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Accommodation or Obfuscation? Product
Innovation in the Variable Annuities Market
Xiaochen Jing and Daniel Bauer
University of Wisconsin - Madison
April 29th, 2020
Page 1 / 22 Background and Literature
• Separate account life insurance contracts linked to a list of financialinstruments with tax advantage
• 2 trillion USD in net assets (25% of US insurance industry’s total assets)
• Equipped with optional features
I Guaranteed Living Benefits (GLBs)
I Guaranteed Minimum Death Benefits (GMDBs)
• 75% of all new VAs include GLBs
• Withdrawal guarantees most popular living benefits since mid-2000s
I Guaranteed Minimum Withdrawal Benefits (GMWBs)
I Guaranteed Lifetime Withdrawal Benefits (GLWBs)
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 2 / 22 Background and Literature
• Plenty of product variation in the VA marketI Radical: GMDB, GMAB, GMIB, GMWB, GLWBI Incremental: Surrender Charge Schedule, Free Withdrawals, Step-Up
Provisions, Impact of Withdrawals, etc.I Beneficial to consumers with specific needs
• VAs are complex productsI Multi-dimensional payoff functionsI On-going decision making throughout the contract periodI Consumers may not be sophisticated to choose optimally
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 3 / 22 Background and Literature
• Classic View on Product Innovation
I Market Incompleteness(Allen and Gale, 1994; Duffie and Rahi, 1995)
I Market Frictions(Ellul et al., 2018; Koijen and Yogo, 2020; Moenig and Bauer, 2016)
• Potential “dark side” of Product Innovation: ObfuscationI Strategic pricing of complexity
(Gabaix and Laibson, 2006; Carlin, 2009)
I Empirical Studies from Retail Financial Markets(Henderson and Pearson, 2011; Célérier and Vallée, 2017)
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 3 / 22 Background and Literature
• Classic View on Product Innovation
I Market Incompleteness(Allen and Gale, 1994; Duffie and Rahi, 1995)
I Market Frictions(Ellul et al., 2018; Koijen and Yogo, 2020; Moenig and Bauer, 2016)
• Potential “dark side” of Product Innovation: ObfuscationI Strategic pricing of complexity
(Gabaix and Laibson, 2006; Carlin, 2009)
I Empirical Studies from Retail Financial Markets(Henderson and Pearson, 2011; Célérier and Vallée, 2017)
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 4 / 22 Outline
• This paper: what drives product innovation in the Variable Annuitiesmarket?
• A stylized model on product price and complexity
• Empirical findingsI In general, product price is positively associated with complexityI Earlier innovations have high pricesI Recurring pattern of radical and incremental innovation
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 4 / 22 Outline
• This paper: what drives product innovation in the Variable Annuitiesmarket?
• A stylized model on product price and complexity
• Empirical findingsI In general, product price is positively associated with complexityI Earlier innovations have high pricesI Recurring pattern of radical and incremental innovation
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 4 / 22 Outline
• This paper: what drives product innovation in the Variable Annuitiesmarket?
• A stylized model on product price and complexity
• Empirical findingsI In general, product price is positively associated with complexityI Earlier innovations have high pricesI Recurring pattern of radical and incremental innovation
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 5 / 22 Table of Contents
1 Background and Literature
2 Outline
3 Model
4 Data and Summary Statistics
5 Regression Analysis
6 Conclusion
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 6 / 22 ModelAn Extension to Carlin (2009)
• N + 1 homogeneous firms: profit maximizersI Choose effort ej for product innovationI Choose product price and complexity (pj , kj)
• Unit mass of consumersI Sophisticated and unsophisticated consumers
? The proportion depends on product complexity in the market
I Type I and type II consumers
Utility Current InnovationType I 1 0Type II 0 1
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 6 / 22 ModelAn Extension to Carlin (2009)
• N + 1 homogeneous firms: profit maximizersI Choose effort ej for product innovationI Choose product price and complexity (pj , kj)
• Unit mass of consumersI Sophisticated and unsophisticated consumers
? The proportion depends on product complexity in the market
I Type I and type II consumers
Utility Current InnovationType I 1 0Type II 0 1
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 7 / 22 ModelTwo-stage Game
• Stage one:I Firms choose levels of effort for innovationI Lottery-like probability of success Pj =
ej∑i ei
• Stage two:I Successful innovator is revealedI Firms choose price and complexity (pj , kj) for their productsI Consumers choose one product to purchase
• Equilibrium solved in reverseI In stage two, successful innovator chooses product typeI In stage two, unsuccessful innovators compete in a Carlin’s gameI In stage one, all firms compete in a Tullock’s game
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 8 / 22 ModelTwo-stage Game
Proposition 1
Successful innovator chooses monopolistic price, lowest complexity,and attracts all type II sophisticated consumers in equilibrium.
