are often atodds; such data problems represent asubstantial challenge to any usefulanalysis of the market.

At its heart, however, the retirement assets would have been quite short. asset market involves multi-year horizon Pensions offered by large firms made upinvestment plans by whole generations of the bulk of nongovernment retirementhouseholds. For these individuals, saving assets, with most individuals using for an event that will occur on the distanthorizon requires discipline and foresight. continued on page 9, column 1Both attributes have been examined in thepopular and academic spheres.

It is commonly thought that thequantity of saving for retirement by thecurrent U.S. population is inadequate to

commonly thought. [9] Other researchers over should require that a minimum[10] have since contributed further percentage be maintained. [17] Thisevidence to the 1993 study by the would decrease retirement asset slippageCongressional Budget Office that used and may in fact be more effective thancohort data in demonstrating that baby new tax-advantaged vehicles, thoughboomers are saving at a faster rate than aggregate saving would not substantiallytheir parents did. [11] increase.

This research is hopeful for the The previously statedretirement asset market, but one should notwithstanding, the new evidence onremember that in all studies there is the accelerating savings accumulation isproblem of defining and measuring hopeful. This is true from a public policywealth. The authors of this article point of view, as it reduces concern foremploy a relatively simple definition the numerous aging baby boomers andusing only standard financial assets implies substantial growth for thoseincluding equity, debt, cash, and short- portions of the financial sector offeringterm instruments. Other analysts have a retirement asset products. Whilemuch more extensive definition of evidence suggests that not all financialindividual wealth, which includes such products have experienced proportionalitems as housing equity and retirement growth, this broad category of financialwealth inclusive of Social Security, minus assets has been flourishing and is likely tooutstanding debt. [12] They have continue to do so.determined that households on the vergeof retirement have average total assets of$499,187 and median total assets of$339,725. [13] These numbers arereduced significantly—to $163,087 and$59,335 respectively—using the definitionemployed in this article. The differencein the mean and median statistics in boththese measures reflects the upward skewimparted by the holdings of the wealthy.

Determining whether these resourcesare adequate for acceptable post-retirement living standards is a difficulttask and is investigated using manydifferent methods. However, in every

The Products: Instrumentsof the Retirement MarketNot long ago, a listing of retirement


“ … the last half century has seen the developmentof a number of tax-advantaged, retirement-specificasset categories, which now make up the bulk ofretirement savings.”


standard depository institution deposits or DEFINED-CONTRIBUTION PLANS allocation plan, and payouts are tiedretail mutual funds as additional assets to account balances.earmarked for retirement. However, the C Employee Stock Purchase Planslast half century has seen the development where shares of the employer areof a number of tax- advantaged, purchased, often with the employerretirement-specific asset categories, matching a portion of the purchasewhich now make up the bulk of price. In many cases, other equitiesretirement savings. To begin the may be purchased, but at least 50discussion of the relative share of these percent must be in employer stock. asset categories, each is reviewed asfollows.

DEFINED-BENEFIT PLANS

Defined-benefit plans are provided byemployers to their employees and promise has no additional rights or responsibilities to how funds are invested. Funds areto pay a specified benefit upon vesting associated with these dedicated assets. segregated into separate accounts,and subsequent retirement. Benefit Contributions tend to be related to salary and interest and dividends arepayments generally continue until the but do not ordinarily recognize past reinvested.death of one or more of the covered service.persons, and as such, these plans are a Employers favor defined contributionstandard insurance product. To finance plans because they are not generally liablethe liability, employer contributions are for asset performance, and administrationdetermined actuarially. Funding by the is less costly and complex. These are employer is tax deductible, as long as it is the same reasons why employees maya qualified plan according to IRS find these plans lessregulations. Once instituted, employer attractive thanfunding is inflexible; that is, proper levels defined-benefit plans. must be maintained, and the employees Determining expectedhave certain legal rights to coverage. asset levels atEmployer contributions are pooled and retirement is complex,can vary over time depending upon the and administrationinvestment performance of the pooled time and cost is non-assets. However, regardless of trivial to theinvestment performance, the employer is employee.legally liable for benefit payouts. With defined-contribution plans,Therefore the firm is the full bearer of employees can determine—indeed theyrisk. are responsible for—asset selection, risk-

From the point of view of the return trade-offs, and their ownindividual worker, this type of plan eases retirement planning. On a positive note,the difficulty of retirement planning. the compounding of interest and/orBenefits are easily and accurately dividends can lead to large sums atdetermined. However, for the employer, retirement, but generally require longthe combination of the actuarial mortality accumulation periods. Poor assetrisk, the vagaries of financial performance, however, can lead toperformance, and high administration inadequate retirement funds, a fact thatcosts have made these programs may be lost on a generation that has neverincreasingly burdensome. These factors seen a bear market.have figured prominently in the The types of defined-contributionmovement toward defined-contribution plans are quite varied; planners shouldplans. consult a dedicated pensions text for full

Under the defined-benefit label, there and detailed information. [18] Aare a number of different benefit plans sampling of the form that defined-with varying methods of payout. A contribution plans can take includes theworker may accrue units—which are tied following:to his or her compensation—or fixeddollar amounts. Other types of benefitsmay be tied to career average salary, orsome variation thereof, and/or linked toyears of service. Payouts are generally inthe form of an annuity.

Defined-contribution plans are employer-sponsored plans that do not promise afixed benefit, but rather have benefitsrelated to contributions and assetperformance. There are a wide variety ofplans of this type. If contributions arewithin specified limits, they areconsidered tax-sheltered and are thereforedeductible by both employee andemployer. Generally, these plans are contributes a fixed percentage of hisstructured so that the firm contributes a or her salary. There may be somecertain sum or salary percentage per degree of employer matching. Thecovered worker; thereafter, the employer employee is often offered a choice as

C Profit-Sharing Plans wherebyemployer payments are tied tocorporate profits (within limits). Insuch cases, there must be a definite

C Thrift Plans in which the employee

C 401(k) Plans in which payments aretied to firm profits. This is thenewest and fastest growing portion ofthis category. In reality, it is avariation of profit-sharing plans.

Contributions are considered to besalary reductions and may bematched by the employer. Assetsaccumulate tax free until withdrawal.

C 403(b) Plans are the counterpart of401(k) plans for nonprofitorganizations. While not properlydescribed as a profit sharing plan,salary reduction and employercontributions mirror their privatesector counterparts. In fact, for datapurposes, these are often aggregatedinto the private sector 401(k) totals.

INDIVIDUAL RETIREMENT ACCOUNTS

Beyond employer-sponsored retirementplans, individuals have access to taxfavored investment through individualretirement accounts, known as IRAs. Once extremely popular, they have fallenout of favor since the tightening of the taxcode in 1986. Contributions are deductedfrom earned income and




can be up to $2,000 (or total in the rapid expansion of the defined-compensation, whichever is lower) for contribution market discussed previously.individuals and $4,000 for marriedcouples. ANNUITIES

However, if the employeeparticipates in another qualified plan, thelimit declines to zero in the $25,000 to$35,000 income band. Beyond thisincome level, contributions are no longertax deductible. [19] An employer maycontribute funds, but these are consideredto be compensation and are taxed asstandard earned income in the year inwhich it is paid. However, tax on allinterest and dividends is deferred untilwithdrawal.

Funds are transferable to otherproviders of IRA services, butwithdrawals are restricted. Assets can beinvested in a wide range of investmentchoices including fixed-term savingsaccounts, certificates of deposit,annuities, mutual funds, and self-directedbrokerage accounts. As is the case withall defined-contribution programs,however, the effects of these investmentdecisions accrue to the program recipientfor better or worse.

Recently, IRA accounts have alsobeen used for at least two other purposes. If an employee receives a lump sumtransfer from a defined contribution plan,associated with early termination or anearly withdrawal from the tax-shelteredplan, the employee may establish an IRAwith the transferred assets and maintaintheir favorable tax status.

