Mortality and expense risk charge

A Mortality and Expense (M&E) risk charge is a fee levied by insurance companies on certain financial products, most notably variable annuities and variable life insurance policies. This charge falls under the broader financial category of Insurance and Annuities fees and compensates the insurer for the various guarantees and risks they undertake. Specifically, it covers the mortality risk—the possibility that a death benefit payout may exceed the policy's cash value—and expense risk, which accounts for administrative costs and sales expenses associated with managing these complex investment products.

History and Origin

The concept of a mortality and expense risk charge evolved with the development of sophisticated insurance-linked investment vehicles, particularly variable annuities. Initially, annuities primarily offered fixed income streams. However, as financial markets matured and investor demand for growth potential increased, variable products emerged, allowing policyholders to allocate premiums to underlying subaccounts that invest in securities.

With this innovation came new risks for insurance companies, such as guaranteeing a death benefit that could exceed the market value of the underlying investments or offering guaranteed income streams regardless of market performance. To offset these risks and cover the associated administrative and distribution costs, the mortality and expense risk charge became a standard component of these contracts. The introduction of optional living and death benefit riders in the late 1990s further solidified the need for such charges, as these enhancements offered additional protections to policyholders but also increased the insurer's potential liabilities.

#¹⁰# Key Takeaways

• The mortality and expense risk charge is a fee deducted from the account value of variable annuities and variable life insurance policies.
• It compensates the insurance company for assuming mortality risk (e.g., guaranteed death benefits) and expense risk (administrative and sales costs).
• This charge is typically expressed as an annual percentage of the policy's account value and can range from approximately 0.40% to 1.75% per year.
• The M&E charge impacts the net returns and growth potential of the investment component within the variable product.
• Policyholders should carefully review the prospectus to understand the specific M&E charges and other fees associated with their contract.

Formula and Calculation

The mortality and expense risk charge is typically calculated as an annual percentage of the policy's account value. While the precise calculation involves complex actuarial assumptions, the direct deduction from a policyholder's account can be illustrated simply:

Where:

• M&E Charge: The dollar amount deducted from the policy's account.
• M&E Rate: The annual percentage rate charged by the insurance company for mortality and expense risks.
• Account Value: The total value of the policyholder's investments in the underlying subaccounts at the time of calculation, which accumulates from premiums paid and investment performance.

Interpreting the Mortality and Expense Risk Charge

The mortality and expense risk charge is a significant component of the total cost of variable annuities and variable life insurance. Understanding this charge is crucial for policyholders to assess the long-term value of their contracts. A typical M&E charge averages around 1.25% annually, but can vary, generally falling within a range of 0.40% to 1.75% per year.

T⁹his charge is deducted from the policy's cash value or investment account, directly reducing the capital available for investment growth. For example, if a policy has an average account value of $100,000 and an M&E charge of 1.25%, $1,250 would be deducted annually. While seemingly small, these ongoing fees can significantly impact overall returns over many years. A higher M&E charge often corresponds to more generous guaranteed benefits, such as a higher guaranteed death benefit or stronger living benefit riders, reflecting the increased risk management undertaken by the insurer.

Hypothetical Example

Consider Sarah, a 45-year-old who purchases a variable annuity with an initial premium of $100,000. The annuity has an annual mortality and expense risk charge of 1.20% of the account value.

In the first year, assuming no investment gains or losses for simplicity, the M&E charge would be calculated as follows:

This $1,200 would be deducted from Sarah's account, leaving $98,800 before any other fees or investment performance. If the account value grows, the dollar amount of the M&E charge will also increase, as it is a percentage of the growing balance. Conversely, if the account value declines due to poor market performance, the M&E charge would also decrease in dollar terms, though it remains a constant percentage. This ongoing deduction is an important consideration in long-term financial planning for products offering guaranteed income or death benefits.

Practical Applications

The mortality and expense risk charge is a fundamental element in the pricing and structure of variable insurance and annuity products.

