The Risk & Return of Variable Insurance Products

What is risk?

  According to Webster’s II New College Dictionary risk is defined as 1. Possibility of suffering harm or loss. 2. A factor, course, or element involving uncertain danger. 3.a. The danger or probability of loss to an insurer.  b. The amount that an insurance company stands to lose.  c. One considered with respect to the possibility of loss to an insurer.

  We live with risk every day of our lives. If we drive a car, we run the risk of being injured in a car accident. If we are involved in dangerous hobbies, such as bungee jumping, we run the risk of being killed. If we bet on a horse race or invest in the stock market through insurance products like variable or equity annuities or variable life insurance products, we run the risk of financial loss.  Virtually everything we do in life involves risk to some degree.

  Even Charlie Brown from the Peanuts comic strip experienced risk. When he got ready to kick the football, he never knew if Lucy would pull the football away leaving him to fall flat on his back. Those of us who read the comics knew that his risk was high (she always pulled it away).  Charlie Brown was a risk-taker. He always thought the next time would be a success.

  When analyzing risk, there are many elements or suitability questions to consider. Like Charlie Brown’s football experiences, past success or failure is one element that needs to be factored in. We know that some types of investments, such as annuities, carry guarantees of minimum return, and they also have past performance histories which allow the investor to evaluate probable future performance. Other types of investments, such as speculative stocks (or any stocks for that matter) have no minimum guarantees. Past performance does give the investor some ability to speculate on future performance, but it is only speculation. That’s why they are called speculative stocks. There are no guarantees!

  Investment risk is related to the probability of earning a return. The greater the chance of low or negative returns, the riskier the investment is.  Certainly, no one puts their money in an investment (insurance product or other product) with the idea of low returns. Everyone invests with the hope of high returns. When Bill Gates started Microsoft, those who invested in his company certainly knew there were no guarantees. Those investors looked at Gates and what he hoped to achieve and took a “risk” with their money. Their risk paid off. However, for every Bill Gates and Microsoft, many newer start-up companies fail.  With each failure, someone probably lost money.

Investment risk specifically refers to the probability of earning less than the expected return on investment. Probability distributions provide the foundation for risk measurement. Probability distribution can be defined as a set of possible outcomes with a probability of occurrence attached to each possibility. Some investments have specific outcomes, such as an annuity with a guaranteed minimum interest rate. Even the annuity has another possibility, however. The minimum earning rate does not mean that a higher rate will not be applied by the insurance company.  In fact, most annuities pay several percentage points higher than the minimum rate.

No investment is risk-free. An annuity with a guaranteed minimum interest rate has risk. Will it keep up with inflation? The T-bill for example is often said to be risk-free because the rate of return is guaranteed. This is often referred to as a “zero-risk investment.” In fact, every investment carries risk because every investment must contend with inflation. Only the nominal returns of the T-bill may be guaranteed. The real return cannot be. The real return refers to the actual buying power the investment ends up with whether that money comes from an insurance product like an annuity or a variable insurance product.

  There is another investment risk called reinvestment rate risk. There are several types of investments that must contend with this type of risk. An example of reinvestment rate risk is the T-bill. It has a maturity date. When the T-bill reaches this maturity date, the money must be reinvested in either another T-bill or some other financial vehicle. If the prevailing interest rate has dropped, the money will begin to earn a lower rate than it previously was. It is this risk of a lower interest rate that is called reinvestment rate risk. Annuities with a fixed rate and zero-coupon bonds do not have reinvestment risk because they do not pay out regular interest payments. Again, reinvestment rate risk is the possibility that the interest earned from an investment will earn less when reinvested. The interest compounds in annuities with a fixed rate and zero-coupon bonds at the same rate. This is because the interest is held onto = interest earning interest.

  Most equity indexed annuities use something simple, such as the S&P 500 and do not take into account reinvested dividends. While the loss in value of reinvestment of dividends can be significant, especially over a number of years, those who invest in these types of annuities are typically more concerned with the safety of their principal and are, therefore, willing to earn less. Even without reinvested dividends, indexes still perform pretty well. Equity indexed annuities usually do better than certificates of deposit or bond rates, although that is certainly not guaranteed.

What is Risk Tolerance?

Charlie Brown obviously had a high-risk tolerance. Why else would he repeatedly allow Lucy to hold the football?  Risk tolerance means how readily a person can cope with volatility - the ups and downs of an investment or other situation. If an investor cannot live with the investment because of its volatility or perceived risk, then obviously they should not be in that type of investment.

  Volumes have been written about risk and what to do about it. Every financial strategy is based on a balance of risk and reward. Measuring risk is the most difficult part of choosing a financial strategy. Some people view putting their money into the stock market as too risky, so they opt for a more stable investment avenue, such as an annuity.  However, that may be even riskier with regard to retirement planning. It all depends on a person’s time horizon. Time horizon is the amount of time available before the person will need their invested money. A thirty-year-old worker has another thirty years to invest whereas a fifty-year-old worker has only about ten or fifteen more years to invest. Time horizon is a required item to consider when offering an annuity product.

  If a person’s time horizon is very short, they have to make some serious decisions. They may want to put their money in short-term fixed-income investments. Those who waited too long to invest for retirement have to consider:

1. Do I now need to invest in riskier investments so that I get higher returns?

2. If I lose my money in a risky investment, am I able to replace the lost money through other avenues, such as earned wages? The older investor has fewer working years to replace lost investments.

3. If I invest in conservative, less risky investment vehicles, will it yield enough income to live off of during retirement? 

  The average retiree must be able to live at least twenty years without a working income. Many people must make their money last much longer, especially women who have longer life spans. Over a longer time horizon, these “safe” investments may not be as wise. As with everything, different people have different opinions as to what is a short-term time horizon versus a long-term horizon. Some view five years as short, others view it as long enough to take a risk.

  Those that view the stock market as a risk, should look at the stock market’s investment returns over a number of five-year blocks to see how the market has performed. A study by Ibbotson & Associates, stock market historians, and analysts, show that there has been no 20-year period in which a person would have lost money in the stock market (as defined by the Standard & Poor’s 500 Stock Index) going back to 1926. Mutual funds, which are stock portfolios, have gained popularity because the risk is spread out among many stocks rather than one. Variable insurance products such as variable annuities, equity annuities and variable life products allow investors to use the stock market and mutual funds to increase their funds through those insurance products.

  People are scared of risks in the investment world. Thus people, especially younger people, make the mistake of choosing only the most conservative investments such as fixed-rate guaranteed investment contracts (GICS) when they are planning their asset allocation models. Why is investing in these GICS a money mistake? Because it is investing too conservatively in investments without adequate growth potential for retirement.

  Again, the critical ingredient in risk is time. Each person will define their time horizon differently.  Some people may not need the entire principal for quite a long time, but they still want to keep the principal in short-term investments. We see many people who continually use Certificates of Deposit, for example, even though they are traditionally low-yielding investments.

  One of the most important things in overcoming risk is knowledge of the investment. It is common for people to invest in something merely because George at work did so, or Aunt Mary thought it sounded wonderful. No insurance professional should ever recommend an investment without understanding it completely. Not only is it possibly a money mistake for the client, but it is also an errors and omissions mistake for the professional.

  When investing, it is important that a person is educated and that it be a well thought out financial decision. Ethical investing has become popular, but it has also become known as one of the more successful investment strategies.  It has become successful not because it has to do with the ethics of a company (although there is that, too), but because ethical investing requires investigation.  How can an investor know if the company is bad for the environment or uses animals in testing unless they first investigate the company? Because of this investigation, the investor is also likely to uncover bad management, faulty management thinking, or failing company returns. Whether investing centers on particular ethical concerns or desired returns, investigation can mean the difference between success and failure.

  The relationship between risk and return is simple: the greater the expected return, the greater the investment risk. Any company that promises higher returns is also undoubtedly promising a higher risk of investment capital. Every investor needs to realize that some types of investments are risking not only interest earnings but also invested capital.

  Professionals define seven types of investment risk.

1. Inflation Risk

2. Interest Rate Risk

3. Business Risk

4. Credit Risk

5. Market Risk

6. Liquidity Risk

7. Portfolio Risk

Inflation Risk

  Inflation risk could also be called long-term risk. Inflation erodes the purchasing power of the dollar and lowers the rate of return on investments. Inflation risk turns cash equivalent and fixed-income investments into high risk and low reward investments. Time usually favors an investor but it can also work against them. The more time investments have to grow; the more time inflation has to rise as well. Our investments need to grow at a higher rate than inflation.

  For example, a person’s cash equivalent and fixed-income investments are earning four percent, but they lose five percent of their value to inflation. The outcome: that person has less purchasing power at the end of a year than they had when they started. This loss due to inflation is seldom recognized by the novice investor. Most investors probably look only at the interest earnings on their yearly statements. Few also consider the rate of inflation.