The second area that has seen recentgrowth is the use of simplified employeepension plans or SEPs. This program isaimed at small employers with less than25 employees (there has been discussionabout increasing this number). Administrative paperwork is kept to aminimum by the adoption of one of twomodel plan documents. Contributions areessentially salary reductions and are taxdeductible by both employee andemployer. This retirement class has beentermed “super IRAs” because of theirmuch higher limits. The employer maycontribute 15 percent of annualcompensation or $30,000, whichever isless. The employee may contribute up to$7,000 annually. SEP creation requires aSEP-linked IRA account into which fundsare transferred in standard defined-contribution fashion. Thus, the IRAmarket has experienced some of itsgrowth because of its ability to participate

This investment type is singled outbecause of the sheer size of its investmentmarket. Generally speaking, an annuitycan be many things. Annuities can beboth a method of payout and aninvestment vehicle in itself. Annuitiesmay begin paying benefits immediately,or payments can be deferred to somefuture date as, for example, expectedretirement. Annuities may be purchasedby a single lump sum payment, orthrough a series of payments over anumber of years.

There are also different types ofannuities depending upon contract termsover the accumulation phase. In somecases, the annuity declares a return eachperiod based upon market performance. In other cases, the return is specified fora predetermined period of months oryears. Guaranteed Investment Contracts(GICs) offer a guaranteed interest rate fora specified period. With a multipleguarantee contract, multiple payments aremade, each with its own interest rate. This market is large, but has been waningin recent years.

Variable annuities are growing inpopularity. In these products, accretionof funds may be tied to an index such asinsurance company general fund returns,the Consumer Price Index, or some otherindex. It may also be directly related tothe performance of the segregated assetsinvested on behalf of the annuity. Theholder is often given latitude as to howfunds are invested and granted permissionto transfer funds to other sectors of thefinancial market.

The variation in the types of annuitiesmakes it difficult to talk about the marketin simple terms. However, its flexibilityis one of its major benefits. Annuitycontracts can be structured for pre- orpost-tax dollars, fixed or variable terms,and fixed or variable returns. In allcases, however, these contracts includetax advantages for interest and dividendsand actuarial risk of some type. Thelatter has developed into both an attributeand Achilles’ heel, discussed as follows.

Recent Trends: The Dynamicsof the Product MarketsThe retirement asset market isexperiencing rapid change. On anaggregate level, retirement assets havebeen growing more rapidly than eitheroverall economic activity or aggregatefinancial wealth. However, the real storyis the changing shares within the market. To best understand these changes; it ishelpful to first review the dynamics ofindividual product markets, and thenconsider institutional market shares. Given the nature of the data available, thebreakdowns between the two aresomewhat different, but are neverthelesshighly descriptive.

PENSION ASSETS

As noted previously, the term “pension”was at one time synonymous with acorporate pension plan, which wasprovided solely by a worker’s employer. This category was divided betweendefined-benefit (DB) plans, wherecontributions are variable and the benefitsare fixed, and defined-contribution (DC)plans, where contributions are fixed andbenefits variable. It is on the defined-contribution side where the picture can bea little opaque. In many cases theemployee is able to contribute with thecorporation matching these contributionsto some degree. This employee aspecthas become increasingly important inrecent years. Therefore, it has becomedifficult to divide the retirement marketstrictly into employer and employeesectors.

Over the period from 1980 to 1993,[20] the combined assets of both DB andDC plans grew from $563.6 billion to$2.3 trillion (see Table 2). Insurancecompany totals, which are usuallyreported separately, increase the total to$3.1 trillion. With inflation and wealthincreasing over this period, these figuresdo not convey much more than that theretirement market has grownprecipitously. The combined marketbenchmarked against total wealth hasfluctuated in the 10.62 to 13.62 percentrange over the period 1983 to 1996. Thegeneral trend has been upward, with thesingle exception of the period 1985 to1988.





TABLE 2Assets of Private Pension Plans (Excluding Insurance Companies)

($ Billions)

TABLE 3Defined-Benefit and Defined-Contribution Assets

as a Percentage of Wealth


However, the decidedly upward driftconceals a dynamic shift in the makeup ofthis sector. As Table 3 illustrates, themarket has demonstrated a strong shiftaway from the defined-benefit planstoward defined contribution plans. In1980, the defined-benefit assets were 2.5times that of defined- contribution assets. By 1993, the last date available, defined-benefit assets were only 1.17 times that ofdefined-contribution plans. The trendsindicate that it is likely the two plans arenow nearly at parity.

The rise of individual saving forretirement, through such vehicles as401(k) accounts, further alters theanalysis. Gross defined-contributionfigures include 401(k) balances in thetotals. Deducting 401(k) assets yields thedata reported in Table 4, which revealsthat the percentage of wealth representedby other defined-contribution plans hasdeclined slightly over the period. Moreimportantly, it is apparent that the totalemployer-related portion of the retirementassets market is declining. Defined-benefit programs have been decliningprecipitously from 5.41 percent to 4.41percent of total wealth over the reporteddecade, as DC plans have drifted onlyslightly lower.

Additional evidence illustrates thatDC programs have substantially replacedDB plans within the corporate pensionfund market over this period. [21] Thisis true even while their total is decliningas a percentage of wealth. This result ishidden by the dramatic increase in 401(k)assets, but is evident in Table 4.

401(K) ACCOUNTS

Legislative action led to the creation of401(k) accounts in 1978. However, thisretirement program did not becomepopular as a savings vehicle until itsoperation was clearly defined by theTreasury Department in 1981. At thattime, the requirements of the market wereset forth. As noted previously theavailability of 401(k) accounts isdependent upon employer sponsorship,but it is essentially an individual’saccount. Because the employer maymatch a portion of the employee’scontribution, 401(k)s are listed asdefined-contribution plans. However, theemployee’s choice of contribution leveland the method of fund investment haveled many to consider 401(k)s as beingindividual accounts.

Contributions to 401(k) accounts affected by the Tax began at modest levels in comparison toboth DB plans and IRAs. Contributions continued on page 12, column 1in 1984 were $16.29 billion but nearlydoubled in the next two years. However,unlike IRAs, 401(k)s were not materially




TABLE 4Modified Defined-Benefit and Defined-Contribution Assets

(% of Total Wealth)

TABLE 5Annual 401(k) and IRA Contributions

($ Billions)


Reform Act of 1986. Therefore,contributions continued to increase eachyear over the last decade. Annualcontributions in 1993 were $69.3 billion,well beyond the peak levels of IRAcontributions (see Table 5).

Total 401(k) assets continue to riseboth absolutely and relatively. Theperiod from 1984 to 1993 saw total assetsincrease from $91.8 billion to $616.3billion. These gross dollar amountscorrespond to 0.74 percent and 2.18percent of total wealth respectively. Thecurrent value of outstanding 401(k) assetsis lower than its IRA counterpart and canbe attributed to a smaller time frame forcontributions (see Table 6).

INDIVIDUAL RETIREMENT ACCOUNTS

Many view individual retirement accountsas beginning with the Tax Act of 1981. However, IRA contributions were $1.4billion as early as 1975. In 1981,however, IRA saving became taxadvantaged, thereby becomingparticularly attractive. At this point,contributions rose from $4.8 billion in1981 to $28.3 billion in 1982. Contributions increased rapidly until theirpeak of $38.2 billion in 1985. Subsequently, the Tax Reform Act of1986 changed the code once again, thistime to the IRA’s disadvantage. Saversresponded by reducing contributions tolevels only slightly higher than those priorto 1981. Table 5 illustrates the sensitivityof IRA annual contributions to the taxcode changes; annual contributionsdeclined immediately following the 1986legislation.

The importance of individualretirement accounts is perhaps better seenby looking at total assets. In 1983, totalIRA assets were $91.3 billion. By year-end 1996, total assets had expanded to$1.35 trillion. Table 6 shows that the1984 figure represents 1.06 percent ofwealth, and the 1993 total represents 3.07percent of wealth. Thus, despite flatcontributions since 1987, total assets havedramatically increased. To be sure, muchof the growth is a result of the gains inthe equity market over this period, but itnevertheless represents a large andvibrant asset pool.

