ABSTRACT
This study investigated economic impact of inflation and interest rate on life annuity business in Nigeria. The study was a secondary research, as such; ex-post facto research design was adopted. Data were sourced from CBN statistical bulletin, PENCOM and NAICOM publications from 2010 to 2020. Stationarity test was first carried out using Phillips- Perrons statistical method and Johansen co-integration test, while ordinary least square (OLS) statistical method was used for data analysis. Results from the tests of hypotheses show that: rising rate of inflation had not posed significant challenge to life annuity business in Nigeria. While interest rate instability had posed significant challenge to life annuity business in Nigeria. The study concludes that inflation rate and interest rate impact on the growth of life annuity business in Nigeria. The study recommends that: government should formulate monetary policy objectives targeted at combating rising inflation rate in Nigeria. By achieving this, the benefits due to life annuity policyholders and investment returns of life insurance companies will not be eroded by inflationary effects. There is need for government through its apex financial sector regulator (CBN), to target favourable interest rate regime that will be sustained for a longer time in order to encourage business growth and investment opportunities in Nigeria. Finally, insurance companies should embark on aggressive awareness creation about the importance of life annuity, improve on the available actuarial skills, be more innovative in designing/marketing life annuity products that will meet the needs and aspiration of Nigerians and ensure prompt payments of benefits to retirees or policyholder in order to deepen life annuity penetration in Nigeria. By doing these, life insurance companies will be in a better position to receive a reasonable proportion of the estimated 10 trillion naira pension fund under management through life annuity premium.
CHAPTER TWO
INTRODUCTION
1.1 Background to the Study
Life annuity is an insurance policy that pays their beneficiaries as long as the beneficiaries are alive. It provides an excellent hedge against longevity risk where an individual outlives his income and savings. It is playing an increasingly important role in retiree’s retirement arrangement. This type of insurance contract has existed over more than two thousand years ago, stretching back through the development of financial markets and new mathematical theories in the 17th Century all the way to Roman times. But the modern era arguably began with the Finance Act of 1956 which first introduced a pension scheme that required members to annuitize the fund at retirement (Lowe, 2013).
Annuity is a series of payments made at equal intervals to the annuitant, which may be for life (life annuity) or for a fixed period of time. From a legal perspective, life annuity may be defined as a contract between two parties; the annuitant and the insurer, whereby the annuitant pays a consideration (the premium) to the insurer who undertakes to pay the other (the annuitant) a stipulated amount (the annuity) periodically throughout the annuitant’s life. Thus, in exchange for an initial premium, these companies commit themselves to paying certain periodic amounts until the death of the policyholder, thereby taking on the annuitant’s longevity risk (Vidal-Melia & Lejarraga-Garcia; 2005). The fact that most people do not annuitize much of their wealth (or at least not enough of it) is often called the “annuity puzzle” (Benartzi, Previtero & Thaler, 2011). Longevity risk is the risk of needing more financial resources due to living longer than expected. Where annuities are not available, retirees could reduce their annual consumption in response to the uncertainty surrounding their date of death. However, they would then run the risk of dying before they had consumed all their available wealth, and this represents a cost of missed opportunity for consumption. This cost will be less if the individuals value the wealth that remains at the time of their death as a bequest (Vidal-Melia & Lejarraga-Garcia; 2005).
Since uncertainty about length of life is an ubiquitous source of risk, financial contract similar to annuities have a long history. Poterba (1997) reported that ancient Roman contracts known as annua promised an individual a stream of payment for a fixed term, or possibly for life, in return for an upfront payment. Speculators who dealt in marine and other lines of insurance offered such contracts. A Roman, Domitius Ulpianus, compiled the first recorded life tables for the purpose of computing the estate values of annuities that a decedent might have purchased on the life of his survivors (Dellinger, 2006). The purpose of annuities is to insure the contract owner against the risk of superannuation, which means outliving one’s income. Older investors who run out of money to support themselves face a dire dilemma. Annuities were therefore created in order to mitigate this risk.
Life annuity business in Nigeria was relatively unknown until the introduction of Contributory pension scheme, through the Pension Acts of 2004. To help retirees manage their contributions after they might have retired, the Pension Act 2014 provided that they have the options of buying life annuity products from insurance companies or take the option of programmed withdrawals from the Pension Fund Administrators. Therefore, to a large extent, life annuity policy take-up and its growth in Nigeria depend mainly on employees’ decision to annuitize their accumulated pension funds at payout phase. Under the Defined Contribution (DC) where the retirement risks have been shifted completely to retirees in Nigeria, each retiring employees is automatically responsible for the investment risk and longevity risk, and these risks are believed to be easily insured using life annuity through organised annuity markets instead of phased withdrawal provided by the Pension Fund Administrators. While the need for life annuities is obvious, it remains unmet (Evans & Sherris, 2009).
