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Charitable Gift Annuity Reinsurance Part II: The Top 10 Creative Solutions for Turbulent Times
In these tumultuous economic times, no gift vehicle has come under greater investment pressure than the charitable gift annuity. In this exclusive article, PGDC contributing author Bryan K. Clontz, CFP discusses 10 creative applications of how commercial reinsurance can be used to mitigate these challenges.
The stock market has fallen nearly 50 percent in the last 15 months (October 2007 - February 2008). Assuming an average asset allocation and effective pool payout rate, most pools have lost between 30-45 percent over this period. Gift annuity pools have never been stress-tested at even half this decline and some are beginning to buckle. In addition, the recent New York state reserve requirements are necessitating operating reserve transfers while donors desire guaranteed income, now, more than ever.
This “perfect storm” has caused three reactions:
- Charities are both hoping and praying the stock market will rebound and thus rescue their CGA pools (and unfortunately, a 50 percent decline must return 100 percent to get back to even!)
- Charities are conducting risk audits to assess the damage and then implementing risk management strategies/tactics to improve the pool.
- Charities are shutting down gift annuity programs.
These reactions are not mutually exclusive of course. But at no time in my 16-year gift planning career has reinsurance been the topic of so many gift annuity conversations. What follows are 10 unique reinsurance applications that our firm has used with clients in the last few months which may be helpful for others. Note that this article assumes familiarity with Charitable Gift Annuity Reinsurance: The Top Ten Most Frequently Asked Questions.
1. Money Now! Total Reinsurance with Immediate Payout
In this environment, charities are looking for every possible way to capture current income. One way is to accelerate a deferred gift into a current gift. At the same time, donors see the critical needs now more than ever, and would like to see their gift working during their lifetime rather than at their death.
Case Facts #1: A charity had a pool of 88 gift annuities. Of that pool, 34 were unrestricted and had a current asset value of $986,000. Their CFO asked for creative solutions to release money today to plug an acute $100,000 operating budget shortfall.
Solution #1: We provided a reinsurance quote grid for the 34 unrestricted annuities and the best quote was $713,000. The CFO reinsured those gift annuities and was able to immediately release the difference - $273,000 - into current operating.
Case Facts #2: A donor wanted to provide a gift annuity to her grand-daughter, but if possible, wanted to build a youth center today.
Solution #2: The charity received the $500,000 gift annuity, reinsured it for a premium of $237,000 and used the difference - $263,000 – to build an additional wing on an existing youth center.
Case Facts #3: A community foundation issued gift annuities on behalf of other affiliated charities so that all the gifts were restricted. The charity was conservative and a Board member said “We can never lose one dollar on any gift annuity because we have no way of sharing losses within the pool. All gains will inure to the affiliated charity, but all losses will inure to us. And I don’t think it is wise to lend our balance sheet to these affiliated charities in these turbulent times when heads they win and tails we lose.” But the foundation’s mission was to support these charities and asked how they could reconcile the Board’s concern with also providing fundraising assistance.
Solution #3: We designed a 100 percent reinsurance program for all gifts (this is not usually recommended except in very unique situations). The first priority was to immunize the charity from any default risk, so reinsurance was used in nearly every new case. This, of course, represented the present value of the liability and ranged from 50-85 percent (averaged around 65 percent) based on various ages. The second priority was to make the affiliated charities “whole” from a present value perspective. So we created a payout grid that calculated the present value of the ACGA-assumed 50 percent future value residuum. The charity could use the money currently of course, but we assumed it would grow at the ACGA-assumed investment rate. So if the affiliate charity immediately received the present value of the future gift, and all assumption held exactly, they would have precisely 50 percent at the annuitant’s life expectancy. This payout ranged from 15-30 percent (averaged around 25 percent) based on various ages. And finally, this community foundation was charging a 1 percent annual fee to compensate it for direct and indirect staff costs, compliance, risk, administration, etc. So, if the average reinsurance cost was 65 percent and the average immediate payout to the affiliate charity was 25 percent, which left exactly 10 percent for the issuing community foundation (actual ranges are between 5-15 percent). Interestingly, this is very close the present value of 1 percent per year for the average annuitant’s life expectancy of 14 years.