The combination of large outstandingbalances, transfers from other retirementasset accounts, and the rise of SEPprograms (which comprised 5 percent of1995 IRA assets invested in mutual funds

[22] make this an attractive market. As accounts. However, the lack of data doessuch, competition for the $1.3 trillion not permit a detailed analysis.aggregate total is fierce. Within thiscategory, rollovers and small business continued on page 13, column 1SEP programs are a more importantactive battleground than are new IRA




TABLE 6IRA, 401(k), and Annuity Percentage of Wealth

TABLE 7Annual Annuity Premiums Received

($ Billions)


THE ANNUITIES MARKET

Group annuities come in many shapes andsizes, but are usually purchased byemployers on behalf of their employees. Group and individual annuities can becomponents of either defined-benefit ordefined-contribution plans. Variableannuities differ in that their funds areusually invested in equity. They aresometimes classified as defined-contribution and can also be either groupor individual.

By any measure, the annuity markethas grown increasingly active in recentyears. Sales of group and individualannuities (including taxable) were $19.45and $15.20 billion respectively in 1982. By 1996, these figures had risen to$92.23 and $84.07 billion. However, thefigures disguise the fact that groupannuity contributions have traditionallybeen greater than those of individualannuities. In 1986, they were more thandouble. The differential peaked duringthe period 1986 to 1990 (see Table 7).

On the other hand, contributions toindividual annuities rose steadily through1995. By 1994, individual annuitycontributions had overtaken groupcontributions, with a slight backing off in1995 and 1996. A similar pattern ofgrowth is shown in Table 8, whereannuity premiums are scaled by totalwealth. Growth is obvious, with thelargest relative gains over the last decadeaccruing to the individual annuity market.

Shifting from premium income tonumbers of contracts, Tables 9 and 10show the growth in the number of peopleholding fixed and variable annuities. Noticing the differential scale, it isobvious that the fixed annuity market stilldominates, but the recent dramatic growthof both individual and group annuities isstartling. In fact, recently reported datasuggests that there are over 47 millionannuity contracts in force. [23]

Turning to assets held in connectionwith the annuities in force, Table 11reports on assets and reserves of annuitycontracts and shows a similar dynamic. Assets and reserves in 1980 were $140.42billion and $31.54 billion for group andindividual annuities respectively, whilethe 1996 totals were $657.06 billion and$658.35 billion (these totals include nontax-advantaged annuities). Normalized asa percentage of wealth, the 1980 figureswere 1.68 percent and 0.38 percentrespectively. These figures rose steadily

to 1.76 percent in 1996. Group annuity As Table 10 illustrates, the growth inassets and reserves peaked in 1990 at the market has been particularly 2.32 percent. On the other hand,individual annuities steadily increased to continued on page 14, column 1their current levels by year-end 1996 (thedata from 1996 is not directly comparableto previous years due to accountingchange).




TABLE 8Annuity Premiums as a Percentage of Total Wealth

TABLE 9Number of Fixed-Individual Annuities (Millions)


spectacular in the variable annuity sector. Several factors account for this recentgrowth:1. The relative decline in defined-

benefit plans2. The increased interest by the more

affluent and educated baby boomercohorts

3. The increased acceptance of equityinvestment for asset accumulation. This latter point may be particularly

relevant. Returns on variable annuitiesdevoted to equity investment tend to behigher than traditional annuities becauseof their similarity (in spirit, if not in fact)to equity mutual funds. While the rate ofinflow of funds to mutual funds has beenquite rapid for over a decade, the rise invariable annuities has been even more so. Contributions increased fourfold since1991, rising from $17.3 billion in 1991 to$73.8 billion in 1996.

The shift to variable annuities isfurther demonstrated by viewing theirincreased share of annual premiumincome. In 1983 only 9.85 percent ofpremiums were for variable annuities; by1996 the share had risen to 31.54 percent. While this total is still substantially belowthe fixed annuity counterpart, the relativegrowth is noteworthy (see Table 12).

Market Shares: The ChangingFortunes in Retirement ProductsWith the changing nature of theretirement market, it is obvious that theproduct mix is dramatically changing. Defined-benefit plans are giving way todefined-contribution plans, 401(k)s,IRAs, and annuities. The battlefield offuture competition is going to be in thesefour product areas, as the defined-benefitmarket is aged and in decline. This facthas several implications for the astuteobserver.

First, institutions that have a largeportion of the defined-benefit market willinevitably lose their relative position inthe broader retirement asset market. Thismeans that insurance firms and bank trustdepartments, which traditionally havebeen strong in this market, will find itvirtually impossible to maintain theirrelative position.

Second, the changing product miximplies that the future growth of thesefirms will depend upon their ability togarner market share in the four growth

areas enumerated previously. Further- discussed in greater detail as follows.more, with the move toward individualpension planning, the real contest will INDIVIDUAL RETIREMENT ACCOUNTScenter on the control of the retail market. In short, the future depends uponmaintaining, acquiring, and/or growingassets in the IRA, 401(k), and annuityproduct areas. Three products are

During the period from 1984 to 1993,IRA assets rose impressively from 9.93





TABLE 10Number of Persons Possessing Variable Annuities (Millions)

TABLE 11Total Annual Assets of Life Insurance Companies (% of Wealth)


percent to 23.41 percent of total pensionassets (see Table 13). As mentionedpreviously, this increase is in spite of thefact that direct IRA contributions havefallen considerably since their peak in1985. The increase in total assets can beattributed to appreciation in asset value,lump-sum rollovers, and the expanded useof IRA accounts in the nascent SEPmarket.

The four main institutional players inthe IRA market are depository institutions(commercial banks, thrifts, and creditunions), investment brokerage firms,mutual fund complexes, and insurancecompanies. Table 14 demonstrates thedramatic changes in relative shareexperienced by these institutions between1985 and 1996. Mutual funds andbrokerages have made sizeable inroadsinto depository institutions’ share. Depository institutional share declinedfrom 61 percent in 1985 to 18.4 percentin 1996. Mutual funds and brokeragespicked up 43.2 percent of this drop, withmutual funds increasing from 15.8percent to 37.9 percent and brokeragesfrom 14.7 percent to 35.8 percent. Partof this change is explained by theappreciation of equities. At the sametime, insurance companies exhibited apronounced decline from a 10.4 percentmarket share in 1990 to 7.8 percent in1996.

With contributions at a low point,competition for lump-sum rollovers willlikely heat up in coming years. TheEmployee Benefit Research Institutelooked at the IRA contributions marketduring the period from 1987 to 1990. [24] During this period, for every newlyinitiated rollover account, contributionscontinued in 3.85 existing accounts. Thepattern is reversed however, whenconsidering dollar amounts. A typicalrollover account has an annualcontribution 3.21 times that of a regularaccount. Of course this figure isstatistically misleading since itincorporates the large initial amount thatis rolled over. Both the number ofaccounts and the dollar amounts weremoving in favor of rollover accountsduring this period. The ratio of existingaccounts to rollover accounts decreasedfrom 4.92:1 in 1987 to 3:1 in 1990. Thedollar ratio of rollovers to regularcontributions increased from $1.99:1 to$4.58:1. IRA rollovers, which areinvested in the mutual fund market, show

a similar trend. The share of rollover the existing huge asset pool. Changes inassets increased from 27.39 percent to relative institutional share will likely be34.17 percent of total IRA assets over the dependent upon making inroads into theperiod extending from 1992 to 1994. [25] rollover market and the new SEP-IRA

As previously noted, IRA contribu- and Roth IRA markets. However, thetion rates are sensitive to changes in the data suggests thattax code. At present, the majority of feeincome is derived from management of continued on page 16, column 1




TABLE 12Life Insurance Annuity Premiums

TABLE 13Instrument Share of the Retirement Asset Market


depositories are clearly losing share tomutual fund complexes and brokeragefirms. Insurance firms can only gain IRAmarket share by being more aggressive inthe rollover competition. This implies aneed to be more responsive to the desiresof retail customers to participate in equityownership, as fixed rate asset choicesseem to be losing market share to equityparticipation across the board.

