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Difficulty: MediumAnnuities and Insurance-Based Products

An investor seeking to protect their retirement income against purchasing power risk purchases a variable annuity rather than a traditional fixed annuity. Which of the following risks is shifted from the insurance company to the contract owner in a variable annuity?

  1. Investment risk, because contract values and future payouts depend on the market performance of subaccounts in a separate account.Answer
  2. B
    Mortality risk, because the insurance company no longer guarantees lifetime income payouts once annuitization begins.
  3. C
    Insolvency risk of the insurer's general account, because subaccount assets are held directly within the insurance company's general account balance sheet.
  4. D
    Tax penalty risk, because all periodic annuitized payouts are subject to a mandatory 10% IRS early withdrawal penalty regardless of the owner's age.

Answer

Investment risk, because contract values and future payouts depend on the market performance of subaccounts in a separate account.
In a variable annuity, contract premiums are directed into a separate account containing market subaccounts. Because the underlying performance of these subaccounts determines cash values and payout amounts, the contract owner assumes full investment risk. The insurance company retains mortality risk (guaranteeing lifetime payments) and expense risk, but does not guarantee investment returns.

Step-by-Step Solution

1
Differentiate between fixed and variable annuity asset structures.
Fixed annuity premiums are held in the insurer's general account, where the insurance company guarantees a minimum interest rate and bears all investment risk. Variable annuity premiums are held in a separate account invested in equity/debt subaccounts.
Asset location determines which party assumes the market risk.
2
Identify risk transfer mechanics in variable annuities.
Because variable subaccount values fluctuate based on market returns, the contract owner bears the investment risk in exchange for potential capital appreciation to offset inflation.
The insurance company maintains guarantees for mortality and administrative expense risks, but does not guarantee investment performance.

Key Concept

Investment Risk vs. Insurance Guarantees in Variable Annuities
Estimated Time:1m 0s
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Topics

Annuities and Insurance-Based Products

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