  A person faces inflation risk with any investment that pays back a fixed dollar amount in the future with no change of growth of principal. These types of investments would include Certificates of Deposit (CDs), bonds, money market accounts, and fixed annuities that do not have a quarterly or yearly interest adjustment which has the potential of matching the changes in inflation.  Some types of investments in hard assets, such as real estate, art, or collectibles might rise with inflation. Of course, there are no guarantees of this. It was once popular to invest in precious metals because they were thought to keep pace or even outpace inflation.  In more recent years, fewer professionals tend to believe this. The stock market has the potential for growth, which can offset the loss in purchasing power of the dollar, but stocks can go both up and down.  Investors are always wise to check out the stocks they are buying. In addition, most professionals recommend the positive investing approach when dealing with stocks. The positive investment approach means investing in products the investor knows and understands.

Protection Against Inflation

  One can protect themselves against the risk of inflation by simply following three steps. These steps would include understanding inflation, alternatives, and a balanced portfolio (proper asset allocation).

  Understanding inflation is the first step. Most people hopefully have a rough understanding of the workings of inflation (what causes it and how it affects various investments and areas of the economy in different ways) so that educated decisions can be made. Understanding inflation will help an investor distinguish between the investments that can reduce financial uncertainty and those that will only make an investor's problems worse.

  A key point to remember is that inflation does not shower its affection on any one investment field. There is no simple inflation hedge that will show a profit because of inflation. One of the worst consequences of inflation is the chaos it creates in the economy and in the investment world.  Because of inflation, nearly all investments go through extreme cycles of boom and bust. That is why so much investing must be done for the long term to really show a substantial yield.

  This could be seen in October 1987. At the close of the market on Monday, October 19, 1987, stocks in the United States and most other countries were down about 40 percent from the highs they had established a few weeks earlier. Some stocks fared worse than others, of course. Some portfolio managers actually profited from the crash. Three years later, the average stock had regained its 1987 losses. The crash of 1987 appeared to have no lasting effects. However, if you asked the 50,000 people who lost their jobs, the hundreds of securities firms that were forced into bankruptcy, or the countless thousands that had planned on early retirement, they may say that there were many lasting effects of the October 1987 stock market crash! There have been other crashes like the mortgage crisis in 2007 and 2008 and the effects of the COVID-19 crash in 2020 that caused devastating effects to the economy.

 It has often been suggested that an investor should measure in an inflation hedge. Doing so is not so much a science, however, as it is an art. At one time, gold was considered a hedge against inflation, primarily because it was something the average person could understand (or so they thought).  Gold represented money to most people. In more recent years, we have seen all precious metals as volatile as any other investment.

  There really is no inflation hedge that is foolproof. The stock market, which was the supposed inflation hedge of the 1960s, has seen downturns. The real estate market's boom of the late 1970s which seemed to be providing an inflation hedge for many people, but even real estate can suddenly turn sour as we have seen. Bottom line: No investment will profit from every stage of an inflationary cycle.  Over the long run, stocks do perform reasonably well as do most real estate investments.  In the short run, continuous performance is difficult to sustain.

  The second step is to become acquainted with the range of investment alternatives and techniques available to the investor. Few investments continually do poorly or continually do well. Most have ups and downs as they respond to market conditions. Annuities fall prey to this trend. As a result, investors need to realize that what did poorly last year may be doing well this year. Of course, the opposite can also be true (doing well last year and poor this year).  Professional investors supposedly know how to read market trends allowing them to buy and sell to take advantage of good returns while avoiding poor returns. Realistically, reading market trends is similar to predicting the weather. It is more of an art than a science. The keyword is “predicting.” Just like the weatherman is not always right, neither is the professional investor.  The best advice when it comes to investing is to make use of all the available data. The more we know about an investment, the more we are likely to profit. It is the old adage: invest in stocks you know and understand.

  The final step in avoiding the risk of inflation is to construct a portfolio so well balanced that an investor can forget (almost) about their investments. The idea is to be able to enjoy our life and be confident that our investments are protected. Our investments should profit no matter how inflation evolves and no matter how and when it comes to an end. Of course, no investor should absolutely forget about their investments, regardless of how well they are doing. While most are designed for the long term, we still need to keep track of our money. A key consideration for an investor is that there be a proper balance amongst several different investments. During a time of inflation and high interest rates, tax deferral is more important for dollar investments than for any others, since high interest rates mean that dollar investments will be producing more taxable income. Thus, a device for deferring taxes will be especially valuable if it can be used to shelter assets denominated in dollars.

  Fixed rate annuities, such as equity-indexed annuities, promise a guaranteed minimum rate of return. This may be referred to as the “floor”[1] rate since it is the lowest rate that will be paid. The annuity might pay a higher rate than guaranteed, but never a lower rate. Higher rates might be paid if market conditions were good. At each anniversary, the minimum rate is re-set, but that would not mean higher rates could not be credited if circumstances warranted it. In the case of equity-indexed annuities, there is also the possibility of bonus earnings if the market index does well.

  A well-diversified portfolio is probably one thing every expert can agree upon. Diversification is a concept that is backed by a great deal of research and market experience. Diversification is the process of reducing risk within a portfolio. As the number of companies increases, the level of risk should decline. In addition to the number of companies, a person also needs to diversify their assets, buying a variety of stocks, bonds, and real estate, if they so desire. To diversify correctly, a person would need to buy a variety of at least 20 different stocks of different companies in different industries. From a common-sense standpoint, 20 stocks in 20 different pharmaceutical companies is not diversification. Even though some may do well even if others are not, the general market risk is too similar to be considered diversification.

  Mutual funds are sold with the idea of diversification. As the types of mutual funds become more specific, a person must keep aware of the diversification of their total portfolio.

  The benefit diversification provides is risk reduction. Risk to investors can be defined as the volatility of return or standard deviation. This refers to the possible variation of investment return.  Investors would prefer returns that are relatively predictable and thus less volatile. Of course, investors also want returns that are high. Diversification eliminates much of the risk without reducing long-term returns.

  Understanding inflation, investment alternatives, and how to acquire a balanced and well-diversified portfolio may be the most intimidating aspects for an investor to overcome. It can be time-consuming and difficult, but it is ultimately worth it.

Measuring Risks

  Professional money managers seek the maximum return for a given level of risk, while also seeking the lowest risk for a given level of return. A rational investment strategy dictates that investment options be ranked according to risk. This means that risk should be measured and quantified.

  Measuring some risks comes intuitively. Investors understand that an aggressive growth stock has more risk than that of a Treasury Bill or that the chances of being hit by lightning are higher than winning a lottery.  We could safely say that all investors understand obvious risks and their counterbalance, the rewarding opportunity.

  Unfortunately, the differences in investment risk are not so clearly stated or defined.  For instance, which is a better buy given their levels of risk and returns:  Aggressive Growth or European equities?  An investor's decision is most often based on either asset allocation models or mutual fund and/or sub-account investing because of their choice of provisionally managed investments.

Alpha & Beta

  The investment industry has devised measurements for each.  They are known as:

1. alpha (reward), and

2. beta (degree of risk).

Alpha is an investor's expected return for the level of risk assumed.  Beta measures the quantified risk over a given time period. In each case, there will be variance which is measured by the standard deviation. This anticipates the upside and downside potential at a given level of risk. By definition, the standard deviation is the opportunity for gain versus the possibility of a loss at a given level of risk.

Alpha is important when measuring and comparing sub-accounts and money manager performance. The performance should be measured over a specified period of time and it should be measured and compared to its peers and industry averages.

  The beta coefficient is one method of measuring risk.  It relates the volatility of an investment to the market as a whole. The market, or measurement index, has a beta of 1.00.

  Beta risk is an important consideration for professional money managers and investors alike because the effective use of diversification can reduce residual risk. Beta derivation is a straightforward concept. Most sub-account betas are accessible to investors through numerous industry research publications and rating services.

Lifecycle Beta

   Beta can also be a measure of risk for an investor's stage in the lifecycle and general attitude toward risk. There is no quantifiable measurement for either because both are subjective. It does not take a genius to figure out that preservation of capital is more important to older investors, while growth is normally more important to younger investors.

  It is important for insurance professionals, financial planners, or whoever is discussing an investment portfolio with a client, they give them a realistic evaluation of the worst-case scenario.

  Part of risk management is risk measurement.  Several aspects of risk measurement have been discussed. The degree of risk was shown to be measured by variation between expected return and/or actual losses. The probability of loss can be measured in three basic ways:

1. frequency,

2. severity, and

3. variation.

Loss Frequency

  It is important for risk managers, on the basis of the past loss experience (frequency) of their firms or that of similar classes of risk exposures, to predict variation risk in future losses. The primary purpose is to help them decide what to do about various loss exposures.