401(K) ACCOUNTS

Currently, this segment of the retirementmarket is slightly over 70 percent of thesize of IRA balances. As of year-end1993, the most recent date available, totalassets were $616.3 billion. With thedownturn in IRA contributions, 401(k)accounts have rapidly taken up the slack.As noted before, annual contributionsrose uninterrupted from 1984 to 1993.Unlike IRAs, both contributions and assetlevels have increased rapidly. This hasled to an increasing share of the totalassets of the pension market. In 1984,401(k) accounts represented only 6.91percent of total retirement assets. By1993, their share had risen to 16.63percent (see Table 13 [using Departmentof Labor figures]).

Data on the institutional makeup ofthe 401(k) market is sparse. The mutualfund industry is the only industry thatregularly reports its market share. Duringthe period from 1986 to 1995, mutualfunds saw their 401(k) share rise from8.39 percent to 38.67 percent (see Table15). The rapid growth in the 401(k)market provides opportunities for bothnew accounts and maintenance ofoutstanding accounts for all segments ofthe financial sector. As with IRAs,rollovers are another avenue by which tomake market in-roads. However, successof the insurance industry depends upon itsability to offer products that permit equityparticipation and to offer a wide range ofinvestment options. Depositoryinstitutions have been losing 401(k)market share because they have notoffered their customers a wide range ofchoices. The insurance industry cannotafford to make the same mistake.

ANNUITIES

Annuities represent the second largestsegment of the retirement market. In thelast year in which aggregate totals areavailable, 1993, annuities held 19.81

percent of the market (IRAs were first trillion, of which $733.93 billion waswith 23.41 percent and 401(k)s followed classified by insurance companies aswith 16.63 percent) (see Table 13). As being retirement targeted. It must be keptwould be expected, insurance companies in mind thatare dominant in this area. Their share ofthe distribution market for annuities in continued on page 17, column 11993 was 75.91 percent. In raw dollaramounts, annuity reserves totaled $1.041




TABLE 14Institutional Share of the IRA Market

TABLE 15Mutual Fund Share of 401(k) Assets


these figures understate retirementannuity totals. Many individuals makepurchases of annuities that do not qualifyfor tax deferred status.

Nonetheless, Table 16 reveals thatthe share of total retirement assets for taxdeferred insurance company annuities hasdeclined over the current decade. Theirmarket share slipped from 20.38 percentin 1983 to 16.61 percent in 1996, havingpeaked in 1990 at 22.56 percent. Thepicture is somewhat better when followingthe Federal Reserve’s practice ofincluding nontax- advantaged annuities. Insurance annuities would then start witha market share of 24.17 percent in 1983,rise to 30.26 percent in 1990, and declineto 25.89 percent in 1996. Using thesetotals, annuities displace IRAs as thelargest retirement asset instruments.

Annuities are sold through manyavenues in addition to direct sales byinsurance companies. Banks are a newand increasingly important distributionchannel. An ominous note for insurancecompanies is that their share of initialsales fees may be declining. Their shareof revenue in the increasingly populararea of variable annuities was 55 percentin 1994 and decreased to 43 percent in1995. Some commentators project theshare will drop to 30 percent by the year2000. [26] This trend could becompounded by the announced intentionof banks to create and market their ownannuities as opposed to merely sellingthose of insurance companies. [27]

Looking Ahead: The Future of the Insurance IndustryAt $5.1 trillion in assets and reserves, theprivate retirement market is massive. Itis growing both absolutely and relatively. Millions of workers are dependent upon itfor their livelihood. Millions more aredependent upon it for their future.

Much has been written about theeroding competitiveness of insurancecompanies in the retirement asset market. While not as severe as portrayed in thepopular press, it is undeniable that theirshare has been decreasing. Overall, from1983 to 1996, insurance company shareslipped from 22.74 percent to 18.03percent (see Table 17). This long-termtrend accelerated between 1990 and 1996,with a decline of 8.35 percent from their1990 peak. Insurance companies shouldbe troubled by this greater than onepercent decline per year.

In their traditional stronghold of relevance is the industry’sannuities, insurers remain preeminent, asdemonstrated by the number of annuity continued on page 18, column 1holders in Table 18. Many investmentfirms and banks have proclaimed theirintention to challenge the insuranceindustry in this area, but have yet to do sowith much visible success. Of greater




TABLE 16Insurance Company Annuities–Share of the Private Retirement Market

TABLE 17Insurance Company Share of the Private Retirement Market


own need to maintain effectiveness andcost efficiency in its delivery systems toremain competitive. In areas such asvariable annuities, insurers are underincreasing attack by mutual fund housesthat wish to gain market share at theexpense of an insurance industry that, attimes, fails to take advantage of itsmarket leadership.

The similarity of variable annuities tomutual funds has been a major reason fortheir success. But therein may lie theproblem. Variable annuities tend to havehigher fees than traditional mutual funds.[28] Part of these fees go to options suchas life insurance attachments and principalprotection. But, as with load mutualfunds, these fees will hurt long-termperformance. Performance may befurther affected by low risk portfoliochoices. As consumers become moreknowledgeable, these inhibitors maynullify the value of insurance attachments,and variable annuities may subsequentlylose their luster.

In fact, the success of insuranceannuities is somewhat problematic. Annuity premium income has eclipsedtraditional sources of income such as lifeand health insurance (see Table 19). There has been a fundamental shift to adependence on the retirement market. Itis for this reason that insurancecompanies should be particularly wary ofencroachment upon their annuity share.

As far as the industry’s potential inother areas, the picture is decidedlymixed. Insurers slipped from their 10.8percent IRA market share peak in 1990 to7.8 percent at year-end 1996. However,at the same time, IRA assets’ proportionof insurance company pension assetsincreased from 3.34 percent in 1983 to12.04 percent in 1996 (see Table 20). Therefore, despite losing market share,IRAs have become increasingly importantto insurance companies’ earnings andasset growth. Insurers cannot afford topassively lose this market to the mutualfund industry, as depositories have done. They must compete with a wider array ofproducts and at a competitive feestructure. Otherwise, their share willfollow that of banks and thrifts in the lastdecade.

Finally, the explosion in the 401(k)market should be a signal to all players inthe retirement market that complacencycan lead to missed opportunity. Thisarea, as with that of IRAs, is marked by

rapid account turnover. The rollover industry is up to the challenge.market is many times larger than that of Overall, insurance companies haveaccount initiation. [29] Perhaps this is the slipped in their share of the retirementmethod whereby insurance companies can assets market over the last decade. Theirwin back market share from mutual niche and strength is annuities.funds. It is a market clearly too big toignore, and a key competitive continued on page 19, column 1opportunity. It remains to be seen if the




TABLE 18Life Insurance Retirement Annuities (Number of Persons–Millions)

TABLE 19Premium Income of Life Insurance Companies


This segment is growing in absolute termsbut is losing share relative to 401(k)s,IRAs, and the retirement market ingeneral. Insurance companies should bewary of inroads here associated withdelivery system weaknesses or excessivefees. At the same time, they must lookfor opportunities for expansion in the IRAand 401(k) markets.

Opportunities may come viatraditional routes such as the rollovermarket, or by creative avenues such asproduct innovation. If they areunsuccessful or choose to ignore theseareas, insurance companies risk becomingminor players in the retirement market. They are not likely to show a disastrousloss in market share akin to thatexperienced by depository institutions inthe IRA market, but attention should bedirected to shoring up their annuitystrength and diversifying to guard againstthe inefficacy of these measures. Insurance companies should askthemselves a fundamental question: Dothey want to link their survival solely tothe annuities market?(I/R Code No. 4400.00/2750.07)

Editor’s Note: This study is part of theWharton Financial Institutions Center-KPMG Peat Marwick project on theRetirement Asset Market.

