Return smoothing in life insurance from a client perspective

Participating (or with-profit) life insurance contracts play an important role in private old-age provision in many countries. Life insurers pool the assets and liabilities of a heterogeneous portfolio of such contracts and typically perform some return smoothing in the collective investment. Participating contracts were historically equipped with a cliquet-style (year-to-year) guarantee. The current low interest rate environment and regulatory requirements have forced life insurers to develop new product designs with lower and/or different types of guarantees. However, observed demand as well as the findings of several studies show that (year-to-year) guarantees are (subjectively) highly attractive for long-term investors. In this paper, we show that return smoothing alone (that is, without guarantees) can significantly increase the attractiveness for such investors. Most importantly, we show that many (loss averse) long-term investors will even prefer products without guarantee but with smoothed returns over other products with guarantee features. The results hold for long-term investors who not only consider the terminal value but at least partially also evaluate potential annual changes in the account value (even if such changes only have a rather low impact on the decision). Additionally, we show that the descriptive model used in this paper is able to explain the popularity of traditional participating life insurance products in Germany providing further evidence that long-term investors consider potential annual value chances already when making the investment decision.