Broadly, life insurers offer annuitants two broad classes of life annuity payouts: pure and refund. With the pure life annuity, income payments continue for as long as the annuitant lives but terminate on the annuitants death or, with a temporary life annuity, at the end of the designated time period, if earlier. On the death of the annuitant, no matter how soon that may occur after the commencement of income, no further amounts are payable to the annuitants estate or to any beneficiary. With this annuity, the entire purchase price is applied to provide income to the annuitant, no part of it paying for any “refund” benefit. Thus, the pure life annuity provides the maximum income for a given annuity purchase price. Because of the high
probability of survival at the younger ages, the difference in income between a pure life annuity and one with a refund feature is small. At older ages, the difference can be great.
Proposed insured’s for individually issued life and health insurance policies must qualify for the insurance by demonstrating that they are in good health and are otherwise insurable. Without insurability requirements, adverse selection would be a massive problem for insurers selling individual life and health policies. Those in poor health would be most likely to apply, and rates charged them would not reflect their probabilities of loss or, if they did, those in good health would tend to avoid the insurance. The underwriting process exists primarily to deter and detect adverse selection in individual life and health insurance, that is, to deter and detect when those with higher than average probabilities of having claims attempt to enter the insurance pool at an average (and, therefore, “unfairly low”) premium rate. Adverse selection also exists with life annuities. Those with higher than average probabilities of having claims would like to enter the risk pool at an average premium rate. However, “higher than average” losses with annuities translate into people being healthier than average, whereas with life and health insurance, this translates into people being less healthy. Adverse selection with life annuities means that those in super standard physical condition will be more likely to purchase them. Individuals in poor health will automatically shy away from them.
Insurers are aware of this phenomenon and, historically, have priced annuities on the assumption that those who purchase them, as a group, will exhibit mortality superior to the population as a whole and superior to that found under life insurance policies. Experience confirms this tendency, for annuity mortality has been far superior to that under life policies and the population as a whole. An effect of this automatic pricing for adverse selection (i.e., excessive longevity) is that those who believe that their life expectancies will not be “superior” tend to avoid purchasing life annuities; just as those in good health would tend to avoid purchasing life insurance policies that had been priced assuming no underwriting (i.e., priced for adverse selection—excessive mortality). Thus, by failing to price to risk, life insurers have deprived themselves of many potential life annuity customers and have deprived many potential customers of the opportunity to purchase “fairly” priced life annuities. This fact has limited the growth of the life annuity market and has led many contract owners to withdraw funds from annuities at the maturity date rather than allow the funds to be retained by the insurer and paid out as a life annuity.
So-called impaired health life annuities have been issued as structured settlement annuities for several years (discussed later). Until recently, however, we had witnessed little movement to offer them to the general public, although Professors Murray and Klugman had argued years ago that a market for such annuities should be developed. By 1996, an insurer in the United Kingdom—known for innovativeness in insurance— began selling impaired life annuities, as had one in the United States. The U.K. annuity is underwritten for poor health; the poorer the health the higher the life annuity payout. The U.S. annuity, available only to smokers, allows them to enjoy higher annuity payouts than that typically available in the standard market. Smokers live some 7 to 10 years less than nonsmokers on average, so a fairly priced life annuity for them should be less expensive. To qualify, proposed annuitants must answer “yes” to the question of whether they have smoked an average of at least 10 cigarettes per day for the previous 10 years.