� �

Paul Hoffman has been a Senior Fellow atthe Wharton Financial Institutions Centersince 1996. Prior to that, he was aHuebner Fellow from 1992 to 1996 andconcurrently a Sloan Fellow from 1993 to1996, both at the Wharton School. Mr.Hoffman received his bachelor’s degree instatistics—Phi Beta Kappa and MagnaCum Laude—from the University ofRochester in 1992.

Anthony M. Santomero, PhD, is theRichard K. Mellon professor of financeand director of the Wharton FinancialInstitution’s Center at the University ofPennsylvania. He received an AB ineconomics from Fordham University in1968, a PhD in economics from BrownUniversity in 1971, and has received anhonorary doctorate from the StockholmSchool of Economics in 1992.

END NOTES

1. American Council of Life Insurance,Life Insurance Fact Book (VariousYears); Board of Governors of theFederal Reserve System, Flow ofFunds Accounts (4th Q. 1997); andInvestment Company

Institute, 1997 Mutual Fund FactBook.

2. Joseph A. Gareis, The Outlook forIndividual Annuities, Broker World,Feb. 1996.





TABLE 20IRA Share of Insurance Company Pension Assets


3. Amy S. Friedman, Insurers Lose401(k) Market Share to MutualFunds, Nat’l Underwriter,Life/Health/Fin. Services Ed., Nov.20, 1995.

4. Stephen J. Butler, Can InsurersSurvive the 401(k) Shakeout?, Best’sReview, Life/Health Ins. Ed., Oct.1995.

5. Variable Annuities May Be MixedBlessing for Insurers, Wall St. J.,Mar. 4, 1997.

6. Pension and Welfare BenefitsAdministration, U.S. Dept. ofLabor, Private Pension PlanBulletin–Abstract of 1993 Form 5500Annual Reports.

7. American Council, supra note 1.8. Jonathan Skinner, Individual

Retirement Accounts: A Review of theEvidence, Work Paper No. 3938,Nat’l. Bureau of EconomicResearch, Dec. 1991.

9. James Smith, Racial and EthnicDifferences in Wealth in the Healthand Retirement Study, J. of HumanResources 30, Supp. 1995, at S158.

10. Olivia S. Mitchell and James F.Moore, Retirement WealthAccumulation and Decumulation:New Developments and OutstandingOpportunities, Work Paper 97–12,Financial Inst. Center, The WhartonSchool.

11. Congressional Budget Office, BabyBoomers in Retirement: An EarlyPerspective, U.S. Gov’t PrintingOff. (1993).

12. Alan S. Gustman, et al., Pension andSocial Security Wealth in the Healthand Retirement Survey, Work Paper,Nat’l Bureau of Economic Research,Feb. 1997.

13. Id.14. Steven F. Venti and David A. Wise,

The Wealth of Cohorts: RetirementSaving and the Changing Assets ofOlder Americans, Work Paper No.5609, Nat’l Bureau of EconomicResearch, June 1996.

15. How to deal with inflation withoutSocial Security’s COLAs is examinedin Zvi Bodie, Pensions As RetirementIncome, Work Paper No.

2917, Nat’l Bureau of Economic 21. Leslie E. Papke, Are 401(k) PlansResearch, Apr. 1989. Replacing Other Employer-Provided

Pensions? Evidence From Panel16. See William G. Gale and John KarlScholz, IRAs and Household Saving,Amer. Econ. Rev., Dec. 1994;James M. Poterba and David A.Wise, Individual Financial Decisionsin Retirement Saving Plans and the Mutual Fund Fact Book.Provision of Resources forRetirement, Work Paper No. 5762,Nat’l Bureau of Economic Research,Sept. 1996.

17. Andrew A. Samwick and JonathanSkinner, Abandoning the Nest Egg?401(k) Plans and Inadequate PensionSaving, Work Paper No. 5568, Nat’lBureau of Economic Research, May1996.

18. See for example, Dan M. McGill, etal., Fundamentals of PrivatePensions, 7th ed., (1996); Pensionsand Profit Sharing, 6th ed. (1994).

19. The income bands for deductibleIRAs were raised in 1997. Inaddition, a new IRA Plus wascreated.

20. The U.S. Dept. of Labor calculatesthese figures from Form 5500 filingswith the IRS. The process has notbeen automated and is thereforesubject to a lengthy delay ofapproximately three years.

Data, Work Paper No. 5736, Nat’lBureau of Economic Research, Aug.1996.

22. Investment Company Institute, 1997

23. American Council of Life Insurance,1997 Life Insurance Fact Book.

24. Employee Benefit Research Institute,EBRI Databook on EmployeeBenefits, 3rd ed. (1995).

25. Retirement Assets Invested in MutualFunds—Summary Table, Nat’lUnderwriter, Life/Health/Fin.Services Ed., Jan. 29, 1996. Source:Investment Company Institute.

26. Variable Annuities, supra note 5.27. For a discussion of the banking

industry in the insurance market, see Anthony M. Santomero, Banking andInsurance: A Banking IndustryPerspective, Financial Managementof Life Insurance Companies (J.David Cummins and Joan Lamm-Tennant, eds., Kluwer AcademicPublishers, 1993).

28. Variable Annuities, supra note 5.29. EBRI Databook, supra note 24.


TABLE 1First-Year Inside Limits—Percent of Premium

Per Policy

Per AgentIncluding

EAP

Per AgencyIncludingEAP andOverrideProduct To Agent

To GAIncludingOverride

Life insuranceSingle-premium life and annuityQualified annuities

55.0%7.0

14.5

63.0%8.0

16.0

91.0%7.0

14.5

99.0%8.5

16.0

TABLE 2Renewal-Year Limits—Percent of Premium

To Agent To GA (Including Override)

Product Year 2 Year 3 Year 4 Year 2 Year 3 Year 4

Life insurance 22.0% 20.0% 18.0% 27.0% 23.0% 20.0%

Qualified annuities 4.5 4.5 4.5 6.0 6.0 6.0

Note: There are no inside limits in years five and later.

New York’s Revised Expense Limitation Lawby Jonathan Hecht, John M. Fenton, and Douglas A. French

n late 1996, a proposed revision to allowances to GAs are only payable on law, the limit includes expenses incurredISection 4228 containing considerable business not personally produced by the in the home office to help produce newliberalizations to the law was GA. Qualified annuities are annuities business.submitted to the New York State issued under Internal Revenue Code Each year, an officer of the company

Assembly. However, that bill did not sections 401, 403 or 457. must complete and sign an annualpass into law. Industry representatives, Table 2 shows renewal-year limits. statement schedule attesting to complianceworking together with the Life Insurance The commission limits can be with this limit. Council of New York, the American redistributed to an extent. UnusedCouncil of Life Insurance, and state commission payments from the firstregulators drafted a new bill that modified policy year or from earlier renewal yearskey provisions of the 1996 bill that some may be shifted to later renewal years on aconstituencies (including state regulators) percentage-for-percentage basis. Unusedfound objectionable. After much expense allowance payments from thenegotiation, the legislature passed the bill first policy year may be paid in laterduring the first week of August 1997. It years on a dollar-for-dollar basis.was signed into law by the governor inSeptember and became effective January1, 1998.

This article summarizes and analyzesthe provisions of New York’s Section4228. It also discusses the implicationsof the law on the design and structure ofsales compensation plans.

Key Elements of the LawNew Inside Limits. The law containsrevised inside limits, which include based on many factors but is considerablycommission limits for agents and general less complicated than the old Schedule Qagents (GAs) that apply on a per-policy limitations. However, unlike the priorbasis, and expense allowancepayment (EAP) limits thatapply on a per-agent basis ora per-agency basis for GAs. The inside limits are similarto those in the previous lawfor the first year, but arevery different for renewalyears. In addition, renewal-year limits apply only inpolicy years two throughfour, and there are no insidelimits in years five and later.