  Some losses may be found to be so infrequent that it would be uneconomical to try to deal with them. Some losses may be so frequent as to be regularly anticipated.

Severity

If properly carried out a risk manager can properly measure the risk to aid in suggesting the best way to treat the most important risks and possible losses.

Variation

With additional information about losses over a period of years, the trends and variations in losses and gains over a period of years can be estimated with more of an educated guess.

Measuring Risk Further

  A probability distribution has been defined as a set of possible outcomes with a probability of occurrence attached to each outcome.  If an investor is considering five different investments, there are five probability distributions: one for each of the five investment alternatives.  For instance, if

the investor was considering corporate bonds, stocks, annuities, mutual funds, or whatever, the return on the investment would not be known until the end of the holding period. Since their outcomes are not known with certainty, the investments can be defined as risky.

  Probability distributions may be either:

1. discrete, or

2. continuous.

  A discrete probability distribution has a limited number of outcomes. There is only one possible value, or outcome, for the T-bills’ rate of return, although for other investments there are alternative outcomes. Each outcome has a corresponding probability of occurrence.

  If an investor can multiply each possible outcome by its probability of occurrence and then sum these products, they will have a weighted average of outcomes. The weights are the probabilities, and the weighted average is defined as the expected value. Since the outcomes are rates of return, the expected values are expected rates of return.

Expected Rate of Return

  The expected rate of return on an investment or portfolio is simply the weighted average of the expected returns of the individual securities in the portfolio.

  Normally, investments with higher expected returns have larger standard deviations (more risk involved) than investments with smaller expected returns. To better explain what standard deviation is, let’s look at an example: let’s say Investment Q has a 30 percent expected rate of return and a standard deviation of 10 percent, while Investment M has an expected rate of return of 10 percent and a standard deviation of 5 percent.  Which looks better? Which would you recommend?

  If the returns of Investment Q and Investment M are approximately normal, then Investment Q would have a very small probability of a negative return in spite of its high standard of deviation.  While Investment M, with its lower standard deviation figure, would have a much higher probability of a loss. Therefore, to properly understand the implications of standard deviation as measures of the relative risks of investments whose returns are different, we need to standardize the standard deviation and calculate the risk per unit of return. This can be accomplished by using the coefficient of variation (CV), which is defined as the standard deviation divided by the expected value.

Bottom line: Investment M actually had more total risk per unit of expected return than Investment Q.  This means that one could debate that Investment M was riskier than Investment Q, in spite of the fact that Investment Q’s standard of deviation was higher (10 percent versus 5 percent).

Maximum Possible & Probable Loss

  Risk managers can divide potential losses into various categories of importance to their firm.  Classifications may be established, such as those losses which are high, moderate, or of slight importance. Estimates of maximum possible loss, the worst that can happen, and the maximum probable loss, the worst that is likely to happen are valuable measures. 

  Probably the most useful to risk managers is the concept of maximum probable loss because by using some actual or even hypothetical data, the probability that severe losses might occur can be observed and measured. Some extreme possibilities that are possible, but not likely, are disregarded in the estimate of maximum probable loss.

Living With Risk and Return

  The concepts of risk and return have been analyzed as separate entities. Hopefully, most investors, as well as the insurance professionals selling to them, understand the positive correlation between risk and return. Increased risk should offer an increased return. Decreased risks also mean decreased returns.

  An investor may expect a safe return of five percent by purchasing risk-free investments such as short-term certificates of deposit. Increasing our expected return above five percent involves also increasing the investor's assumption of risk. The relationship between risk and reward differs between investors and with the ever-changing business environment.

Interest Rate Risk

  Interest rate risk basically applies to fixed-income investments such as bonds or CDs (Certificates of Deposit).  As a general rule, the bonds of any organization have more interest rate risk the longer the maturity of the bond. This means a maturity risk premium, which is higher the longer the years to maturity, must be included in the required interest rate. The effect of maturity risk premiums is to raise interest rates on long-term bonds relative to those on short-term bonds.

  Interest rate risk can be divided into two categories:

1. Value Risk, and

2. Reinvestment Rate Risk.

Value Risk:  Interest rate fluctuations can severely affect bond values and certificate of deposit (CD) rates.  Rising interest rates cause falling bond prices.  Fixed-income investment unit values decrease periods of sharply rising interest rates. 

  If an investor owns a bond and its market price goes down, it does not mean that they need to sell.  If the investor bought the bond for fixed income and they still expect to receive the full face value at maturity, no money will be lost by holding them. The risk lies in the possibility of needing to sell prior to maturity. In such an event, a lower price than paid would be received. Therefore, a loss would occur.

  “Bond funds are especially vulnerable to value interest rate risk because they have no maturity date. An ordinary bond, which has lost value due to rising interest rates, can be held until maturity, and the investor will receive the full face value - no money is lost. However, because bond funds do not have a maturity date, there is no promise of receiving the full value at maturity. Mutual funds are priced at the current market value of the securities held in the fund, which may mean the depressed market price of the individual bonds held in the fund.” - All About Your 401(k) Plan by Ellie Williams Clinton and Diane Pearl

  Reinvestment rate risk:  If interest rates fall after an investor invests, they will be reinvesting the interest payments that they receive at a lower rate. Short-term bonds are highly exposed to reinvestment risk. This means that when the investment matures, or if it is “called” before maturity, the investor’s choice of reinvesting the principal could result in their earning a lower rate of interest.  So while investing in short-term investments preserves a person’s principal, the interest income provided by short-term investments varies from year to year, depending on reinvestment rates.

  When an investment is “called” before maturity it is termed Call Risk. Call risk is the risk that a bond (investment) will be called or bought back prior to maturity by the issuer on demand. Not all tax-free bonds are callable, but those that are may be called after interest rates have declined. Calling a bond allows the issuer to reissue the bonds at a lower interest rate.  Normally the bonds are only called after the interest rates have declined. The investors then have to reinvest their money at lower interest rates. This is very similar to what homeowners do when interest rates fall - they refinance their homes to take advantage of the lower interest rate.

  Some bonds have call protection. This is a guarantee that a security cannot be bought back by the issuer until a specific amount of time has gone by. Treasury securities are almost always noncallable.

Business Risk

  Investors face business risk when they invest in such things as common stocks and corporate bonds.  If an investor has common stock or corporate bonds in a certain corporation, this is the risk that faces an individual corporation from such diverse sources as management error, faulty products, poor financial planning, market mistakes, and so on. If the individual corporation starts to experience income statements in the “red”, the investor’s common stocks or corporate bonds may be in trouble. The most severe trouble may be when this individual corporation files for bankruptcy.  Why? If an investor holds common stock, they are at the bottom of the list when it comes to repayment. The investor is behind the IRS, lawyers, banks, bondholders, and preferred stockholders when it comes to getting any money back.

  How can an investor avoid business risk? The best way is simply diversification. If stocks of individual companies are held, it is recommended that no less than 15 different stocks be purchased individually or through mutual funds. When an investor has a “cushion” of 14 other companies, experts say that the business risk of any one company is effectively diversified.

  An investor's income can decline due to a number of reasons occurring naturally in the business environment. This is important to money managers when making individual securities investments. It is less important to investors who have hired money managers to analyze the risk of individual securities.  It is important, however, for investors purchasing individual securities.

  Business risk also called diversifiable risk or unsystematic risk can also be caused by such company-specific events as lawsuits, strikes, successful and unsuccessful marketing campaigns, and winning and losing major contracts. Again, since these occurrences are unique to a particular industry or firm, they are essentially random and can be compensated for through diversification. It cannot be overstated that an investor can diminish their business risk (diversifiable risk) by sending their investments to a variety of industries or firms - thus diversifying.

Credit Risk

  Credit risk, also termed Default Risk, is the risk that the borrower cannot pay back the interest or principal they owe the investor. This is why corporate and municipal bonds are risk-rated by rating agencies. Investments with a lower credit rating pay a higher rate of interest because investors generally demand more interest to compensate for the possibility (risk) that the issuer may default. We see this higher rate usage in just about any type of loan where the default of repayment is a possibility. Even mortgage loans and car loans impose higher rates for those with a higher risk of nonpayment.

  US Treasury securities have no credit risk; thus, they have some of the lowest interest rates on taxable securities in the United States. Treasury securities are free of credit risk because a person can be virtually certain that the federal government will pay interest on its bonds and will also pay them off when they mature. For corporate bonds, the higher the bond’s rating, and the lower its credit risk, the lower the interest rate charged.

  The greater the credit risk, the higher the interest rate issuers charge. No one would invest in something that offered a high amount of risk and low returns.

Market Risk

Non-diversifiable Risk or Systematic Risk

  Market risk is a type of risk that remains even in a diversified portfolio. Market risk pertains to the factors that affect the economy as a whole. Since economic factors can be good or bad, investments can be affected negatively or positively by them. This, in effect, causes investments to change in value regardless of the fundamentals of individual investments. The market value of an investment can vary substantially over short periods of time. Market risk lessens over time. 