So when all the dust settled, the charity has shifted all the risk, the affiliated charities immediately receive the present value of what they expected in the future, and the issuing community foundation received the present value of future annual fees. More than 300 contracts have been issued under this model in the last 6 years with positive results.
[Caveat: If the life insurer defaults on the immediate annuity, the charity is still obligated to make the payments. This has never happened in our history – but the word unprecedented has been used a lot in the last year!]
2. “Under-Water” CGA Optimization: Solves for Longest Possible Payments
About half of our recent cases are on larger gift annuities that are “under-water” or, said simply, are under-funded. Charities assume at that point, there are no options. Procrastinating too long does take away a number of strategies, but there are still ways to mitigate gift annuity losses.
Case Facts #4: A charity received a $5 million gift annuity in 2006 that was deferred until 2008. Based on ACGA-assumptions, the gift was projected to grow to $5.5 million, but the actual balance was $3.9 million. Calculations showed the current liability of $5.1 million (assuming ACGA life expectancies and 5 percent discount rate). So currently, the gift is “under-water” (liability greater than current assets) by $1.2 million. The charity asked for help in determining what to do.
Solution #4: The reinsurance premium required to cover the entire liability (leaving nothing to the charity) was $4.7 million - $800,000 more than current assets. They did not want to move additional money out of the endowment to cover the liability. By staying the course with a 60 percent equity and 40 percent asset allocation, Monte Carlo projections generated a 76 percent probability of exhaustion (when there are no assets left and payments must continue to the charity). By changing the asset allocation to 50-50, and then reinsuring only 50 percent of the current assets ($1.85 million) with the remainder held all-equity, the exhaustion probability dropped to 51 percent. The partially reinsured liability functioned as a fixed income alternative with a powerful longevity hedge. This approach brought down the potential up-side, but also significantly pulled up the down-side and solved for: “What equity, fixed income and reinsurance allocation will provide the longest payment to the annuitant possible before exhaustion?” A very deep analysis of this approach can be seen in this paper:
Note: Recent reinsurance quotes have generated guaranteed internal rates of return (IRR) to ACGA-assumed life expectancy from 6.25-6.75 percent for annuitants under 70, 6.75-8.5 percent for annuitants between 70-85, and as high as 8.5-15.25 percent for annuitants over 85. In my 13 years of working on reinsurance, these are the highest projected rates of return I have seen. The reason is that the credit market completely dislocated in 2008 where the spreads between Treasuries and corporate bonds were at record highs, as were the spreads between low and high quality bonds. As the credit markets normalize, these projected internal rates of return should begin dropping.
3. NY Reserve Requirement Mitigation: A Double-Kicker
Charities are scrambling to comply with the New York reserve requirements, not only for 2008, but for 2009 and 2010 as well. Most are at the “quantify every option”- stage and are realizing that reinsurance can be a particularly effective tool.
Case Facts #5: A non-NY charity had a current asset reserve of $24.8 million, but had a NY reserve requirement for 2008 of $25.9 million, for 2009 of $27.2 million and 2010 of $29.7 million. They wanted to exhaust every avenue possible before having to move endowment money over to meet these requirements.
Solution #5: New York allows for a complete liability reduction for the amount reinsured under a treaty contract (nearly all other states allow charities the same reduction for traditional commercially-insured annuities). Of the 930 gift annuities the charity had, we pulled out the largest 18 gift annuities that represented roughly 25 percent of the entire pool’s assets or $5.7 million. When analyzing the base-level New York reserve requirement, the calculations showed a required reserve of $5.9 million (with the additional surplus requirements of $6.5 million in 2008, $6.8 million in 2009 and $7.5 million in 2010). But to reinsure these 18 gifts, the premium was $5.1 million. So the charity was able to first reduce the required reserve level by $800K immediately (the difference between the base reserve calculation of $5.9 million and the reinsurance premium of $5.1 million). More importantly, they were not required to add the additional $1.6 million by 2010.
So reinsuring just these 18 gifts, which also represented the largest concentration of risk, saved the charity $2.4 million in required reserve transfers.