The first-year insidelimits are shown in Table I. The first-year commission onlife insurance is payable onthe premiums received up tothe qualifying first-yearbenchmark premium, asdefined by the law. Commissions payable onpremiums received in excessof the qualifying first-yearpremium are limited to 7%for agents and 8% for GAs. All extra commission

Total Selling Expense LimitsThe Schedule Q limits in the old law(first-year field expense limit, total fieldexpense limit, and total expense limit) arereplaced by the total selling expense limit. This is an aggregate limit on all “selling”expenses that may be incurred foracquiring new individual life and annuitybusiness and applies on a total-companybasis. The total selling expense limit is

Compensation Based on AssetsUnder Management (Fund-BasedCompensation)Compensation may be payable based onassets under management instead of as apercentage of premium. This is asignificant shift away from the historicalNew York position that compensationmay only be paid when premiums arepaid. Although the old laws technicallypermitted fund-based compensation, itwas effectively discouraged. Theallowable trade-off between percent-of-premium commission and fund-basedcompensation was generally viewed asunattractive to agents.

continued on page 22, columnn 1


New Yorkcontinued from page 21

The law states that the per-policy Insurance Department to continue usingcommission limits may be converted to the plan. To receive approval, the com-fund-based compensation, subject to the pany must demonstrate that agents willfollowing provisions: not receive more compensation over their

projected careers than they would haveC For life insurance other thansingle-premium, a company mayconvert 1% of renewal commissionin years two through four to 0.30%of fund-based compensation in yearstwo through four.

C For single-premium life and allannuities, a company may convert1% of premium-based commissionand EAP to 0.30% of fund-basedcompensation in years one throughfour.For example, instead of paying a

commission equal to 7% of premium on asingle-premium deferred annuity, acompany may pay 2.1% fund-basedcompensation in years two through four(and in all years thereafter).

With prior approval from theInsurance Department, a company maypay fund-based compensation using that is similar to the prior law.different trade-offs as long as the factorsare equivalent using reasonableassumptions.

In addition, the total selling expenselimit contains provisions for fund-basedcompensation. The per-premiumallowances in the total selling expenselimit may be converted to fund-basedallowances, using factors similar to thoseused for the per-policy limits.

Bonus PlansAs to the design of bonus plans, the lawis more flexible including the use ofretroactive factors, provided themaximum is within the inside limits. Inthe prior law, pure bonus plans were notpermitted, although persistency plans witha bonus element were allowed. Inaddition, bonus plans were not permittedon a first-dollar retroactive basis. Requiring the use of the maximum ratedoes differ from the current law, whichgenerally permits use of an average rate.

Other Forms of CompensationCompensation plans, including salaryplans, based on factors other than per-premium or percent-of-fund are per-mitted. A company may start a salaryplan and operate under it for a period oftwo years. After the two-year period, thecompany must obtain approval from the

earned under a plan consisting entirely ofcommissions and expense allowances thatcomply with the inside limits. Thisdemonstration must use reasonableassumptions for mortality, persistency,interest, agent sales, and agent turnover. The demonstration may be done in theaggregate for all agents covered under theplan.

Training Allowance Plans (TAP) for New AgentsThe law modifies and clarifies therequirements on training allowances to Department to promulgate a regulationnew agents. that establishes guidelines for

Agency Development Allowance (ADA)ADA for new GAs is allowed on a basis

Prizes, Awards, Conventions,and ConferencesThe law also clarifies and liberalizes thetreatment of prizes, awards, conventions,and conferences relating to the expenselimitations. Awards and prizes are notcounted against the inside commissionlimitations as long as no singleaward/prize exceeds $250 and their totalvalue in any year does not exceed $1,000. Also, an additional award/ prize of up to$25 in value may be paid as frequently asonce a month.

The expenses associated withconventions, conferences, or businessmeetings are not included in the insidelimits as long as they meet the IRSstandard for ordinary business expensesand are not includable in the recipient'sgross income for federal tax purposes. However, these expenses are countedagainst the total selling expense limit.

ExtraterritorialitySection 4228 remains extraterritorial—that is, it applies to all individual life andannuity business sold in the United Statesby a company licensed in New YorkState.

Product Self-Support RequirementThe law contains stricter language as tothe requirement that all actively soldpolicy forms be self-supporting, usingreasonably expected assumptionsincluding only the expenses incurred asallocated to the new sales.

A self-support certification must besigned by a qualified actuary andsubmitted with the policy form filing. Also, such a statement must be submittedwith any filing of an increasedcompensation plan. Documentationsupporting the statement must be kept inthe home office while the policy form isbeing offered and for six years thereafter. Finally, the law requires the Insurance

demonstrating compliance with thisrequirement.

Transition RulesThe law contains several provisionsdesigned to ease the transition from theprevious law. These rules are alsointended to prevent companies fromsubverting certain provisions:C A company may continue to use, for

a period of one year, any approvedcompensation plan that it was usingas of the effective date of the newlaw.

C For up to four years after theeffective date of the law, a companymay continue to use an existingapproved plan of compensation thatprovides for the payment of renewalcommissions on in-force businessthat may exceed the inside limits ofthe law.

C For the first year after the effectivedate of the law, the total selling limitwill be increased by 5%.

C Within four years of the law'seffective date, if an increasedcommission is paid after the fourthpolicy year for a policy in force as ofthe law’s effective date and theincrease is contingent upon thevolume of new business written, thensuch an increase that exceeds 1% ofpremium will be counted against theexpense allowance limits.




C Similarly, if an increased fund- based C Expense allowance plans that provide Levelized Commission Plans. Significantcommission is paid after the fourth goods and services as well as cash changes to commission plans can be madepolicy year for a policy in force as of payments in the area of level commissions. Thethe law’s effective date and within commission limits in years two throughfour years of the law’s effective date, four are more flexible than in the old lawand the increase is contingent on the and no limits apply in years five andvolume of new business written, then later. Further, the new law containssuch an increase that exceeds 0.30% explicit provisions for redistributingof the fund will be counted against commissions and EAP between earlythe expense allowance limits. policy years and later years, for both the

inside limits and the total selling limits.These last two provisions wereincluded in the law to prevent a companyfrom paying large renewal commissionson in-force business that really serve asfirst-year commissions and may subvertthe first-year limit.

Compensation Plan Filing ProceduresThe law specifies three levels of filingrequirements, depending on the type ofplan: informational filings, file and use,and filing for prior approval. Pre-approval of all compensation plans is nolonger required.

Most basic plans require only annualinformational filings. They include:C Plans where the compensation

percentages (including EAP) do notexceed the inside limit maximumswithout taking into account anyredistribution of commissions

C Plans where fund-basedcompensation does not exceed 2.0%annually in the first four policy years

C Agency development allowanceplans.These filings should fully describe

the compensation arrangements. Theymust be completed by the end of Februaryfollowing the year in which the coveredplans became effective.

File and use is required for:C Plans that redistribute commissions in

years two, three, or fourC Plans that pay a commission rate in

any year after year five that is greaterthan that allowed in year four

C Agent training allowance planscommissions based onC Salary plans that have been in effect

for less than two years

C Plans that are affected by thetransition rules due to certainincreases in renewal commissions onbusiness in force at the effective dateof the new law.A company may implement these

plans immediately upon filing. Thesuperintendent then has 90 days torespond. If the superintendent findsobjections to the plan and the companydoes not satisfy them within 60 days, thesuperintendent may order the company tostop using the plan.

Filing for prior approval is requiredfor plans using:C Fund-based compensation based on

nonstandard trade-offsC Training allowance payments

containing nonstandard provisionsC Expense allowance payments that are

redistributed from the first year torenewal years

C Salary plans that are continuedbeyond two years—the filing mustdemonstrate that the value of thepayments under the plan does notexceed the value of payments thatwould otherwise have been paidunder a plan of commissions

C Any other nonstandard arrangement.These filings must contain descriptive

information, including assumptions andtechniques, in enough detail for theInsurance Department’s review. If thesuperintendent does not object to the planwithin 90 days, it is deemed to beapproved.