  Market risk, or non-diversifiable risk, comes from external events such as war, inflation, recession, and high interest rates, which have an impact on the economy. Since it is “all” affected at once by these factors, market risk cannot be eliminated by diversification. It can be reduced, but not eliminated.

  Market risk can also be called systematic risk because it shows the degree to which a stock moves systematically with other stocks. 

  An investor cannot control market risk. An investor could not have stopped the stock market crash of 1987, which is an example of stock market risk. An investor could not have stopped the economic downturn of the early 1990s, which is an example of market or economic risk for real estate investments.

What is Total Risk?

Total risk is the riskiness of an asset held in isolation. For instance, if an investor holds only stocks from Boeing or Starbucks. The stock’s risk is measured by the dispersion of returns on its expected returns. The greater the dispersion, the higher the chances that the return will be below the expected return, which in turn means the individual stock holds a greater risk.

  However, when an investor practices asset allocation diversification total risk can be reduced. When an investor holds a large number of different types of stocks in their portfolio, then the importance of an individual stock becomes less risky. A stock or asset that would be considered risky by itself (held in isolation) may not be risky at all if it is in a diversified portfolio. In other words, the risk of one of the stocks is offset by the gains of another. In this case, the relevant risk of each stock is its market risk, which measures the stock’s contribution to the overall riskiness of the portfolio.

  With this in mind, we can see a clear picture of how the greater the impact of a stock on the overall riskiness of a portfolio, the higher the market risk of the stock. A stock’s risk is affected by its total risk, but it is also affected by the connection of its returns with the returns on a portfolio of stocks.

  Total and market risk affects all types of investments such as securities, stocks and bonds, real estate, precious metals, corporate capital investments, and so on.

Liquidity Risk

  Liquidity risk refers to the ability to “cash out” an investment. The risk of cashing out refers to the ability to sell the investment quickly without losing principal. An investor may have an appraised value of their home or stamp collection, but that won’t put cash in their pocket if they cannot find a buyer who is willing to pay the appraised price. Liquidity risk affects investments that do not have active secondary markets and investments that are in volatile or cyclical markets, such as real estate.

 Investors and insurance professionals should never simply assume liquidity will be available somewhere, such as home equity or amazing investment growth. Taking the optimistic view does not comply with product suitability or best interest requirements. Any investor who does not have sufficient liquidity for the surprises in life should not invest everything in an annuity; enough cash reserves should be retained in a liquid account of some kind. This is true for all investors of all ages. We all need an emergency account that can be easily accessed.

  There is no question that annuities are long-term investments and, as such, lack liquidity.  Large early withdrawals – prior to the end of the surrender penalties – will also result in loss of principal due to penalties. Therefore, large withdrawals are not suggested during the surrender penalty years.  Many products allow smaller withdrawals during the surrender penalty years without any insurer fees, however. All annuity investors must be aware of the Internal Revenue Service penalty of 10 percent on withdrawals prior to age 59½, called early withdrawal penalties.

  It is due to these early withdrawal fees, both from the IRS and the insurer, which make it theoretically possible for equity indexed annuities to lose money. According to NASD, the guaranteed minimum return for an equity indexed annuity is typically 90 percent of the premium paid at a 3 percent annual interest rate. If, however, the investor surrendered his or her equity indexed annuity early, he or she could end up paying a significant surrender charge and a 10 percent tax penalty that would reduce or even eliminate any returns.

  Since many EIA products only guarantee a return of 90 percent it is possible to lose money on equity indexed annuities, whereas traditional fixed rate annuities guarantee 100 percent of the amount deposited into the annuity product. Obviously, one way to avoid this is to look for equity indexed annuities that guarantee 100 percent of the premiums paid.

  Some equity indexed annuities do not pay earnings until maturity, which is usually the point at which the surrender penalties end. In other words, some contracts will not credit the annuity with the index-linked interest if it is surrendered early.

  Annuities and variable life insurance (VLI) are typically not suitable for short-term use. In most cases, investors may take all or part of the money at any time but there is likely to be a cost for doing so. The cost may be stated as a dollar amount, a percentage, or as interest earnings. The greatest disadvantage of an equity indexed annuity is its significant surrender charges[2], especially during the first few years of the contract. It is these surrender charges that allow the insurance companies to make long term investments, so they may pay investors the earnings the annuities guarantee. If too many EIA investors pulled their money early the insurers could not earn the returns they need. Surrender penalties, therefore, are used to discourage early withdrawals. Regardless of why insurers do this, however, the important thing for investors to fully understand is that they must be willing to leave their deposits in the annuity or variable life insurance product for the number of years stated as surrender penalties in their contracts. Investors must always be aware that the money they deposit in an equity indexed annuity is not for short term use or goals. At all times, the investors must have other cash on hand for emergencies that arise. If insurance professionals learn nothing else from this course, they must learn to stress the long-term nature of annuities and variable life insurance with their clients.

Portfolio Risk

  Market risk referred to the market as a whole. Market risk cannot be controlled by an investor.  Market and total risk could be reduced by diversification. Then there is portfolio risk. Portfolio risk is the expected return on a portfolio as a whole. This type of risk can be measured.

  The expected return on a portfolio is the weighted average of the expected return of the individual investments in the portfolio. The realized rate of return on the investment may be seen a year or so later.  What an investor expects and what they actually receive (realize) are two different things.

  Where the return portion of the investment can be measured, the standard deviation of a portfolio is normally not a weighted average of the standard deviations of the individual investments in the portfolio. Each stock’s contributions to the portfolio’s standard deviation are not either.

  Theoretically, then, it is possible to combine two stocks that are individually risky, as measured by the standard deviations, and to form from these risky investments a portfolio that is completely riskless.

Covariance & Correlation Coefficient

  The riskiness of a portfolio is measured by the standard deviation of its return distribution. Two key concepts in portfolio analysis are:

1. covariance, and

2. correlation coefficient.

  Covariance is a measure that reflects both the variance (or volatility) of a stock’s returns and the tendency of those returns to move up or down at the same time other stocks move up or down.

  For example, the covariance between Stocks Y and Z tells us whether the returns of the two stocks tend to rise and fall together and how large those movements tend to be. If the covariance turns out to be zero, this indicates that there is no relationship between the variables. The variables are independent.

  Since it is difficult to interpret the magnitude of the covariance term, the correlation coefficient is often used to measure the degree of covariance movement between two variables. The correlation coefficient standardizes the covariance by dividing using a product term. This facilitates comparisons by putting things on a similar scale.

Efficient Portfolios

  Of course, a person would want to select a portfolio design that is efficient.  This would be defined as a portfolio that provides the highest expected return for any degree of risk or the lowest degree of risk for any expected return. The policy owner of an annuity or variable life insurance policy would want to understand the options available. However, they could be broken down by the amount of risk: low, moderate or high.

  For example, let us assume that we have Subaccount Y and Subaccount Z and we have a specific amount of money to invest.  We can allocate our funds between the securities in any portion.

· Subaccount Y has an expected rate of return of 5% and a standard deviation of return of 4%.

· Subaccount Z has an expected rate of return of 8% and a standard deviation of return of 10%.

  This means that Subaccount Y has an expected rate of return of 5% but could deviate (swerve) 4% up or down.  The investor could end up with a rate of return of 9% or as low as 1%.

  Subaccount Z has an expected rate of return of 8% but could deviate (swerve) 10% up or down. The investor could end up with a rate of return as high as 18% or as low as -2%.

  How would we set up our asset allocation or our portfolio for the most efficient use? This would depend upon what age the investor is and what they expect from their portfolio.

The policy owner of a variable life insurance product may direct the premiums (after certain deductions are made) to a specific subaccount held by the insurer. What those subaccounts are will vary. They could include a money market account, a growth stock account, a bond account, or some other type of investment vehicle. Some companies may allow changes among the accounts more than once per year while other companies may have limitations on the number of times that funds may be moved among the various investments. Usually, the death benefit is adjusted once per year while the cash value is adjusted daily. Premiums tend to be fixed so that they remain the same. The product gets its name, variable life, because both the surrender value and the death benefit can vary.

  For example, if Daniel took out a Variable Life insurance policy, he could have the choice of a number of mutual funds in which to invest the cash within the policy. Or, if Daniel plans on staying with variable life for a few years, he will probably want to invest in growth stock mutual funds that are likely to outperform fixed interest rates. Otherwise, it is not worth paying the extra charges and fees associated with variable life policies.

  Before the policy owner can divert any of the contract’s funds into a sub-account, charges must first be paid. These charges would include administrative and sales expenses, any state premium taxes, and of course, mortality costs. This is one of the biggest problems with variable life policies. The policyholder may think their investments are doing well but the cash value may not be growing quite as much. To reiterate, this may be due to the insurance company taking out their fees and mortality charges before the investment return is credited to the policy's cash value. This, of course, would lower the policy's total investment return.