4. Commercial Single Premium Immediate Annuity (SPIA): An Elegantly Simple Solution
Charities wishing to write gift annuities but are not registered in a state or do not have a program at all frequently turn down giving opportunities; but there is an easy alternative.
Case Facts #6: One charity was not registered in four states (WA, CA, NY and FL). A New York donor called and wanted to purchase a $100,000 gift annuity. Another charity had decided to close their program to any new gift annuities and had received two recent donor calls (a $25,000 and a $35,000 gift annuity). And the last charity had never started a gift annuity program and didn’t intend to now. One of their Board members wanted a $110,000 gift annuity. Note: All these gift annuities were to be funded with cash.
Solution #6: This solution is so simple that it is often over-looked. For each of these annuities, we used the ACGA recommended payout to determine the income the donor/annuitant could receive. Then, rather than entering into a gift annuity agreement with the charity, we simply sold a commercial immediate annuity that exactly matched the ACGA rate.
For example, the NY resident with $100,000, the recommended payout was 7.5 percent. So we put an annuity quote grid to solve for “single premium required to provide $7,500/yr. for life (not reinsurance since no gift annuity was created and the individual would be the owner/payor/payee on the contract rather than the charity). The best premium was $62,500. So she simply purchased a standard immediate annuity, and then gave the charity the difference of $37,500.
Think about what just happened. The charity does not have to register, invest or administer a gift annuity, but it will receive a current cash contribution of 37.5 percent of the gift. This can be used currently or added to the endowment. There is no liability to the charity, no FASB 106-107 calculations and no 1099s. The donor receives the same income and a deduction that is very close to what she would have under a CGA (actually, in this rare case, the deduction would have been lower - $34,200, see #6 below).
This solution was successfully used in every one of the aforementioned case fact scenarios. Without this approach, these four gift opportunity would have been lost, and these charities would not have received $102,650 of combined cash contributions.
5. Large CGA Risk Mitigation: Collaring the Outliers
In the last quarter of 2008, we worked on five gift annuities between $4.5-10 million. Never before have I seen so many large gift annuity cases, and is clearly a result of the extremely volatile stock market. It also is a result of the AFR rate being so low; as to cause many Charitable Remainder Annuity trusts to fail the 5 percent probability of exhaustion test thereby making them unavailable. Two of the five large gift annuities had originally intended to be CRATs.
Case Facts #7: A charity had 118 gift annuities representing approximately $8.5 million in assets. A donor approached them with the intent of making a $4 million gift in exchange for a gift annuity. The Finance Committee voted to decline the gift because of the size and the current market. The investment manager recommended using reinsurance as a potential solution.
Solution #7: We provided the charity with a reinsurance quote grid and ended up using three different insurance companies to issue the annuity. This helped improve pricing as well as diversifying any potential default risk with a single carrier. The reinsurance premium was $2.5 million leaving the charity with $1.5 million after reinsurance to increase the gift annuity reserve.
6. Required Reinsurance to Maximize Charitable Income Tax Deduction: AFR and Immediate Annuity Rate Arbitrage
In 99 percent of the reinsurance cases I have worked on, it was better for the donor to receive the standard charitable income tax deduction rather than the modified reinsurance charitable income tax deduction. The quick rule is that if a charity requires reinsuring the gift, then the deduction is the difference between the amount contributed and the reinsurance premium. If the charity can choose to reinsure at its discretion, most always a wiser course, then the charitable income tax deduction as well as the taxation on the payments are identical to a non-reinsured gift. In the last six months, the AFR discount rate has been falling precipitously while immediate annuity interest rates have been holding steady or rising. The difference between the two has become so great that it has become material enough to disclose to the donor what the enhanced deduction would be under reinsurance.
Case Facts #8: A charity had a donor who wished to donate $8 million for a gift annuity for his four children. The charity was planning on reinsuring only the fixed income portion of the gift which would allow the standard charitable income tax deduction of $1.8 million (the present value of the life-time income was $6.2 million). But in crunching the numbers, assuming a 100 percent reinsured gift, the total premium was only $5.2 million. So if the charity “required” reinsurance in this case, the donor would receive an income tax deduction of $2.8 million (Gift value of $8 million – reinsurance premium of $5.2 million).