Impact on Various Types of Compensation PlansFund-Based Compensation. Asmentioned earlier, fund-based compensa-tion arrangements are explicitlyrecognized in Section 4228. These planscan be implemented, subject to per-policylimits that are similar to the limits on

percent-of-premium factors. Further,fund-based compensation plans thatcomply with certain standards can beincluded in an informational filing and donot require prior approval.

Under the inside limits, unusedcommission payments from the firstpolicy year or from earlier renewal yearsmay be shifted to later renewal years on apercentage-for-percentage basis. Therefore, commissions can be structuredin a number of ways. For example, thecommissions payable to a selling agentcould be 55% in year one followed by20% in all renewal years or, alternatively,28.75% in all years. (The limits for ageneral agent would be slightly higher.)

If expense allowance payments aretaken into account, the allowable totalcompensation (to a selling agent) maybecome:C 91% in year one followed by 20% in

all renewal years, orC 36% in year one followed by 38.33%

in all renewal years (assumes theentire 55% first-year commissionlimit is shifted to later years), or

C A level 37.75% in all years (shifts53.25% of the 55% first-yearcommission limit to later years, inorder to obtain a completely levelcommission design).Per-policy commission levels are also

indirectly affected by the total sellingexpense limit. Although this limitoperates on an aggregate basis and appliesto all of a company’s individual life andannuity business, many companies wishto have each product stand on its ownwhen it comes to these allowances.

The percent of premium commissionallowances under the total selling expenselimit are 55% of first-year premium, plusan additional 60.5% of first-yearpremium (expressed in the




law as 110% of 55%), plus 12% of plans are permitted, provided that they do C Plans that provide incentives to therenewal premium. However, the 55% not exceed the inside limits and they field to achieve certain broad-basedfactor may be shifted to renewal years on comply with the total selling expense objectives such as increaseda three-for-one basis. Therefore, the limit. household penetration and producteffective inside limits (including EAP) cross-selling and higher consumerunder the total selling expense limits may satisfaction levelsbe:C 115.5% in year one, followed by

12% in all renewal years, or enable insurers to target betterrecruits with the expectation ofC 60.5% in year one, followed by

30.33% in all renewal years (if theentire 55% first year allowance isshifted to later years).

designed to reward agents for writingTherefore, the limits needed tocomply with the total selling expense limitmay be different from those that resultfrom an analysis of the inside limits in non-career-agency channels (foralone. Both limits must be taken into example, grid-based payouts andaccount in structuring a levelized asset-based trailers to stock-brokerscommission arrangement. Of course, and independent broker/ self-support must always be demonstrated dealers).and may also be a limiting factor indesigning a compensation plan.

Since renewal-year commissionlimitations are considerably more liberalin the long term under the law, companieshave a real opportunity to explore levelcommission alternatives, if desired.

Salary Plans. Salary plans will also beeasier to design and implement. Salaryplans may be started and operated for twoyears without prior approval. After twoyears, a company must be able todemonstrate that the plan does not providemore compensation than would otherwisehave been paid under a plan ofcommissions and expense allowances.

Bonus Plans. Bonus plans are alsopermitted. Essentially, all compensation

Potential Industry Reactions to the LawThe past few years have been challengingfor many life insurance companies andtheir sales forces. Several factors havecontributed to losses in the distributionside of the business including flat ordeclining agent productivity, deterioratingagent retention, and a shift in sales awayfrom the core life insurance products toinvestment products.

To reverse this trend, companies areexploring new approaches to the sellingproposition including enhanced salessupport and lead generation programs,greater consumer focus, and revisedcompensation plans. Until recently, theexisting laws on field compensation inSection 4228 have been an impediment tochange. They have significantlyconstrained a company's ability to designflexible compensation plans that aligncompany objectives with those of thefield.

While the new version of the lawdoes not provide complete flexibility indesigning new plans, companies mayimplement the following changes in agentand/or manager compensation plans:C Agent plans that defer a larger

portion of compensation into lateryears through the use of levelizedcommissions (although most likelynot level) and/or payments based onassets under management

C Increased training allowancepayments to new agents that may

generating higher agent productivityand retention

C More flexible bonus programs

larger volumes of quality businessC Plans similar to those commonly used

Overall, the new filing proceduresshould enable insurers to respond morequickly to market developments inbringing new plans to market. However,given increased competition forconsumers’ savings dollars from otherfinancial services companies (generally atlower distribution costs), it is unlikely thatinsurance companies will be able to usethe new law to increase commissions as ameans of expanding distribution. Whilerevisions in compensation plans may helpincrease sales force effectiveness, otherchanges will likely be needed.

Jonathan Hecht, FSA, John M. Fenton,FSA, and Douglas A. French, FSA, arewith Tillinghast-Towers Perrin in NewYork, New York, Atlanta, Georgia, andStamford, Connecticut respectively.


Ten Years Ago ...he July 1988 issue of Product the premium paymentTDevelopment News featured the requirements underfollowing articles: indeterminate premium

Risk-Adjusted Profit (Part 3) by Shane A. ChalkeIn this article, Shane Chalke addressedsome comments that had appeared in theApril issue, which were responses toideas presented in a series of seminars. Itdiscussed that risk-adjusted profit (oreconomic value) is an indispensableanalysis tool in the product developmentprocess. He stated that the primaryadvantages of risk adjusted profitmeasures were:C Risk-adjusted profit was a better

measure of the true value of aventure to the company than anexpected value

C Risk-adjusted measures were ordinalin nature and could be used to choosebetween ventures with differingdistributions of risks.The risk-adjusted profit calculation

used exponential utility functions. Advantages of such a utility function overdealing with raw data were stated as:C The use of a utility function resulted

in a more disciplined and consistentposture toward contingent situation

C The use of a utility function madedecision making possible where theraw data was too complex for mentaldigestion.

AIDS Pricing and ProductDesignby Thomas W. ReeseTom Reese started his article with asuggested mid-1990s actuarial examquestion. This question assumed thatAIDS claims had become 15% of totalcompany death claims. The questionasked what measures should have beentaken back in 1988 to prevent thisscenario? He suggested in his answer thatsound product design against the threat ofAIDS should have focused on two basicprinciples.C Control the insurance coverage you

provide including design featuressuch as limiting term renewals to oneadditional period, allowing termconversions only during the first fiveyears of the policy, and strengthening

products.C Maximize company

pricing optionsincluding higherguaranteed premiumsand higherguaranteed charges,reduce dividends in earlier yearsto build up a fund to allow forworsening experience, and considerthe capability to vary charges bystate.While the AIDS impact on life

insurance has not reached the levelexpected, many insurance companies havecertainly felt the impact.

Acceleration of Death Benefit on Catastrophic Illness by Guy V. BarkerThis benefit provided a portion of thedeath benefit from a life policy if a personhad certain conditions that have a highprobability of indicating likely deathwithin a brief number of years. Pricingfor this additional benefit is a challenge,as available population statistics must beadjusted for the insurance population. The benefit also required carefulunderwriting for family history of certainhealth conditions. It stated that conditionscovered must be those that can beidentified by objective tests as opposed tosubjective opinions of physicians. Thearticle noted that these benefits had realvalue to the consumer and would helpprovide a competitive edge to lifeproducts.

Impact of Black Monday on Variable Product Sales by William E. ConnorThis article summarized the impact ofBlack Monday on variable productsoffered by Pruco Life. The biggest shiftwas noted overall in where the money invariable products went. In September1987, only one dollar in seven was goinginto fixed rate options, while in May1988, about six dollars in seven weregoing to fixed rate options. Additionalobservations were shared about specificproducts. The variable universal lifeproduct saw both a decrease in the

number of applications (about 15%),


as well as a shift in the investment optionschosen toward fixed. Within the single-premium annuity and life products, thesales level before Black Monday wasabout 60% in variable and dropped to30% after Black Monday. In the flexible-premium variable annuity, the shift inpercentage of fixed option went from2½% to 21% by May 1988. Sales of afixed-premium variable life insuranceproduct without a fixed option declinedsignificantly. The author stated thecompany was committed to variableproducts as solid long-term products. Weare seeing great interest in variablestoday. If and when the market reversesits current trend, will we see some of theabove shifts repeating themselves?