  For policyholders who desire to take an active role in their finances, a variable life policy is an attractive type of life insurance. The policyholder may direct where his or her premium dollars are placed but it can also be a gamble. The insurer may not offer the options necessary to really be a worthwhile investment.

  Variable life insurance policies enjoy the same income tax treatment as other types of insurance policies. Earnings from the investments are currently income tax-deferred, which is always a benefit to the consumer. There is no tax on the internal build-up of cash values. If the policy is surrendered (cashed-in) and if the cash proceeds are more than the policy owner's cost basis, then the proceeds may experience some taxability. Death benefits, regardless of growth, pass income tax-free in most cases.

  Most variable life insurance policies allow the policy owner to borrow a designated percentage of the cash value without surrendering the policy. Normally, the insurance company charges interest on the loan, but often the rate is lower than the rate that would be charged by a bank or other lending institution.

Asset Allocation

  Asset allocation is the process of deciding where to invest. Most people do understand diversification, so asset allocation entails deciding which portion of the available investment funds goes to which investment. This might include such things as annuities, stocks, mutual funds, or real estate, to name a few.

  Each category of an investment may be further divided. For example, the portion that a person may want to invest in stocks would normally be divided between directly owned stocks and stock mutual funds. Within the stock mutual fund, a person must decide if they want to invest in higher-risk funds or conservative funds, thus another layer with each investment made.

  An annuity or variable life investor could make the job of asset allocation very hard if they chose to. A person can consider many different and potentially volatile factors in deciding how to invest their money, including stock market conditions, interest rates, economic prospects, tax regulations, and the person’s own personal finances. This is one big reason why people do not pay attention to asset allocation. They do not want to take the time to look at the big picture. Normally, people tend to focus on one investment such as stock mutual funds, a municipal fund, or some other investment of interest to them.

  There is a risk involved with not paying enough attention to asset allocation: there may be no long-term investment plan. A person’s investment plan could be inappropriately allocated. In these instances, a person may not find out until it is too late. The other extreme is the person who is so obsessed with all the expert opinions that they move their investments all over the place and too often. This has been shown to also be an inappropriate allocation.

  A term that we should concentrate on is permanent portfolio structure. A permanent portfolio structure is maintained over a long period of time with only minor changes; sometimes no change at all is made. A person should decide if they are a conservative, moderate or aggressive investor before establishing a permanent or nearly permanent investment strategy. Once a person has decided, there really is no reason to vary the investments. It has been shown that people who keep their investments relatively stable in a mixture of investment vehicles do very well over a long period of time. This does not mean that a person should never make any changes. It only means that a person should not make rapid or frequent changes to their portfolio.

Guidelines for Asset Allocation

  Investors who like to invest in extremes may think they are well diversified. Even so, they may be overlooking some kinds of investments that may help them achieve investment success. An investor should decide how much their total investments they wish to invest in each of the three primary categories (stocks, interest-earning investments, and real estate). Not everyone will want to invest in all three categories, but for the broadest diversification, it would be advised to do so.

  Younger and/or middle-aged people should weigh their investments in favor of stocks and real estate if they so wish. This is because these investments have the best chance of beating inflation risk and producing long-term returns. A portion of the portfolio should be allocated so some of the portfolios remain conservatively invested. 

  People who are within about ten years of retirement should begin gradual shifts to more conservative investments. This decreases their market risk since they will be needing their money sooner than a younger investor and would be subject to market losses. Shifting a pre-retiree’s investments to more conservative “safe” investments lessens the risk of being caught in a stock market downturn or a real estate slump.

  For people who are already retired, the amount that is in riskier investments depends on how much they rely on their money to live on. If retirees need this money to live on, they may require investments that yield current income either with interest-earning securities or dividend-paying stocks. It may be wise for a person not to neglect stocks because they may need capital appreciation to fund a long retirement. Many retirees find that they have time to devote to the stock market and do quite well.

Expected Return

  The expected rate of return on a portfolio or combination of assets is simply the weighted average of the expected returns of the individual securities in the portfolio. Generally, an asset held as part of a portfolio is less risky than the same asset held in isolation. This is not so hard to understand. An asset that would be considered relatively risky if held in isolation may not be risky at all if it is held in a well-diversified portfolio. In this instance, considering risk in a portfolio could completely change a decision based on an analysis of total risk.

How Much Return is Required to Compensate for a Given Amount of Risk?

  As we have determined, the riskiness of a portfolio is measured by its standard deviation of returns. This is generally less than the average risk of the individual assets within the portfolio. Since an investor should and normally does hold portfolios of securities, it is reasonable to consider the riskiness of any security in terms of its contribution to the riskiness of a portfolio rather than in terms of the risk for singular security held in isolation. The Capital Asset Pricing Model (CAPM) specifies the relationship between risk and required rates of return on assets when they are held in well-diversified portfolios.

Treating Risk

  We have discussed the identification of risk and how to measure risk. We now need to discuss the treatment of risk and/or the administration of risk.

  A pitfall that some people fall into is assuming that there is a single method of treatment in the solution of risk. In reality, it is much more common to find all or at least several techniques used together to provide the best solutions for meeting the financial problems of risk.

Two Basic Methods

  There are two basic methods of treating risk:

1. risk control in order to minimize losses, and

2. risk financing in order to reduce the costs of those losses which do occur.

  In just about every case, it is not merely which to choose from (risk control or risk financing).  Good risk management requires that both be used in methods of treating risk.

Risk Control

  Risk control involves a number of alternatives. These alternatives are not limited to using just one. The goal is the proper choices, using all methods which result in benefits that exceed the costs. Many associations use all or most of the techniques in order to best handle the diverse types of risk. The alternatives include:

· risk avoidance,

· separation, diversification, or combination of loss exposures,

· loss prevention and reduction, and

· some noninsurance transfer loss.

Risk Financing

  Risk financing also includes many alternatives that can be used separately or in combination with one another and with the previously identified risk control measures. Financing methods are subdivided into two different categories:

1. risk retention and

2. risk transfer.

Risk-retention helps provide different types of funding when paying for losses: absorption in expenses, special reserves, funds, deductibles, self-insurance, and captive insurers. Insurance is the most common type of risk transfer, but some noninsurance transfers of risk and credit mechanisms are also useful.

Risk Control Alternatives

  In each of the alternatives, the primary goal is to achieve the purpose of minimizing losses that might occur to assets and income.

Risk Avoidance

  This is probably the most obvious choice - avoid risks entirely, at least to the extent possible.  Some types of risk are either not assumed or are abandoned altogether. For instance, a person could choose not to buy a home in order to avoid the risk of losing the home value through the peril of fire or real estate declines. Some risk must be assumed simply because we are alive. It would be impossible to avoid all risks entirely. Financial risks can be avoided to some extent. What usually happens, however, is that one risk is simply traded for another. For example, a person who is afraid of stock market risks may never invest anywhere at all. Therefore, they have traded the risk of a market downturn for the risk of poverty in their retirement years. That same person could have saved through another vehicle and avoided stock market risk while still saving for their retirement years. Risk avoidance is a common factor for most people when they invest. They avoid certain stocks but purchase others. They avoid certain life activities, such as skydiving, but participate in others, such as water sports. Even deciding where to live can involve risk avoidance. Most people buy homes in areas they consider safe.

  Total avoidance of risk is no practical solution to the many risks that are involved in normal day-to-day life. Some unusual risks with a high chance of loss can be avoided, but realistically the avoidance of risk is only an alternative in regard to a restricted number of economic risks. Some risks may be impossible to avoid. Others may not be economically desirable, either because the benefits outweigh the costs or because avoiding one risk may create another. For all avoidable risks, other solutions must be considered.

Combination, Segregation & Diversification

  The combination of exposures to loss is a common method of risk control. This method broadens the units of exposure and may aid in predicting future losses. Combining risks may spread the risk and create more stability in the loss experience. This can be seen when combining singular investments that may be rated very aggressive or “risky” into a portfolio that equalizes them out, thus their risk rating may go down. Combination is a basic principle of insurance and self-insurance and it may also be used in many other business situations. 

  Generally, the combination risk reducer process has to be in combination or conjunction with other methods. For instance, for the combination method to be most effective, it should be used in conjunction with segregation and diversification or with other methods of risk financing. Just combining exposures is not the most effective way to reduce risk. In some cases, it may increase risk more than decrease it if the added exposures are more concentrated or variable than the previous exposures.

Segregation is the separation or dispersion of loss exposures. It is often an effective way of limiting the severity of loss by reducing the concentration of exposures.

  Diversification uses different types of loss exposures as opposed to having only one type in order to improve one predictability. When assets are duplicated at different locations, the diversification technique is used. Investing money into different types of investments is a way of diversifying.

