Although some insurance company executives say they are now using analytics, others say they’re still on the fence about it or only beginning to explore its possibilities.
By Linda Koco
The de-risked variable annuity (VA) business took it on the chin in a surprising report by Moody's Investors Service.
Despite the recent equities rally, and despite insurer moves to increase reserves and capital to offset risk linked to these products, “balance sheet headaches are lingering long after the end of the financial crisis," said Moody's senior vice president Scott Robinson.
In fact, “substantial variable annuities-linked risks remain on insurers’ balance sheets,” the report said.
At three of the largest variable annuity writers — Prudential, Jackson National and MetLife -- exposure to living benefit guarantees embedded in variable annuities “is reducing, but remains substantial,” the analysts said. “This exposure won’t dissipate as a credit concern any time soon,” they predicted.
The conclusions may not be greeted warmly by variable annuity professionals. In the past two years or more, optimism has grown that the various de-risking measures that variable annuity carriers have implemented — lowering guarantee levels, restricting investment options and the like — have helped bring guarantee-related risk exposure into line with economic realities. Therefore, to learn that a nationally recognized credit rating firm has found “substantial” risk still lingers will be unsettling.
The findings are based on an analysis of inforce business containing guaranteed living benefits at the three insurers. They also draw from results of some “simplified” stress testing the analysts performed of the companies’ inforce business as of the end of third quarter last year. The data came from public information.
The report is not saying that the variable annuity business is D.O.A. But it is saying is that risk exposure from legacy variable annuity business still exists.
Based on the simplified stress test, the analysts said, “the three companies rely heavily on their hedge programs to protect capital in the event of a sharp and immediate downturn in the equity markets.”
At first blush, this may not seem of great moment. Many carriers (if not most) use hedging to manage their variable annuity business. This is widely viewed as an acceptable way of reducing the vulnerability of variable annuity blocks to market decline.
But the fly in the ointment is that the researchers said the study looked at carrier reliance on “the effective performance” of their hedging programs. This invites an almost unavoidable risk-related question: what happens if a hedging program on which there is heavy reliance is not highly effective or does not work as projected?
The impact of policy features
The commentary indicates that certain features in new products add to risk exposure, although there are countervailing factors too. This is even though the contracts examined have been de-risked from previous versions.
At Prudential, the variable annuity block is dominated by policies having the auto-rebalancing feature, the researchers noted. The company also uses a “capital protection framework” for protecting capital under stress scenarios. The framework and the auto-rebalancing feature are “credit positives,” the analysts said, but “the company still has material financial exposure to equity market volatility, a prolonged low interest rate environment and policyholder behavior.”
Another Prudential product feature — the daily ratchet —somewhat offsets the benefit from the auto rebalancing, they said. This feature allows the daily setting of a new high water mark for the living benefit’s guaranteed benefit base. Ratchets lock in investment gains, Moody’s said, and they add “significant risk” because they prevent a rising equity market from lowering the company's guarantee risk. In a rising market, the daily ratcheting could make the product more reliant on auto-rebalancing and hedging effectiveness, the researcher said.
The analysts looked at the living benefit features, too. MetLife includes a guaranteed minimum income benefit in its annuities with a dollar-for-dollar feature, they noted, whereas the other two carriers sell annuities with guaranteed minimum withdrawal benefits. The MetLife benefit is embedded with conservative annuity factors, they said. But the stress test found that maximum policyholder use of the income benefit could make the feature’s risk profile similar to that of a withdrawal benefit. On a positive note, Moody’s added, MetLife is highly diversified, “helping to limit its exposure as a percent of statutory surplus.”
Another product area spotlighted by Moody’s is product diversification. Jackson’s overall U.S. business is less diversified that that of the other two carriers studied, the analysts said, concluding that this makes the effectiveness of its variable annuity hedging program of increased relative importance. But they also noted that the carrier has some “favorable credit characteristics that help offset its exposure.”
The analysts did include some caveats for interpreting the results. For instance, they pointed out that: the stress test analysis is "imprecise" for various reasons, the effectiveness of the carriers’ hedging programs is uncertain as that was not part of the stress test model, and that comparability between companies is "challenging.”
Even with those caveats in mind, variable annuity professionals are likely to react to the findings.
Some will draw comfort at the news that the risk exposure at carriers is “reducing.” Many have been expecting this since market values have risen to new highs and many product designs have become ultra-conservative.
But the finding that variable annuity carriers’ exposure to risk still “remains substantial” may contribute to uncertainty about what the future may hold for the business, and for customers who have assets held inside of variable annuities.
In the field, the “lingering” headache identified by Moody’s Robinson may become ammunition for annuity antagonists who look for any and every reason to dissuade consumers from buying variable annuities.
On the fixed annuity side of the annuity industry, practitioners may worry that the findings will be broadly interpreted to apply to all annuities, including fixed, and not only to variable annuities. This may spur some fixed annuity specialists to take proactive steps in order to clarify things with customers. Other fixed specialists may decide to leverage the findings, pointing out to customers that their own products are “not involved in all that.”
Whether the report will spur state insurance examiners to do their own assessment of exposure to risk posed by legacy business having guarantees remains to be seen. But at some might at least review the findings.
Linda Koco, MBA, is a contributing editor to InsuranceNewsNet, specializing in life insurance, annuities and income planning. Linda may be reached at [email protected].
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