Life annuity business growth is influenced by both internal and external factors. Whereas internal factors focus on an insurer’s specific characteristics, the external factors concern both industry features and macroeconomic variables. It is argued that macroeconomic factors have profound effect on the growth of insurance companies (Cheechee & Herbeman, 2002). Macroeconomic factors such as economic output, unemployment, inflation, exchange rate, interest rate, savings and investment are key indicators of economic performance and are closely monitored by governments, businesses and consumers (Investopedia, 2020).
Two major statistics that mean a lot to retirees and pension plan savers are inflation rate and real rate of return. Real rate of return is the nominal rate of return less inflation. In a layman’s language, it is the rate of return that shows what your investment return can purchase, given current price level. With inflation inching upwards in Nigeria, and interest rate going the opposite way, pension plan savers may be subjected to double “punishment” or double jeopardy. According to economists, falling interest rates are prone to causing inflation, if that happens, pension plan savers may be in for the worse (Nairametrics, 2020).
One thing that characterized the Nigerian Economy and the Nigerian capital market in 2019 was the fast decline in yield or interest rates towards the end of the year. The Nigerian 10-year Bond Yield, which opened the year 2019 at 15%, is poised to close the year at around 11% or less and other tenors are currently trending at single- digit interest rates. According to Brown and Poterba (2000), the annuity payout rate depends on both the annuitant’s perspective mortality risk and on the return that the annuity provider can earn on invested assets. This study therefore, is geared towards investigating the economic impact of inflation and interest rates on life annuity business in Nigeria.
1.2 Statement of the Problem
Over the years, the life annuity business of the Nigerian Insurance industry has continued to face growth challenges. Successive governments have, in various ways, attempted to reform the Nigerian insurance industry as well as life annuity business. However, it is still surprising that despite the nation’s high population, which is estimated currently at 200 million people, coupled with the introduction of contributory pension scheme in 2004, life annuity business has continued to experience slow growth in Nigeria. As years went by, the evolution of life annuity became more and more visible, though, in comparison with other world countries, life annuity in Nigeria is growing quite poorly. The reasons for this come not only from insurance services but also from economic factors as well as market risks.
Inflation affects asset returns and thus, the asset side of an insurer which may offset or magnify reserving risks in the presence of inflation. National pension systems address longevity and inflation risks in various ways (Holzman & Hinz, 2005). For the most part, the OECD countries rely on social insurance principles applied on universal basis to address longevity risk. Inflation risk is addressed in different ways: some countries apply price or wage indexation to pensions, while others rely on ad-hoc increases in pension amounts (Asher & Vasudevan, 2009). Increasing longevity compounds the cumulative impact of even low inflation rates (Barr and Diamond, 2008). Inflation losses are particularly damaging for retirees because they may not be able to make up by increasing their earnings or saving power. These annuities simply provide fixed guaranteed annual increases to pay-outs, the cost of which has to be borne by the annuitant. The insurer does not bear any inflation risk.
Market risk refers to the possibility of earning lower-than-expected returns due to adverse changes in asset prices (interest rates, exchange rates, equity prices, real estate prices) that during the term of the products. Annuities are long term financial instruments and are consequently subject to higher market risk than short duration products. The most challenging issue for annuity underwriters is to match annuity-related liabilities with an appropriate pool of long term investments (Asher & Vasudevan, 2009). On the other hand, the interest rate environment also affects demand by policyholders for certain insurance products. For example, fixed-rate annuities can promise a pre- specified return for investments over a potentially extended period. When interest rates are very low, as they are currently, life insurers can only make money on these annuities if they offer policyholders a low return.
From the foregoing, one can opine that Nigerian insurance industry life annuity growth may be influenced by both internal and external factors. Whereas internal factors focus on an insurer’s specific characteristics, the external factors concern both industry features and macroeconomic variables. It is therefore against this background that this study investigates the economic impact of inflation and interest rates on life annuity business in Nigeria.
1.3 Objectives of the Study
The main objective of the study is to investigate the economic impact of inflation and interest rates on life annuity business in Nigeria. The specific objectives of the study include, to:
1. Find out whether rising inflation rate has posed significant challenge to the growth of life annuity business in Nigeria.
2. Examine whether interest rate instability has posed significant challenge to the growth of life annuity business in Nigeria.
1.4 Research Hypotheses
The following hypotheses were formulated for the study:
Hypothesis one
H0: Rising inflation rate does not pose significant challenge to the growth of life annuity business in Nigeria
Hypothesis two
H0: Interest rate instability does not pose significant challenge to the growth of life annuity business in Nigeria
1.5 Scope of the Study
The study was time-series based, and was exclusively geared towards investigating macroeconomic challenges militating against the growth life annuity business in Nigeria, with specific interest on rising inflation rate, interest rate instability, exchange rate fluctuation and high rate of unemployment. The study covered a period of eleven years; from 2010 to 2020.
The year 2010 was chosen as base year given that it was when data on life annuity business was published separately by National Pension Commission (PENCOM) from 2010 and jointly by PENCOM and National Insurance Commission (NAICOM) from 2014 to 2020. In addition, the study adopted sub-industry wide coverage.
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