Loss Prevention & Reduction

  Loss Prevention and Loss reduction could be considered separately, but because they are so closely related, we will discuss them as one.

Loss prevention may involve the elimination of the chance of loss and thus risk. More often, a reduction in the probability of loss is accomplished.

Loss reduction has the goal of reducing the severity of loss which includes the steps taken to accomplish this either before or after a loss.

  The techniques used to help prevent or reduce loss are often logical. This is important since losses are rarely completely taken care of by just one method. Preventing or reducing risk makes sense if it can be done for a reasonable cost in relation to its potential benefits. If human life were at stake, cost may become secondary.

  Loss prevention and loss reduction are not the same things as risk reduction. The risk or uncertainty of variable losses may still be the same, while the chance of decreasing loss or value is reduced. There may be a reduction of the conditions increasing the ratio of the likelihood of hazards to the cause of loss.

  Much more could be said about loss prevention and loss reduction because this applies to so many fields including insurance professionals, financial planners, brokers, consultants, insurers, and insureds.

Noninsurance Transfers

  Noninsurance transfers are effected by means of a contract, other than insurance, in which one party transfers to another the legal responsibility for property or employee losses. A method of risk financing transfers the financial burden of the transferor.

  Subcontracting is one example of noninsurance transfer. When a company wants to build a building, they subcontract the electrical, plumbing, drywall, and framing to outside companies. Those companies are financially responsible for the injuries those employees may face on that job, thus the financial burden or risk of loss is transferred or subcontracted out to another company.

  Licensing is another example of noninsurance transfer. Under licensing contracts, a manufacturer that does not want to produce or sell certain goods can transfer some of the responsibilities. The manufacturer would receive only a royalty or a fee for licensing others to do the work. The licensees would have the responsibility for injuries to their own employees.

Risk Financing Alternatives

  Using methods of risk control in most cases only lessens the loss. One exception to that is risk avoidance in which the probability of loss or risk is eliminated. All the other methods of risk control still incur losses. Because of this, some additional choices are necessary for deciding how to pay for them. These choices in methods of risk financing will be explained by the two major types of risk financing: risk retention and risk transfer.

Risk Retention

  If a certain risk has not been avoided, a person may decide to keep it. This is called risk retention or risk assumption.  The residual risk must in some way be paid for. There are five basic methods for paying for the residual risk.

1. absorption in operating expenses,

2. funding and reserves,

3. deductibles and excess plans,

4. self-insurance, and

5. captive insurance.

  Lack of planning is probably the way most pure risks are retained. Some risks are retained because the existence or importance of the risks is not known. Lack of knowledge or the inability to reach the right decision even with accurate knowledge may result in the assumption or retention of risks. The information a person may require may not be available or the information may be available but not used.  We often see others take risks that we ourselves would not be willing to take. Perhaps our neighbors are willing to own a home, but not willing to purchase fire insurance. Perhaps someone we know is willing to build their home on a flood plain. Whatever the peril, some will be willing to accept risk while others will not. Unplanned retention of risk may also result from unintentional, irrational action or from passive behavior due to a lack of thought, laziness, or lack of interest in discovering the possibility of loss.

  The important risks that people face day to day that could cause financial hardship are the risks that must be paid for in some way. This is planned risk retention and is one method for risk retention.  Planned risk retention happens when it is the result of purposeful, conscious, intentional, and active behavior.

  We could ask ourselves what reasons are there for using risk retention?  The reasons are simple:

· the necessity,

· control or convenience, and

· cost.

  Some pure risks can only be financed by retention. The risks are knowingly retained by necessity and are impossible to transfer. A certain market for insurance may temporarily be unavailable because there is a high probability of loss or a bad experience of loss. If this is the case, retention is necessary until the competitive world markets make adjustments permitting risk transfer. 

  Retention of risks may be used because individuals or businesses want the control and/or convenience of paying for losses themselves. Regardless of cost comparisons, some may want to have the benefits of direct and complete control.

  A major consideration of risk retention is the cost. A comparison of the cost involved in each alternative method of financing losses is necessary.  For instance, how much would it cost to insure a building for earthquakes versus building the building to withstand an earthquake? Another consideration is loss frequency and severity. All costs of the various alternatives, including indirect and direct costs are needed for fair comparisons.

Risk Transfer

  Risks and losses that cannot be retained by individuals and businesses might be some of the most important to insure against. The primary method for consideration is the transfer of as much as possible of the unpredictability (the loss) to someone else. Three ways or methods are possible:

1. Credit arrangements,

2. some noninsurance transfers, and

3. insurance.

  The use of credit arrangements or contracts to pay for losses may be considered one way to transfer risk. However, borrowing money usually has another purpose, such as financing homes or business expansions. Since credit is always limited, it seems generally unwise to use credit for relatively unpredictable needs. Pure risks, especially for larger and infrequent losses are difficult to handle by borrowing after the need arises. In fact, a person may be adding the additional risk of not being able to obtain credit. It would generally be wiser to transfer these risks to others.

  Risks may be transferred to others by several other types of noninsurance transfers. A hedging contract is one method of transferring some speculative (loss or gain) risks. Sometimes this balancing of possible profit and loss through two offsetting contracts is called neutralization. This method cannot be used for pure risk, which involves no possibility of gain. Under neutralization or a hedging contract, there must be two possibilities: loss or gain.

  Another method is the hold-harmless agreement. Most noninsurance transfers for risk financing deal with liability risks and the hold-harmless agreement is the best example of this. In this contract clause, the transferee agrees to hold the transferor harmless in the case of legal liability to others. The transferee agrees to pay claimants or to repay such losses if they fall on the transferor. If the transferee is unable to pay the losses, the ultimate responsibility remains with the transferor.

  There are several types of legal contracts that commonly use hold-harmless agreements. In lease contracts, for example, a wide variety of legal responsibilities are transferred from one party to another through hold-harmless agreements.

Insurance is the most common type of risk transfer method used. A definition of insurance may be developed from several viewpoints:

· economic,

· legal,

· business,

· social, and

· mathematical.

  No matter which view is used, a full interpretation should include both a statement of its objective as well as the technique by which its purpose is achieved. 

  When we enter the field of insurance as a means of transferring risk, multiple types of risk transfer must be considered. We have primarily considered investment risk so far, but insurance transfer deals with virtually every type of common-day activity and the risks associated with them.  Insurance covers our health, our homes, our motor vehicles, our liability to others, and virtually anything else one can dream up. In fact, some very unusual policies have been written for people who are willing to pay the premiums.

  Insurance companies, who assume our everyday risks, employ actuaries. These men and women determine whether or not an insurance company is willing (from an economic standpoint) to assume the risks of another person or entity. It is their job to predict what the possible losses and gains are for the insurance company based on the facts. Sometimes there are few facts from which to make these predictions, especially if the field of insurance is new.

  In simple terms, insurance is merely the transfer of risk from an individual or a business to the insurance company. With that transfer of risk, the transfer of a possible loss also happens. If enough people or businesses are interested in transferring a particular risk, the cost of doing so becomes relatively inexpensive. That’s why we see life insurance policies (which insure against premature death) so affordable. Lots of people buy the policies, so the insurance company can offer affordable rates. Of course, competition also has some bearing on the cost. When lots of people want something, the field becomes competitive.

  When lots of people or businesses wish to insure the same risk, the role of the insurance company actually changes. While they do assume the individual risk, as a group risk, the danger is no longer as great. This group risk causes the science of probability to change. The probability laws of large numbers now apply. It is much easier to predict losses for a large group, but much harder to do so for an individual. Since the insurance company does not need to know precisely who will suffer the loss, they can predict their personal losses (as the insurer) for the group as a whole. Actuaries are surprisingly accurate at determining how many out of the group of insured will experience losses.  From these figures, the insurance companies can set their premium rates that will provide the funds necessary to meet expected losses, plus the expenses incident to the conduct of business.  Everyone wins. The individuals might be able to completely shift the risk, and the insurance company, while assuming that risk, makes a profit.

  Even though premium rates can be developed that are very accurate, it would be unusual for them to be “on the mark.” Inevitably, the number of losses that actually do happen will be slightly above or below the predictions. Insurance companies know this and hedge for the possible higher losses. The same is true for investments. The earnings may be higher or lower than expected. While this affects individuals who invest, it also affects the insurance companies. They, too, invest. They invest the premium dollars as part of their hedge against higher than anticipated losses. We have sometimes seen insurance companies that were not as competent as they needed to be.

Law of Large Numbers

  Insurance companies use the “law of large numbers” to predict their losses. It is true that the use of insurance reduces the risk.  It may be difficult to understand why a pooling of the risks would actually reduce them, but this is the case. The law of large numbers is often referred to as the law of averages. Although it is called a “law”, it is actually an entire branch of mathematics.  In the 17th century, European mathematicians were constructing crude mortality tables. From these tables, it was discovered that the percentage of male and female deaths among each year’s births tended to be constant if sufficient numbers of births and deaths were tabulated. It was Denis Poisson, in the 19th century, who named these tabulations the law of large numbers.

