Market Discipline in the Individual Annuity Market

• Date: 01 March 2011
• Author: James M. Carson,Randy E. Dumm,James S. Doran
• DOI: http://doi.org/10.1111/j.1540-6296.2010.01189.x
• Published date: 01 March 2011

C

Risk Management and Insurance Review, 2011, Vol.14, No. 1, 27-47

DOI: 10.1111/j.1540-6296.2010.01189.x

MARKET DISCIPLINE IN THE INDIVIDUAL

ANNUITY MARKET

James M. Carson

James S. Doran

Randy E. Dumm

ABSTRACT

Theoretical expectations related to market discipline generally suggest a posi-

tive relationship between firm financial strength and price. We examine mar-

ket discipline in the individual annuity market by measuring annuity contract

yields during the accumulation phase and find that, among other results, firm

financial strength is positively related to yield (i.e., negatively related to price).

We argue that this apparent anomaly can be viewed as a form of market disci-

pline itself, for at least four related reasons, the foremost reason being that in

order to compete in the asset accumulation market, an insurer has an incentive

to provide a track record of historically strong credited interest rates within

the annuity. In addition, the credited interest rates within an annuity are only

revealed ex post over time, thus diminishing consumer ability to impose tra-

ditional market discipline relating firm financial strength and price, and also

enabling financially weaker insurers to impose higher ex post prices in the form

of lower realized annuity yields.

INTRODUCTION

Capital allocation theory (e.g., Merton and Perold, 1993; Myers and Read, 2001) holds

that customers of financial institutions care about firm financial strength since the per-

formance of financial contracts is contingent on the firm’s continued survival. Thus, the

demand for a financial institution’s intermediated products is expected to vary directly

with firm financial strength (e.g., Cummins, Lin, and Phillips, 2005). More specifically,

prior research posits a direct relationship between product price and insurer financial

strength (e.g., Sommer, 1996). Cummins (2000, p. 8) suggests that insurers carry higher

James M. Carson is a member of the Faculty of Risk Management and Insurance, Florida State

University; e-mail: jcarson@fsu.edu. James S. Doran is a member of the Faculty of Finance,

Florida State University; e-mail: jsdoran@fsu.edu. Randy E. Dumm is a member of the Faculty of

Risk Management and Insurance, Florida State University; e-mail: rdumm@fsu.edu. The authors

acknowledge the research assistance of Stephen Fier as well as helpful comments from the editor,

the anonymous referees, and participants from presentations at The University of Georgia and

conferences of ARIA, WRIA, SRIA, and WRIEC. All errors are our own. This article was subject

to double-blind peer review.

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28 RISK MANAGEMENT AND INSURANCE REVIEW

levels of capital in order to “assure policyholders that claims will be paid even if larger

than expected.”1In a broader context, external market discipline impacts the capital

allocation decisions of the firm.

The purpose of this study is to examine market discipline in the individual deferred

annuity market. Previous research on annuities has focused largely on issues related to

annuity payouts, either in the form of social payments or retirement plan payments (e.g.,

Bodie, 1990; Brown and Porterba, 2000; Brown, 2003). Milevsky (2001) analyzes optimal

annuitization, and Milevsky (1998) examines the decision of whether or not to annuitize

in the context of optimal asset allocation. Williams (1986) examines the expected impact

that higher interest rates and longer lifetimes have on the appeal for life annuities.

Although previous research has examined price disparity for the annuity market as a

whole, variations across insurers and across annuity-specific provisions also likely play

important roles in explaining variation in annuity pricing. For example, Warshawsky

(1988) notes that price dispersion could reflect the relative riskiness of asset portfolios

across insurers.

The study contributes to the literature in several ways, and we believe the research

design allows for a distinctive test of market discipline and the commonly hypothesized

relationships between price and various firm characteristics that are posited in the

literature on capital allocation theory and the pricing of intermediated risks. First, by

focusing on the annuity market, we examine market discipline for a product that has

both insurance and asset accumulation features, as opposed to a pure-risk product such

as property–casualty insurance. Second, unlike many previous studies, our price data

for annuities allow us to focus on one product line. Thus, by avoiding the use of multiline

data, we minimize the potentially confounding effects of differential pricing practices

across various lines of coverage. Third, the analysis is focused on annuity values well

within the range of state guaranty fund coverage.2As such, the research tests for the

existence of market discipline in a market in which there is less need for consumers to

impose market discipline stemming from concerns about insolvency. To the extent that

market discipline exists in this market, it is arguably even more likely to exist in markets

for other types of financial products where guaranty fund coverage either does not exist

or is not as complete. Fourth, although we focus primarily on the accumulation phase

of annuities, the empirical analysis also accounts for factors related to longevity risk

that may become manifest during the annuity payout (decumulation) phase. Finally,we

provide an explanation for the seemingly paradoxical finding that firm financial strength

is positively related to annuity yield (i.e., negatively related to annuity price). Although

this result is similar to the finding of Doerpinghaus and Gustavson (1999) for long-term

care insurance, our finding for annuities is different than the results in prior researchfor

property–casualty products (e.g., Sommer, 1996; Phillips, Cummins, and Allen, 1998)

1Financial services firms like annuity insurers operate in an environment in which the entities

with oversight responsibilities (i.e., regulators and rating agencies) focus on insolvency risk

related to interestrate exposure, in addition to potential insured losses. Of all insurance contracts

offeredby insurers, the deferred annuity most closely represents the features in savings contracts

offered by banks.

2State guaranty funds typically provide at least $100,000 of coverage for annuities (see

NOLHIGA, 2008).