Annuities: Good news and bad news

Insurance companies and distributors face major changes for risk management and product development as variable annuities and their guarantees pressure insurers' risk-based capital, industry experts said. The bloodletting in the stock market is expected to attract investors to variable annuities, especially those with lifetime guarantees. However, analysts and other industry observers say that increased demand for these products could place additional strains on carriers' capital and reserves. "There is no question that with equity markets declining and with volatility increasing, big variable annuity writers are under pressure from a reserving and capital standpoint," said Joel Levine, senior vice president for U.S. life and health insurers at Moody's Investors Service in New York. Changes to both products and pricing were announced at The Hartford (Conn.) Financial Services Group Inc. during a conference call on Oct. 29, after the carrier revealed a $133 million loss from its guaranteed minimum withdrawal benefits during the third quarter. The bulk of the quarterly loss came during September, finance chief Liz Zlatkus noted during the call. Further hemorrhaging occurred in October, when the equity markets deteriorated, she added. Along with new hedging programs, some carriers could pluck VA offerings and their benefits from their roster, said a Washington attorney who asked not to be identified. "If you're going to be a player, you have to offer the lifetime withdrawal benefits, but now the question is if you can do that," the lawyer said. Falling equity markets have taken a toll on guarantee features, raising the capital and reserves required to support the VA business by up to $15 billion year-to-date, according to a recent report by Fitch Ratings Ltd. Additionally, the New York-based rating agency estimated that VA guarantees that are now "in the money," or paying off more than their original value, have increased by about 10% year-to-date. That is a problematic situation for companies that didn't properly hedge their guarantees and thus face strains on their capital as they pay out to policyholders. "The guarantees are in the money because the stock market went down, but that's only a concern if you didn't hedge," said Ken Mungan, a Chicago-based practice leader for financial risk management at Milliman Inc. of Seattle. Effective hedging techniques allow carriers to pay claims on their policyholders' guarantees, he added. For one thing, The Hartford was underhedged for volatility, Ms. Zlatkus said. The carrier dynamically hedged 44% of its U.S. GMWB account value and transferred the remaining 56% of the market risk to reinsurance and long-dated derivatives, she said. As a result, changes are ahead for this and other carriers, distributors and customers at the end of the chain. Some insurance companies are going to retrench their product lines. They may cut back on lifetime withdrawal benefits and other guarantees. "It could be the end of the [GMWB] for some carriers because it's going to be too much for them," the attorney said. "It also means that the bigger players will have more market share, and that there will be a shakeout of carriers." Carriers will also adjust their guarantee hedges to take positions on Treasury futures and interest-rate swaps in order to balance guarantees' sensitivity to interest rates and the stock markets, Mr. Mungan noted. Insurers will also want to cut back their interest-rate exposure on roll-up features, which guarantee a minimum rate of return. Instead, they might emphasize ratchet features, which raise the account value at a given time. "In a low-interest-rate environment, high roll-up rates aren't as manageable by the insurance companies as the ratchets are," Mr. Mungan said. Broker-dealers, nervous about liability exposure, will also scrutinize insurers, looking for further assurances that carriers can indeed stand behind their guarantees — perhaps through an on-site meeting with executives and written proof of the insurer's strength, the attorney said. One issue that broker-dealers are looking at is whether insurers have balanced their exposure to variable annuities by working in other lines of business, according to Eric Schwartz, president and chief executive of Cambridge Investment Research Inc. in Fairfield, Iowa. But aside from that, he also said that he wonders about carriers' hedging.
"If it was an A-rated company, you didn't scrutinize their hedging strategies with great care," Mr. Schwartz said. "You had your due diligence team go in, but there was the assumption the insurance companies knew what they were doing and that assumption is no longer there." The firm hasn't decided on its course of action just yet, but it is considering its due diligence strategies for the future. "I suspect most broker-dealers are in tune with what's going on, but what do you do differently?" asked Paul Tolley, chief compliance officer at Commonwealth Financial Network of Waltham, Mass. The independent broker-dealer is staying in touch with its product vendors and eyeing ratings. The next round of third-quarter reports, plus any actions taken by ratings agencies, should give the firm a better idea of how to proceed, Mr. Tolley said. Still, he conceded that the system isn't perfect and there are questions about how much weight one should give to a rating. "Absent a better system, we could have the staff going through filings to glean certain information, but I'm not sure we're going to get more than what's publicly available," Mr. Tolley said. For now, the firm is also watching for which insurers take money from the federal bailout package and noting the purposes for the funding.

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MetLife Inc. reported a "heightened" level of interest from distributors, who are asking questions about balance sheets, liabilities and statutory capital. "Firms have been active in dealing with us and they've also had some interaction with our senior management," said Mike Farrell, executive vice president of the New York insurer. Although the company won't change its VA products, it has been re-viewing its pricing, though no decisions have been made, he said. The sheer size of the company's annuity assets allows MetLife to set up hedges, something that would be difficult for smaller carriers to do, Mr. Farrell said. "It's costly to set these hedges up," he said. "We're looking at products and pricing, and we'll act prudently if the volatility continues." Nevertheless, observers expect a slowdown in the arms race to add features; the passing on of higher costs to consumers from new hedges and a new level of skepticism from distributors toward insurers that were once thought to be bulletproof. "The burden on the insurance companies is that they must prove they're the survivors, and it's the broker-dealer's burden to ensure they have a big file on due diligence on the survivors," Mr. Schwartz said. E-mail Darla Mercado at dmercado@investmentnews.com.