  Why would individual risk be higher than group risk? The answer lies in the number of participants. The law of large numbers, or the law of averages, is based on the regularity of events. What seems random when it happens to an individual could be predicted when put in the context of a group.  While group predictions cannot say who will experience the loss, they can say that it will happen to someone within the group. So, the only reason an individual cannot say what will happen to them personally is that they do not have sufficient mathematical information. To gain this information, they must become part of the group. Again, this will not tell the individual whether or not they personally will be affected; only that someone within the group will be.

  What appears to be chance, results with surprising regularity as the number of observations increases. We see this every day on the nightly news. We just do not recognize it as the law of large numbers, sometimes called the laws of probability. Not only insurance companies use these mathematical statistics. Gambling establishments know these laws well. They know with surprising accuracy how many people will win and how many will lose. They just don’t know who the winners and losers will be.

  The law of large numbers is the basis of all types of insurance, including health, disability, auto, home, and liability. This law of large numbers changes the impossibility of predicting life events for one individual, to surprising accuracy for predicting life events for a large group. Insurance companies are perhaps the best scorekeepers of all. They know approximately how many houses will burn each year; how many deaths and at what ages they will occur, how many people will die in auto accidents over the 4th of July holiday, and how many people will be permanently injured in job-related accidents.  If an insurance company insures it, they know the statistics.

  Insurance companies want to insure sufficient quantities of people to minimize their risk. That brings in competition. It is important for each insurance company to bring in the number of policies necessary to minimize their losses. To bring in sufficient quantities, they must be competitive. This brings consumers better and wider choices.

  Of course, statistics do not completely eliminate risk for insurance companies. It is impossible to achieve an infinite number of exposure units, so there will always be some margin for error. In addition, statistics are not perfect.  It is possible to have wrong “facts.”  It is also possible to misread the available information or to have too little information for a factual observance.  An actuary was once quoted as saying that they initially had to underwrite nursing home policies with a crystal ball. Why? They had too little information available to know the outcome of their profits and losses. As more information became available (and as states made laws regarding long-term care coverage), LTC policies became better and gave more to the consumer.

  Since risk diminishes with larger numbers and insurance seems so logical a method, one might wonder why all uncertainties are not combined in one big insurance pool to virtually eliminate risk entirely. Unfortunately, it’s not quite that simple. In order for an insurance company to operate successfully, several things are needed:

1. a large group of homogeneous exposure units,

2. the loss produced by the peril must be definite,

3. the occurrence of the loss in individual cases must be accidental or fortuitous (not purposely done, such as arson),

4. the potential loss must be large enough to actually cause a hardship,

5. the cost of the insurance must be within the means of large numbers of people,

6. the chance of loss must be calculable, and

7. the peril must be unlikely to produce loss to lots of people simultaneously.

   Let’s look at these points individually. The first one, a large group of homogeneous exposure units, means it is essential that a large number of exposures be similar, though not necessarily identical. If there are not enough policyholders facing the same peril, then not enough policies would be sold. If not enough were sold, the insurance company could not offer premiums at a price that consumers would buy. In life insurance policies, for example, many people are needed of differing age, health, and occupation classifications. This allows the insurance company to spread out its potential risk. While some people will die and collect benefits, more will live to pay additional premiums to the company.

The second point, the loss produced by the peril must be definite, which means it must be difficult to counterfeit. Death is probably the best peril because it is difficult to counterfeit death (although it is sometimes attempted). As we know, it is common for people to try to collect from insurance companies by fraudulent means. Disability insurance is now subject to strict underwriting because of past problems with adverse experiences. In other words, they lost too much money to disability claims.

  The third point, the occurrence of the loss must be accidental or fortuitous, which means it must be an accidental unexpected loss. The loss should be beyond the control of the insured. Purposely setting fire to the insureds’ home is not unexpected. If the homeowner sets a match to his or her house, he or she fully expects it to burn down!

  In some types of insurance, certain happenings are not covered because they are considered to be anticipated losses. For example, under mercantile theft insurance, shoplifting losses are not covered because they are considered to be part of the business; they are anticipated losses. In credit insurance, bad debt losses are not covered; they are anticipated losses for that line of business. Life insurance does not actually cover death, because everyone is expected to die at some point. Rather, life insurance covers premature death, because the exact point of death cannot be determined.

  The fourth point, the loss must be large enough to actually cause a hardship, which means the loss must cause the insured economic stress. Some types of loss are simply too small to be worth the time, effort, and expense to set down an insurance contract. Remember that every written policy had expenses involved from the actuaries down to the selling insurance professionals. These expenses are reflected in the premium price. Obviously, consumers are not likely to pay the cost of a premium that is potentially higher than the actual loss would be. Even so, there are some types of coverage that are part of larger policies that do cover small items. Small losses that could be absorbed are seldom a worthwhile buy. Still, we see consumers buy such things as dread disease policies or hospital indemnity policies because the premium is low.

  The fifth point, affordable premium costs, is a must. If not enough consumers purchase the insurance, the cost will not be low enough. If the cost is not low enough, there will not be sufficient quantities of insured.

  The sixth point, the chance of loss must be calculable, which means the probabilities of loss can be determined by logic or by a tabulation of experience. Most types of insurance are determined empirically, which means by a tabulation of experience which can be projected into the future. If no statistics on the chance of loss are available, the ability to accurately predict loss is low even if large numbers are available.

  The final point, the peril must be unlikely to produce loss to many people simultaneously, is not hard to understand. No insurer can afford to insure a loss that happens massively at the same time, such as a loss due to floods or volcanoes. Although everyone will die at some point in time, insurers can still underwrite life insurance because it would be unlikely that all of their policyholders would die simultaneously. War and acts of war, which might cause large quantities of death at once, are not covered.

  All of us face risks every day. Some are larger risks than others, but they still exist. Even though we face daily risks, most of us do not feel we are in danger. We expect the auto fatality to happen to that mysterious “other guy.” We try to be careful in our homes to prevent loss from fire. We do not expect to be disabled and unable to work. That doesn’t mean that we can’t die in an auto accident, have a house fire, or become disabled. We just don’t expect it to happen to us.

  Few people really think about the risks in their lives and this is the way it should be. No one could be productive if they were paralyzed by fear. Even so, most Americans do use insurance to minimize their risks. We also generally recognize some of the risks we take in our investments.  Recognizing risks and doing what can logically be done to minimize them has become an accepted part of life. Although we may not realize it, most Americans are involved in risk management. The objective of risk management is simple: minimize risk or transfer risk to another. Although we don’t state it, our purpose is to maximize productive efficiency by bringing about a balance between financial resources and the possibility of a financial loss. We want a balance between premium costs and the protection it offers.

Sales Practices

  Insurance professionals know they are required by their state and the insurers they represent to be honest in the course of practicing their profession, but appropriate sales practices go beyond that. Insurance professionals could adopt the medical profession’s code of “do no harm.” The first step in any financial transaction is acknowledging that wrong choices could financially affect the buyer. Unfortunately, the buyer or investor is often unaware that he or she has been adversely affected until years later when they reach retirement or some other pre-planned goal.

  In an effort to mandate ethical behavior many states now require a certain number of “ethic” hours, but there is concern that mandating education does not necessarily translate into ethical behavior. It is a difficult situation for lawmakers and others who have the burden of protecting America’s consumers. On the plus side, when insurance professionals have taken courses on ethical behavior, they cannot use the “I didn’t know” excuse for their behavior.

  Sales practices include everything from the first contact to the final delivery of the policy. As it relates to annuity or variable life insurance products, establishing product suitability (or best interest) and ethical practices are closely related. An ethical insurance professional would not place a product that is not suitable for the buyer.

  Appropriate sales practices would dictate that each item be given adequate consideration prior to placing the insurance product. There must be reasonable grounds to believe the insurance product is suitable for the consumers' needs and goals.

  Insurance professionals must know the customer’s financial situation, understand the available options and communicate the basis of the recommendations.  Section 6 of the NAIC’s Model Act reads:

Section 6. Duties of Insurers and Producers

A. Best Interest Obligations. A producer, when making a recommendation of an annuity, shall act in the best interest of the consumer under the circumstances known at the time the recommendation is made, without placing the producer’s or the insurer’s financial interest ahead of the consumer’s interest. A producer has acted in the best interest of the consumer if they have satisfied the following obligations regarding care, disclosure, conflict of interest, and documentation:

(1) (a) Care Obligation. The producer, in making a recommendation shall exercise reasonable diligence, care, and skill to:

i. Know the consumer’s financial situation, insurance needs, and financial objectives;

ii. Understand the available recommendation options after making a reasonable inquiry into options available to the producer;

iii. Have a reasonable basis to believe the recommended option effectively addresses the consumer’s financial situation, insurance needs, and financial objectives over the life of the product, as evaluated in light of the consumer profile information; and

iv. Communicate the basis or bases of the recommendation.