Solution #8: The charity disclosed this difference to the donor’s advisors, and because it was a cash gift, the donor actually chose to purchase a commercial annuity to mimic the gift annuity payments to his children, and then gave the charity $2.8 million in cash (so a combination of the aforementioned #1, 4, 5 and 6).
7. Options for Unhealthy Gift Annuitants
It is certainly rare for an unhealthy donor to enter into a gift annuity agreement, but not unheard of. More common, is an annuitant who has become unhealthy over time. In most cases, reinsuring an unhealthy donor does not make sense for obvious reasons. But there are some unique situations where it may fit.
Case Facts #9: A healthcare charity had a donor who wanted a $1,000,000 gift annuity. He had a series of life-threatening health issues that were only half resolved, but he directly credited the charity with saving his life. Rather than leave the charity a bequest, he wanted to receive some income for life and then leave the remainder to the charity. But this gift would represent half the charity’s gift annuity pool.
Solution #9: Life insurance companies issue impaired risk immediate annuities based on a shorter life expectancy. So if you are 45 but have had three heart attacks, the company may age-rate you to 75. The annuity benefit and premium is then based on that rated-age. In this case, the donor agreed to allow the underwriter to access his medical records and they assumed the 68 year-old donor was really 83. So the reinsurance premium was only $375,000. The charity, of course, hoped he would live a long time and were doing everything they could to make that happen. But from a risk perspective, that would not be the best thing for a gift annuity, so the development officer told me “I like the fact that we now hope he will live forever to “beat” the insurance company instead of having it be more beneficial to us if he died very soon.” [I won’t get into the ethical implications of that statement given that this was a hospital but I understood what he was saying.]
8. Isolating and Immunizing Longevity Risk: Chopping Off the Statistical Tail
Many charities are comfortable with their investment management programs and do not want to use full reinsurance or the partial, fixed income alternative. However, the money managers are not able to appropriately hedge longevity risk through asset allocation and therefore may require sub-optimal duration construction within the fixed income portfolios. Said simply, if a money manager knew a person was going to live exactly 15 years and needed $X payments annually, then he/she can deploy asset-liability matching to that known cash flow need. But what if there is a 50 percent chance the person lives longer than 15 years, and perhaps a 10 percent chance the person could even live 25 years or more. How can that “statistical tail” be managed without overly insuring the risk?
Case Facts #10: A large university was investing their gift annuities in their endowment and had enjoyed great returns. But their investment manager asked if there might be a way to completely collar any longevity exposure in the future while minimizing the pool’s current impact.
Solution #10: A few life insurance companies issue an annuity product called longevity insurance. In its purest form, it requires a premium today, but will not pay a guaranteed known benefit until a specified age in the future. The typical premium is 10-15 percent of the gift annuity, but if the annuitant dies before the annuity start date, the charity would get nothing back. But if the annuitant lived beyond life expectancy, the annuity would pay the entire liability. It is almost the exact mirror-image of term life insurance (designed to cover the risk of dying too soon) but in an immediate annuity form (designed to cover the risk of living too long). So we were able to design a group contract that only would pay at the life-expectancy of the annuitants (the charity can select any age). In this way, the money manager was able to manage the money more aggressively, because he no longer had to worry about longevity since the policy had completely insured the liability at that point. The total premium was about 12 percent of the pool in this case.
[Note: This solution will not allow any reduction in the liability for reserve requirements, and is a bit of a challenge to revalue for FASB calculations. But once annuitants live past life expectancy, the gift would be deemed fully reinsured so a reserve reduction would occur at that time.]
9. Private Letter Rulings Clarify Reinsurance Rider Options and UBI Issues
In the last 90 days, two interesting private letter rulings have confirmed what many have expected. The first, Ltr. Rul. 200847014, confirmed the understood tax treatment of gift annuity reinsurance, but also clarified that a premium refund feature would not be prohibited under § 170(f)(10). Next, Ltr. Rul. 200852037 made clear that reinsurance would not trigger any kind of unrelated business taxable income issues and that a premium refund feature would be acceptable. Some commentators have wondered why these letter rulings were necessary, but in particular with 170(f)(10) which requires the annuity to provide “substantially the same timing and amounts under reinsurance”, there was some ambiguity. The question was, “Could you do a 5 or 10-year period certain? Or would this violate the letter or spirit of substantially the same?”