Proposition 2
Unsuccessful innovators compete over type I sophisticated consumers.Higher competition leads to higher levels of complexity.
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 9 / 22 Data and Summary Statistics
• VA prospectus: typically several hundred-page long documents withdetailed description
• Our source: Morningstar Annuity IntelligenceI 2,302 plain VA contracts and 22,623 VA + benefit combinationsI Staring from 1994I Numerical values on fees and benefitsI Textual description on add-ons and conditions
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 10 / 22 Data and Summary Statistics
• Frequent innovation and increasing complexity
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 11 / 22 Data and Summary Statistics
• Increasing VA fees and benefit charges
• In line with recent findings
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 12 / 22 Data and Summary StatisticsAnalysis at the benefit level
• Popularity of various optional benefits overtime
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 13 / 22 Data and Summary StatisticsAnalysis at the benefit level
• Sub-markets characteristics
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 14 / 22 Data and Summary StatisticsAnalysis at the benefit level
• Complexity trends in sub-markets
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 15 / 22 Data and Summary StatisticsAnalysis at the benefit level
• Price trends in sub-markets
• Aggregate vs. sub-markets, virtuous and obfuscating innovations
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 16 / 22 Regression AnalysisProduct Complexity
• Measured by description length and number of scenarios
• Baseline model
Complexityi = α∗Firsti+βyear ∗Yeari+βtype∗Benefit Typei+Fixed Effectsi+εi
• Interaction term to capture sub-market patterns
Complexityi =α ∗ Firsti + βyear ∗ Yeari + βtype ∗ Benefit Typei
+ γ ∗ Yeari ∗ Benefit Typei + Fixed Effectsi + εi
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 16 / 22 Regression AnalysisProduct Complexity
• Measured by description length and number of scenarios
• Baseline model
Complexityi = α∗Firsti+βyear ∗Yeari+βtype∗Benefit Typei+Fixed Effectsi+εi
• Interaction term to capture sub-market patterns
Complexityi =α ∗ Firsti + βyear ∗ Yeari + βtype ∗ Benefit Typei
+ γ ∗ Yeari ∗ Benefit Typei + Fixed Effectsi + εi
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 17 / 22 Regression AnalysisProduct Complexity
• Pair of terms to capture the “increasing-stagnating" trendI t0i : time after first sub-market innovationI txi = max(t0i − x , 0)
Complexityi =α ∗ Firsti + βyear ∗ Yeari + βtype ∗ Benefit Typei
+ γ0 ∗ t0i + γx ∗ txi + Fixed Effectsi + εi
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 18 / 22 Regression AnalysisProduct Complexity
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 18 / 22 Regression AnalysisProduct Complexity
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 18 / 22 Regression AnalysisProduct Complexity
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 19 / 22 Regression AnalysisVariable Annuity and Benefit Fees
• Measured by total fees of the product
• Baseline model
Feei =α ∗ Firsti + βyear ∗ Yeari + βtype ∗ Benefit Typei + βcomp ∗ Complexityi
+ Fixed Effectsi + εi
• Interaction term to capture sub-market patterns
Feei =α ∗ Firsti + βyear ∗ Yeari + βtype ∗ Benefit Typei + βcomp ∗ Complexityi
+ γ ∗ Yeari ∗ Benefit Typei + Fixed Effectsi + εi
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 20 / 22 Regression AnalysisVariable Annuity and Benefit Fees
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 20 / 22 Regression AnalysisVariable Annuity and Benefit Fees
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 21 / 22 Conclusion
• Extended Carlin’s model for product complexity by allowing for "virtuous"product innovationI In equilibrium, "virtuous" and "obfuscating" firm behavior co-exist.
• Empirical analysis on Variable Annuity marketI In general, product price is positively associated with complexityI Earlier innovations have high pricesI The recurring pattern of radical and incremental innovation
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market
Page 22 / 22
Thank you!
Xiaochen Jing & Daniel Bauer Product Innovation in the Variable Annuities Market