Not so long ago, annuity carriers were judged primarily on the investment options, guarantees and services they provided. Now, with many in the industry walking with a bear on their back, firms are taking a much closer look at annuity carriers. As a matter of due diligence, firms need to seriously judge annuity partners on their long-term prospects for remaining diversified and stable companies.
To help determine if carriers are likely to stick around, firms need to ask five important sets of questions.
1. To what extent does the company reinsure the insurance guarantees?
Reinsurance helps reduce the risk inherent in life insurance guarantees so that market downturns affect the company less. However, not all reinsurance is equal, so ask for details:
How strong is the reinsurer?
How strong are its reserves?
Are its liabilities backed by a strong parent?
Does the reinsurance cover all the risk, or are there deductibles, coinsurance or caps?
Just as a property-casualty insurer has to pay many claims at once for a natural disaster, annuity reinsurers can be hit with heavy claims. The strength of the reinsurer is as important a due-diligence consideration as the strength of the annuity provider.
Deductibles and coinsurance may be an effective way to keep reinsurance costs down. However, caps can leave the direct writer with significant catastrophic risk. Other risk management strategies, such as hedging via the capital markets, may be a more prudent alternative.
2. If the company is not reinsuring benefits, then how does it manage annuity benefit risk?
There are few reinsurers remaining in the annuity guarantee market, and most of them do not provide complete protection. Therefore, many carriers choose to retain the annuity benefit risk. Not reinsuring guarantee risks can have significant impacts on operating earnings and statutory capital. But if done properly, retaining benefit risk can be more cost effective.
Determine if the company has the investment expertise to actively hedge annuity guarantee risk with derivatives.
Research the guarantees offered. Some guarantees are impossible to hedge away, especially those with more-generous benefits.
Make sure your carrier conducts scenario modeling to help predict its solvency in the unpredictable future. Certainly, no one knows what the future holds, but a responsible annuity carrier will conduct comprehensive scenario testing to help determine how the company can remain viable in just about every economic possibility - from deflation to high interest rates.
3. Does the company have adequate capital?
The market decline has caused life insurance capital levels to erode. Annuity carriers must have adequate capital to maintain current business and fuel continued growth.
Determine if the company has access to additional capital if needed. Look at the financial statements of the life insurer and its parent company, if it has one. A company that is owned by a diversified and stable parent usually will have greater access to capital.
Determine if the company has adequate capital to support operations until the markets return to normalized growth rates. Even though revenues have declined, the annuity customer base has grown. Make sure your carrier is able to support your producers and customers throughout the down market.
Determine if the company has adequate capital to carry it through a prolonged down market. Even though some guarantees may not come due for many years, more reserves (usually from capital) may be needed in the meantime if the market continues to erode.
4. How does the company diversify its exposure in terms of product, benefits and time?
The more diversified a company is, the greater its chances are of weathering a host of market conditions.
Product - Look for a partner with a presence in life insurance and other products that may experience little impact from changing economic conditions, such as group retirement savings products and fixed annuities.
Benefit mix - Make sure the variable-annuity company has a balance of features that have different levels of benefits so that a market downturn does not prove catastrophic.
Time - Similar to the concept of dollar cost averaging, a company that spreads its book of business over a long time period will not be nearly as affected as a company that started at a market peak.
5. Does the company have a conservative investment portfolio?
A conservative, investment-grade fixed-income portfolio is one that effectively manages credit risk and cash flow risk.
Credit risk - Is the carrier properly diversified? Credit risk is managed primarily through diversification of asset classes, sectors and issuers. Typically, a conservative portfolio has a solid holding of private and public corporate bonds, mixed with some asset-backed securities and some commercial-mortgage exposure.
Cash-flow risk - How well do liabilities match up with security maturation? As contracts mature, the portfolio should spin off cash to cover the maturing liabilities. While it is not possible to perfectly match up every liability to an asset, the portfolio manager should be aware of expected liability cash flows and attempt to buy securities that best match these flows. A red flag should be raised if the duration of the portfolio gets out of line with the duration of the liabilities by even a couple of years.
As with any insurance product, annuity guarantees are as good as the company backing them. The answers to these questions will go a long way to help determine if the companies you partner with will be there for you and your clients.
Eric Henderson is associate vice president and variable-annuity product manager for Nationwide Financial Services Inc. in Columbus, Ohio.