A Universal Life NonforfeitureProposal by John M. BraggIn this article, Jack Bragg described aproposal concerning universal life cashvalues that he had made to the NAICActuarial Task Force. Under theproposed method, the minimum cashvalue would be based on a fixed, staticaccumulation. Premiums actually paidwere accumulated and expense allowancesand statutory mortality charges deducted. Interest was at a specified fixed rate. Theconcept was to provide that traditionalproducts would have the same cash valuesusing either the new accumulation processor the traditional prospective method.



Ten Years Ago ...continued from page 25

Reversionary Incomes by Kenneth Faig, Jr. In this article, the author made the pointthat he believed reversionary annuitieswould have the potential to provideadequately for financial needs that wouldbe prohibitively expensive to provide forwith life insurance. He discussed bothreversionary annuities following thenormal pattern where the life triggeringthe contingent event was older as well aswhere that life was younger. Thatinstance would provide for the parents ofseverely impaired children to provide forincome to care for those children upon theparents’ deaths. He noted that two of thebiggest obstacles for this form of annuitywere probably (1) existing rigidities andunanswered questions as to StandardValuation Law and Internal RevenueCode and (2) potential criticism of the“forfeiture” which occurred if the y would have been of interest to productpredeceased x (y being the one to whom development actuaries that had beenbenefits would be paid upon the death of discussed at the June 1988 meeting of thex). He noted that period certain options NAIC. They were:might alleviate some of the secondconcern.

AIDS Term Price Increases in the U.K. by Thomas W. Reese and Mark E. TurnerThe authors reported that premium ratesfor term assurance in the U.K. were might have been even more onerous thanbeing increased during 1988. For males, the final provisions.)the percentage increase ranged from

156% at age 30 down to 5% at age 60. with reserves for guaranteedSome of the increases were prompted by minimum death benefits.recommendations to use new reserves thatprovided for AIDS. The article alsoreported that permanent plan rates had notseen the impact of the increases in term. This was due to the fact that with-profitpolicies paid substantial bonuses reflectingexperience. Since the bonuses were notguaranteed, they could be adjusted toreflect the impact of AIDS on experience. The products similar to universal life hadmortality charges that could be reviewedat any time. (It would be interesting tosee a follow-up on what has happened inthe ten years since 1988 to such premiumrates.)

NAIC and Elsewhereby Bill CarrollBill Carroll reported on four items that

C Proposed regulation for the valuationof universal life insurance beingconsidered for adoption in California

C Actuarial guideline dealing with thevaluation of structured settlements

C Actuarial guideline dealing with thevaluation of annuities on substandardlives

C Proposed change to the reserveliability article of the Variable LifeInsurance Model Regulation dealing

Modified Guaranteed Life and Annuity Regulationsby Donald R. SondergeldThe article reported that there had beenslow progress in getting the states toadopt a model regulation on MGAs. Italso stated that the ACLI had begun totake steps to encourage statewide adoptingof the regulation and called for support ingetting the regulations adopted.

Tax Notesby John J. PalmerJohn Palmer reported on activity on the“single premium” issue since the lastnewsletter. At the time of the article,there had been initial provisions for aclass of Section 7702—qualifying lifeinsurance contracts known as “modifiedendowments.” He reported on some ofthe evolution that had gone on in gettingto the initial provisions. Rather thanseven pay, initial proposals were for up to20 pay. Penalties for early withdrawalwere proposed to be 15% rather than10%. The initial thought was for nograndfathering of existing contracts. Limits on mortality and expenses for thelimits were discussed. (In looking back atsome of the early considerations, this rule


Thanks to 1998 Hawaii Spring Meeting Participants

he Product Development Section Council wishes to express its sincerest appreciation for all those who participated in theTsessions sponsored by the Product Development Section. The sessions were very well received due to the commitment andtalents of these individuals.

C UP-TO-THE-MINUTE NEWS FLASH ON REGULATORY C COLI—TRENDS AND OUTLOOKDEVELOPMENTS Timothy Simon Millwood, Milliman & Robertson Inc.Donna R. Claire, Claire Thinking Inc. Ian Arthur Glew, CIGNA Individual InsuranceThomas C. Foley, North Dakota Insurance Dept. Christopher L. Parker, Clark/Bardes Inc.Sheldon D. Summers, California Department Gary Thomas, William M. Mercer, Inc.

of InsuranceJeffrey P. Newnam, PT AJ Principal Egalita IO C EQUITY-INDEXED PRODUCTS—NOW THAT YOUR HAVE

C MILLENNIUM UNDERWRITING J. Lynn Peabody, Milliman & Robertson Inc.Richard L. Bergstrom, Milliman & Robertson Inc. Ann R. Bryant, Lutheran Church Missouri SynodH. Michael Gaines, PMSI Jean B. Liebmann, SAFECO Life Insurance Co.Henry C. (Hank) George, Lab One Inc.

C MARKET CONDUCT ISSUES FOR PRODUCT DEVELOPMENT Noel J. Abkemeier, Milliman & Robertson Inc.ACTUARIES Donna R. Claire, Claire Thinking Inc.Mark A. Milton, Kansas City Life Insurance Co. Errol Cramer, Allstate Life Insurance Co.Bruce F. Deal, Analysis Group Economics Marc-Andre Giguere, Tillinghast-Towers Perrin C PREFERRED UNDERWRITING SURVEYRobert Schwab, Milliman & Robertson Mary J. Bahna-Nolan, North American Co. Life/Health

C INSIDE THE MEDICAL INFORMATION BUREAU David N. Wylde, American United Life Insurance Co.John A. Luff, Society of ActuariesJohn R. Avery, MIB Inc. C EVALUATING LIFE INSURANCE COMPANIES John Detwiler, MIB Inc. FROM THE OUTSIDEStacy Gill, MIB Inc. Deanne L. Osgood, Milliman & Robertson Inc.

C INSURANCE COMPENSATION TRENDS AND OUTLOOK David S. Kimmel, JP Morgan & Company, Inc.Joel I. Wolfe, Massachusetts Mutual Life Insurance Co. James H. Overholt, Milliman & Robertson, Inc.Deanne L. Osgood, Milliman & Robertson Inc. John D. Ladley, Ernst & Young LLPJeffrey M. Robinson, Life Insurance Financial

Essentials/HAS C TERM WARS

C CURRENT ISSUES IN SALES ILLUSTRATIONS David N. Wylde, American United Life Insurance Co.John D. Branscomb, Milliman & Robertson Inc.David N. Karo, ECTA Corporation C VARIABLE ANNUITY PRODUCT DESIGNWm. Harold Phillips, California Department of Insurance Deanne L. Osgood, Milliman & Robertson Inc.Forrest A. Richen, Standard Insurance Co. Jeffrey K. Dellinger, Lincoln National Life Insurance

C PREFERRED RISK PLANS: SHOULD WE HAVE THREE Lilia M. Sham, Tillinghast-Towers Perrin CLASSES OR SIX? Terry J. Simpson, Lincoln National Life InsuranceAllen M. Klein, CNA Life ReJames D. Atkins, First Colony Life Insurance C EXPENSES AND PRICINGCarl J. Macero, Transameric Reinsurance Katherine A. Anderson, Security Life ReinsuranceDavid A. Rains, Security Life Reinsurance Sam Gutterman, Price Waterhouse LLPJennifer K. Richards, The Principal Financial GroupShaun D. Parks, First Colony Life Insurance

THEM, WHAT ARE YOU GOING TO DO WITH THEM?

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