• Variable Annuities: This is where the M&E charge is most commonly encountered. It covers the insurer's cost of providing various guarantees, such as a guaranteed minimum death benefit (GMDB), which ensures beneficiaries receive at least the amount invested (or more) even if the market value of the subaccounts declines. It⁸ also supports guaranteed minimum income benefits (GMIB) or guaranteed minimum withdrawal benefits (GMWB), which provide policyholders with a baseline income stream in retirement, regardless of market performance.
• ⁷ Variable Life Insurance: Similar to variable annuities, variable life insurance policies also incorporate an M&E charge. In this context, it primarily covers the cost of providing the guaranteed death benefit and administrative expenses associated with the policy's investment component.
• ⁶ Pricing and Profitability: For insurance companies, the M&E charge is a crucial revenue stream that offsets the substantial actuarial science and administrative costs of managing these complex contracts. Profits derived from the M&E charge can also be used to cover sales commissions paid to financial professionals.
• ⁵ Regulatory Oversight: Due to their complexity and the fees involved, variable annuities are subject to significant regulation by bodies such as the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). These regulators require disclosure of all fees, including the mortality and expense risk charge, to ensure investors are fully informed. The SEC provides detailed information on variable annuity charges, including the M&E risk charge, to help investors understand these products.

#⁴# Limitations and Criticisms

While the mortality and expense risk charge is a necessary component for insurers to offer guarantees and manage complex investment-linked products, it is also a frequent subject of criticism.

One primary limitation is its impact on net returns. As an ongoing percentage deduction from the account value, the mortality and expense risk charge can significantly erode the compounding growth potential of the underlying investments, particularly over long periods. In³vestors might find that a seemingly modest annual percentage translates to a substantial dollar amount over time, especially with larger account balances.

Critics also point to the complexity and lack of transparency sometimes associated with all the fees in variable annuities, including M&E charges. While prospectuses detail these fees, understanding their cumulative effect can be challenging for the average investor. Some sales practices have been criticized for not adequately disclosing the full impact of these charges, leading to potential "switching" or "churning" of annuities that primarily benefits the salesperson through new commissions and subjects the investor to new surrender charges and higher overall costs. Th²e Financial Industry Regulatory Authority (FINRA) has issued rules to address such concerns, emphasizing the importance of suitability and full disclosure of fees and costs associated with variable annuities.

#¹# Mortality and Expense Risk Charge vs. Cost of Insurance

While both the mortality and expense risk charge and the cost of insurance (COI) are fees in life insurance and annuity products related to mortality, they differ in their scope and application.

The key distinction lies in the "expense" component of the M&E charge, which covers broader operational and sales costs, and its application to the entire account value of variable products. The cost of insurance, in contrast, is solely focused on the actuarial cost of the death benefit itself.

FAQs

What products typically include a mortality and expense risk charge?

The mortality and expense risk charge is primarily associated with variable annuities and variable life insurance policies. These products combine investment components with insurance guarantees.

Why do insurance companies charge a mortality and expense risk charge?

Insurance companies charge this fee to cover two main types of risk: mortality risk, which is the risk of having to pay out a guaranteed death benefit that exceeds the policy's account value, and expense risk, which covers the administrative, sales, and distribution costs of the product.

How does the mortality and expense risk charge affect my investment?

The mortality and expense risk charge is deducted from your policy's account value, typically on an annual basis. This means it reduces the amount of money available to be invested and grow, thereby impacting your net returns and the overall accumulation of your cash value over time.

Is the mortality and expense risk charge negotiable?

Generally, the mortality and expense risk charge is a fixed percentage set by the insurance company for a given contract and is not negotiable for individual policyholders. However, comparing different variable annuity or variable life insurance products from various providers will reveal different M&E rates, allowing you to choose a product with charges that align with your financial goals.

Are there other fees in variable annuities besides the M&E charge?

Yes, variable annuities typically have several other fees, including administrative fees for record-keeping, underlying fund expenses for the investments in the subaccounts, and potential surrender charges if you withdraw money early. There may also be additional fees for optional riders that enhance benefits like guaranteed income or death benefits.