Under the current stress of the financial crisis, governments all over Europe discuss the introduction of a transaction tax for financial instruments. Especially, the German and French government propose a 0.1% tax on every equity trade and 0.01% tax on derivative instruments. This does not sound large, but what would happen to guarantees of life insurances, e.g. the so-called variable annuities like Axa Twin Star or Allianz Invest4Life?

What happens to Variable Annuities?

The variable annuities guarantee the premiums paid by the customer while being invested in investment funds. In order to realize this desirable guarantee with up-side potential, the insurances use so-called hedging strategies. That means, the insurance does not gamble against the customer but it invests in a dynamic strategy which pays for the guarantee and the up-side potential. This way, the insurance profit is not sensitive to market movements.

But, the introduction of transaction taxes can become expensive for the insurances. Using a simple transaction cost model, we can compute that a hedging strategy which cost 2.0% p.a. now will cost about 2.2% p.a. after the introduction of 0.1% transaction tax. This is a raise of 10% in insurance fees.

Considering the existing customers which have contracts for the next 10 to 30 years, the insurances might be in trouble. For new customers, the raise in fees will result in a significant reduction of the up-side potential.

These results are in line with DWS who computed that a so called Riester-Rente – a German annuity contract – where the customer pays 100 € per months over 40 years would lose about 10%. That means at maturity of the contract the customer receives 135,000€ instead of 149,000€. Another similar result is given in my study about Constant Proportional Portfolio Insurance (CPPI) under Financial Transaction Tax, which shows that the upside potential of the customer is hit dramatically – up to 50%.

Conclusion

The taxation of transactions will increase the cost of hedging significantly. Especially, for long running contracts like life insurance contracts, the risk elimination will become very costly. Private investors who buy guarantee products for retirement are hit by the proposed financial transaction tax – not only the targeted high-frequency traders.