Optimal annuitization with imperfect information about insolvency risk

• Author: Casey Rothschild,Hui Li,Seth Neumuller
• DOI: http://doi.org/10.1111/jori.12318
• Published date: 01 March 2021
• Date: 01 March 2021

J Risk Insur. 2021;88:101–130. wileyonlinelibrary.com/journal/JORI

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101

Received: 2 May 2019

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Accepted: 10 June 2020

DOI: 10.1111/jori.12318

ORIGINAL ARTICLE

Optimal annuitization with imperfect

information about insolvency risk

Hui Li

1

|Seth Neumuller

2

|Casey Rothschild

2

1

Department of Biostatistics, Harvard

University, Cambridge, Massachusetts

2

Department of Economics, Wellesley

College, Wellesley, Massachusetts

Correspondence

Casey Rothschild, Department of

Economics, Wellesley College, Wellesley,

MA 02482.

Email: crothsch@wellesley.edu

Abstract

Even the highest‐rated life‐annuity providers have a

nonzero probability of becoming insolvent during an

annuitant's retirement, and many potential annui-

tants are unaware of the state guaranty associations

(SGAs) which provide insurance against the asso-

ciated financial consequences. We study the theore-

tical implications of insolvency risk—real and

perceived—for annuitization. Then, using a dis-

ciplined calibration of annuitant misperceptions in a

standard life cycle model, we show that even the

modest perceived risk of default associated with

highly‐rated providers can—absent awareness of the

SGAs—reduce annuitization and significantly reduce

welfare. We further consider the implications of in-

formation frictions which prevent retirees from dis-

cerning true insolvency risk and we find that these

frictions have plausibly large additional quantitative

implications for annuitization and welfare. Simula-

tions of our model further suggest that the general

lack of awareness of the SGA backstop by potential

annuitants can erode a sizable fraction of the poten-

tial welfare benefits thereof.

KEYWORDS

annuity puzzle, financial sophistication, nonperformance risk

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© 2020 American Risk and Insurance Association

1|INTRODUCTION

The vast majority of the theoretical and computational models of retirees' annuitization decisions in

the economics literature assume that annuity contracts are risk‐free investments. This assumption is

only correct (within the United States) because of the presence of the state guaranty associations

(SGAs) which backstop annuitants against the default risk of their annuity providers. Providers

themselves are not infinitely lived: since 1983 at least 100 annuity providers have been deemed

insolvent and subsequently liquidated.

1

Figures 1and 2report the empirical distribution of solvent

U.S. domiciled insurers across financial strength ratings (FSRs) and the cumulative probability of

impairment during an individual's retirement period conditional on the insurer's FSR at age 65,

respectively.

2

Note first that, per Figure 1, there is significant variation in FSRs across insurers. Note

second that, per Figure 2,although“A”‐rated annuity providers are less likely to become financially

impaired than “D”‐rated providers, “A”‐rated providers still have a nontrivial probability of becoming

financially impaired, and subsequently insolvent, during an individual's retirement period.

There are, in principle, three distinct potential adverse consequences of insurer insolvency

from the point of view of an annuitant. The first is a “haircut:”at worst, insurer default could

lead the annuitant to lose their annuity entirely; in less extreme cases, the annuitant might

recover only a fraction of the value of their annuity when their insurer is liquidated. The second

is a delay: the annuitant's periodic payments might cease for an interval between default and

the resolution thereof. The third is a de‐annuitization: the annuitant might have their annuity

terminated in exchange for a lump‐sum recovery payment as part of their insurer's liquidation;

this is undesirable insofar as the opportunities for re‐annuitization are limited or expensive. The

anticipation of one or more of these potential consequences will make annuities a less effective

tool for managing longevity risk in retirement.

As indicated above, these potential risks are virtually eliminated, in practice, by SGAs, which

provide annuitants with high‐quality insurance against insolvency risk. All insurance companies

must be members of the SGA in the state in which they are licensed to sell annuities. SGAs have two

main sources of funding when providing coverage to policyholders. First, SGAs have subrogation

rights to a proportionate share of the assets remaining in the failed insurer, which are often sub-

stantial. Second, insurers doing business in that state are assessed a share of the amount required to

meet the portion of the claims not covered by the assets remaining in the failed insurer.

3

In most

cases, however, SGAs facilitate a transfer of the failed insurer's liabilities to other solvent insurers,

thereby avoiding the reduction, termination, or delay in benefits paid to annuitants, provided the

present value of their annuity is below the established threshold coverage limit for their state.

4

1

Source: www.nolhga.com/factsandfigures/main.cfm/location/insolvencies. Accessed September 25, 2018.

2

Impairment precedes insolvency. When an insurer is unable to meet its obligations, the insurance commissioner in the

firm's home state can deem the firm financially impaired at which time efforts are made to help the firm regain its

financial footing through a process known as rehabilitation. If it is determined that the firm cannot be rehabilitated, the

company is declared insolvent, and the commissioner will ask the state court to order the liquidation of the company.

3

The amount insurers are assessed is based on the amount of premiums that they collect in that state. The National

Organization of Life and Health Insurance Guaranty Associations (NOLHGA) is made up of the SGAs of all 50 states and the

District of Columbia. Through NOLHGA, the SGAs work together to provide continued protection for annuitants affect ed by

multi‐state insurance insolvencies.

4

An extensive search of more than 100 multi‐state insolvencies between 1983 and 2016 revealed no known cases of benefits

being terminated, reduced, or delayed more than 2 weeks except in cases where the present value of the annuity exceeded the

SGA's threshold coverage limit. Most SGAs provide coverage for up to $250,000 in the present value of annuity benefits per

individual. Individuals who wish to purchase annuities in excess of this amount can spread their purchases across insurers and

still remain under the coverage limit. The lone exception is California in which the first 20% of losses due to insolvency are not

coveredbythestate'sguarantyassociation.Source:www.nolhga.com/fact sandfigures/main.cfm/location/insolvencies.

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