Case Facts #11: A charity had a donor who wished to contribute $500,000 for a gift annuity. The Board was very concerned about the potential of losing so much money if the annuitant died early. While the probability is extremely low, so too is the premium.
Solution #11: We reinsured the gift with a standard immediate annuity, but included a premium refund rider. So if the charity paid $275,000 in premium, and the annuity paid out $25,000 in benefits when the annuitant died, then the policy would provide a refund of $250,000 (Premium – Benefits Paid) to the charity as owner of the contract.
[Note: I rarely recommend this option unless there is an overriding concern of early death. Basically, the rider is an additional sliver of decreasing term life insurance protecting the charity against early death. While I understand the concern, the probability is very low for gift annuitants in particular, and an early death would still provide 45 percent of the gift immediately in this specific case. So, the ACGA-assumed 50 percent future value remainder becomes 45 percent immediately in this extremely low probability “worst-case” scenario. In my view, that is not an additional risk that necessarily needs hedging.]
10. The Stop-Loss Two-Step: Eating the Apple in Two Bites
Some charities would rather take a “wait-and-see” approach to gift annuity management with a caveat that a stop-loss is set so that they can never be “under water.” The approach is to only use reinsurance for the fixed income allocation to start (see #2 above), while letting the remaining equity portion ride. If, at some point, the equity portion has dropped to the point that the remaining amount is exactly equal to the required amount to reinsure 100 percent of the remaining liability, then they immediately reinsure the rest. This usually works well on a new large gift annuity, as well as a gift annuity that is already underwater. Clearly this approach takes active monitoring, especially in volatile times, but this effectively allows the charity to retain as much “upside” as possible, while still collaring the entire “downside” at a precise moment in the future.
Case Facts #12: A charity had received a $2,000,000 gift annuity in 2006. The current asset balance was $950,000, but the amount to reinsure the entire liability was $1,150,000. So they were “under water” by $200,000 and moving that amount out of reserves was not an option. They stated, “As soon as this gift could be fully reinsured using only its assets, we would do that in a second.”
Solution #12: The current asset allocation was 60 percent equity and 40 percent bond. So we took 40 percent of the $950,000 balance ($380,000) and used that for the reinsurance annuity premium. This annuity provided a projected net guaranteed internal rate of return of 6.84 percent to assumed life expectancy, which was roughly 1.5 percent higher than their projected net bond yield. This increase, when coupled with the fact the annuity would continue to pay after life expectancy, dramatically lowered the exhaustion probability. But the charity also planned to monitor the growth of the remaining 60 percent held in equity. As soon as it grew to the point that it matched the required premium necessary to reinsure the rest of the liability, they wanted to immediately reinsure. They realized there would be no gift remaining, but they also realized they no longer would carry a large potential loss exposure. They said, “We took a gamble on a large gift and it didn’t work out. We would hate to “punt” this issue to our successors 20 years from now (that was the life expectancy) only to potentially put the organization in a very bad position. All based on a decision that we make today. So a break-even approach two years ago when we received the gift annuity would not have been part of the discussion, but at this point we think it is the most prudent thing to do.”
This scenario involves an already “under-water” gift annuity, but could just as easily have been for a new gift annuity. Rather than waiting for the equity portion to rise to the point where the second portion of the liability could be reinsured, a new gift annuity would have a stop-loss approach that would only trigger if the equity portion fell to the point the remaining liability could still be reinsured without taking a loss. Obviously, the charity hopes this would never occur.
Gift annuity reinsurance is not, nor will it ever be, the perfect solution. But when I wrote my first article on this topic 11 years ago, reinsurance was drastically under-used (the market was going to go up 20 percent a year forever). Today, it is being over-used (the market is going to go down 20 percent a year forever). Moderation in life usually is best. Hopefully these 10 distinct scenarios will be helpful in managing gift annuity risk in these unprecedented times, and most importantly, will help your charity capture and your clients make more gifts.