(b) The requirements under Subparagraph (a) of this paragraph include making reasonable efforts to obtain consumer profile information from the consumer prior to the recommendation of an annuity.

(c) The requirements under Subparagraph (a) of this paragraph require a producer to consider the types of products the producer is authorized and licensed to recommend or sell that address the consumer’s financial situation, insurance needs, and financial objectives. This does not require analysis or consideration of any products outside the authority and license of the producer or other possible alternative products or strategies available in the market at the time of the recommendation. Producers shall be held to standards applicable to producers with similar authority and licensure.

(d) The requirements under this subsection do not create a fiduciary obligation or relationship and only create a regulatory obligation as established in this regulation.

(e) The consumer profile information, characteristics of the insurer, and product costs, rates, benefits, and features are those factors generally relevant in making a determination whether an annuity effectively addresses the consumer’s financial situation, insurance needs, and financial objectives, but the level of importance of each factor under the care obligation of this paragraph may vary depending on the facts and circumstances of a particular case. However, each factor may not be considered in isolation.

(f) The requirements under Subparagraph (a) of this paragraph include having a reasonable basis to believe the consumer would benefit from certain features of the annuity, such as annuitization, death or living benefit, or other insurance-related features.

(g) The requirements under Subparagraph (a) of this paragraph apply to the particular annuity as a whole and the underlying subaccounts to which funds are allocated at the time of purchase or exchange of an annuity, and riders and similar producer enhancements, if any.

(h) The requirements under Subparagraph (a) of this paragraph do not mean the annuity with the lowest one-time or multiple occurrence compensation structure shall necessarily be recommended.

(i) The requirements under Subparagraph (a) of this paragraph do not mean the producer has ongoing monitoring obligations under the care obligation under this paragraph, although such an obligation may be separately owed under the terms of a fiduciary, consulting, investment advising, or financial planning agreement between the consumer and the producer.

Product Replacement with Best Interest in Mind

  There are situations that call for replacing one existing product with a newer insurance product, but this is not true in every case. Insurance professionals should never replace an existing product with another product unless there are specific reasons for doing so and those reasons are sensible, meaning the client’s best interest has been considered. Especially when an annuity is the investment tool involved, there are times when a replacement might be unwise. This would especially be true if the annuity owner’s contract were past the surrender period. Putting the client into a new annuity with a new surrender period should not be done without serious thought.

  Obviously, insurance professionals must observe all state-mandated replacement procedures. Most states have specific replacement procedures, which must be followed.

  What does this mean? It all comes down to one question: does the consumer benefit from the product replacement? It could also be asked another way: would the insurance professional make the same replacement if the product in question belonged to him or her instead of someone else? Would the insurance professional make the same product choice for themselves that they are advising others to make?

  Here is how the NAIC Model Act recommends product replacement.

(j) In the case of an exchange or replacement of an annuity, the producer shall consider the whole transaction, which includes taking into consideration whether:

i. The consumer will incur a surrender charge, be subject to the commencement of a new surrender period, lose existing benefits, such as death, living, or other contractual benefits, or be subject to increased fees, investment advisory fees or charges for riders and similar product enhancements;

ii. The replacing product would substantially benefit the consumer in comparison to the replaced product over the life of the product; and

iii. The consumer has had another annuity exchange or replacement and, in particular, an exchange or replacement within the preceding 60 months.

(k) Nothing in this regulation should be construed to require a producer to obtain any license other than a producer license with the appropriate line of authority to sell, solicit or negotiate insurance in this state, including but not limited to any securities license, in order to fulfill the duties and obligations contained in this regulation; provided the producer does not give advice or provide services that are otherwise subject to securities laws or engage in any other activity requiring other professional licenses.

Full Disclosure

  As we know some products are more complex than others. A criticism of equity-indexed annuities, for example, is their complexity. Only when the insurance professional understands the product will he or she be able to adequately communicate all aspects of the investment to their clients.

  It is important to fully disclose all product characteristics, including product limitations. Consumers will make better decisions when they understand the various products and are able to make an informed decision. More important for the insurance producer’s commission is the fact that consumers will keep the product when they are satisfied that an informed decision was made.

  When recommending an annuity, we know that suitability hinges on information. If the insurance professional does not request adequate information, he or she cannot make an adequate recommendation.

Section 6. Duties of Insurers and Producers

(2) Disclosure obligation.

(a) Prior to the recommendation or sale of an annuity, the producer shall prominently disclose to the consumer on a form substantially similar to Appendix A:

(i) A description of the scope and terms of the relationship with the consumer and the role of the producer in the transaction;

(ii) An affirmative statement on whether the producer is licensed and authorized to sell the following products:

(I) Fixed annuities;

(II) Fixed indexed annuities;

(III) Variable annuities;

(IV) Life insurance;

(V) Mutual funds;

(VI) Stocks and bonds; and

(VII) Certificates of deposit;

(iii) An affirmative statement describing the insurers the producer is authorized, contracted (or appointed), or otherwise able to sell insurance products for, using the following descriptions:

(I) From one insurer;

(II) From two or more insurers; or

(III) From two or more insurers although primarily contracted with one insurer.

(iv) A description of the sources and types of cash compensation and non-cash compensation to be received by the producer, including whether the producer is to be compensated for the sale of a recommended annuity by the commission as part of the premium or other remuneration received from the insurer, intermediary or other producer or by a fee as a result of a contract for advice or consulting services; and

(v) A notice of the consumer’s right to request additional information regarding cash compensation described in Subparagraph (b) of this paragraph;

(b) Upon request of the consumer or the consumer’s designated representative, the producer shall disclose:

(i) A reasonable estimate of the amount of cash compensation to be received by the producer, which may be stated as a range of amounts or percentages; and

(ii) Whether the cash compensation is a one-time or multiple occurrence amount, and if a multiple occurrence amount, the frequency and amount of the occurrence, which may be stated as a range of amounts or percentages; and

(c) Prior to or at the time of the recommendation or sale of an annuity, the producer shall have a reasonable basis to believe the consumer has been informed of various features of the annuity, such as the potential surrender period and surrender charge, potential tax penalty if the consumer sells, exchanges, surrenders or annuitizes the annuity, mortality and expense fees, investment advisory fees, any annual fees, potential charges for and features of riders or other options of the annuity, limitations on interest returns, potential changes in non-guaranteed elements of the annuity, insurance, and investment components and market risk.

(3) Conflict of interest obligation. A producer shall identify and avoid or reasonably manage and disclose material conflicts of interest, including material conflicts of interest related to an ownership interest.

(4) Documentation obligation. A producer shall at the time of recommendation or sale:

(a) Make a written record of any recommendation and the basis for the recommendation subject to this regulation;

(b) Obtain a consumer signed statement on a form substantially similar to Appendix B documenting:

(i) A customer’s refusal to provide the consumer profile information, if any; and

(ii) A customer’s understanding of the ramifications of not providing his or her consumer profile information or providing insufficient consumer profile information; and

(c) Obtain a consumer signed statement on a form substantially similar to Appendix C acknowledging the annuity transaction is not recommended if a customer decides to enter into an annuity transaction that is not based on the producer’s recommendation.

(5) Application of the best interest obligation. Any requirement applicable to a producer under this subsection shall apply to every producer who has exercised material control or influence in the making of a recommendation and has received direct compensation as a result of the recommendation or sale, regardless of whether the producer has had any direct contact with the consumer. Activities such as providing or delivering marketing or educational materials, product wholesaling or other back-office product support, and general supervision of a producer do not, in and of themselves, constitute material control or influence.

  The law quoted in this course is not the complete law. We encourage readers to look up the full law and become acquainted with it. https://content.naic.org/sites/default/files/inline-files/MDL-275.pdf

  It is also recommended to read: https://www.finra.org/rules-guidance/rulebooks/finra-rules/2111

United Insurance Educators, Inc.

PO Box 1030

Eatonville, WA 98328

(253) 846-1155

mail@uiece.com

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[1] The floor in an annuity is the minimum interest rate that an annuity can earn. Insurers set floors to protect annuity owners from market downturns and ensure that the interest rate on the annuity's investment funds will not fall below a certain level. This may help prevent the policyholder's account from losing value due to negative market returns.

[2] A surrender charge, also known as a surrender fee or penalty, is a fee that an insurance company or other institution may impose when a policyholder cancels or withdraws money from a policy or investment before a specified period. The purpose of these charges is to compensate the institution for administrative costs and potential losses, and to discourage policyholders from terminating their policies early.