Annuities With GLBs Pose Risks To Financial System, FSOC Says

By Arthur Postal

WASHINGTON — Annuities sold with guaranteed living benefits (GLBs) pose “meaningful financial risks” to the U.S. financial system, the Financial Stability Oversight Council (FSOC) said in its annual report. The report was released earlier this week.

Moreover, the FSOC appeared to voice particular concern with fixed index annuities, citing their growth and the fact they represent approximately half the account value of all outstanding fixed annuities.

At the same time, the report appeared to imply that while the low interest rate environment poses a serious potential risk to all financial service providers, insurers appear to be weathering the storm well. This is because the decline in the net yield on invested assets of insurers has been gradual and not as large as changes in market interest rates.

Regarding annuities, the report said that between 2009 and 2013, sales of individual variable annuities (VAs) with GLBs averaged $83 billion annually. This compares with total variable annuity average annual sales of $111 billion — not including allocations to fixed accounts.

Moreover, as of the end of 2014, the estimated total outstanding account value of all variable annuities with GLBs exceeds $800 billion, the report said.

More than two-thirds of the fast-growing fixed index annuity market includes sales of products with GLBs. As of the end of 2014, the aggregate account value of fixed index annuities with GLBs was $112 billion — approximately half the account value of all outstanding fixed annuities, the report said.

To deal with the increased risk from GLBs, insurers are broadening their use of derivatives. The report said available data for five of the largest 10 writers of VAs with GLBs show aggregate gross notional amounts of outstanding derivatives contracts grew from $132 billion in 2003 to over $1.139 trillion as of year-end 2014.

The report said reforms being implemented as a result of provisions of the Dodd-Frank financial services reform law “will help improve transparency and mitigate the counterparty risks arising from the use of derivatives associated with hedging of GLB market risks.”

The report acknowledged that following the 2007-2010 financial crisis, some insurers have exited the market and others “have taken a range of actions” to mitigate the risk from arising from both new and in-force business.

“Although these actions have significantly reduced balance sheet exposures, GLBs continue to present meaningful financial risks,” the report said.

The report said the historically low-yield environment “continues to encourage greater risk-taking across the financial system.” This is making it difficult for pension and retirement funds to meet their long-term liabilities. As a result, some are seeking to boost returns by extending the duration of their assets or by purchasing lower quality, higher- yielding assets.

The report added that some insurance companies also have repositioned their investment portfolios in a similar fashion.

“A sharp increase in interest rates or credit spreads could generate losses on longer-term assets, including less liquid assets such as high-yield and emerging market bonds,” the report said. “If such losses are borne by leveraged investors, they could lead to fire sales and further declines in asset prices,” the report cautioned.

As to the emerging issue of pension risk transfers, the FSOC report said that consequences include the growth in the number of counterparties as well as changes in the type and amount of financial counterparty risk arising from the risk shifting transactions.

In the case of buyouts by insurance companies, the beneficiaries have their credit exposure shifted from the pension plan to the life insurer.

“Accordingly, the backstop for pension plans switches from the Pension Benefit Guaranty Corporation to the state insurance guaranty funds,” the report said.

In the case of longevity swaps, the counterparty risk is like that of other derivatives and resides with the dealer or insurer,” the report said.

In other areas, the report noted that cyber security affects all financial service providers. In addition, the FSOC stated its support for including vendors who serve financial services firms as part of the risk to financial service providers. The FSOC also cited concerns with the new phenomenon of insurers taking the risk of pension risk transfers, shifting the liability to insurers. Finally, the FSOC again cited the use of captives as an area of concern.

The report said that, in the life sector, premiums and investment income “remained strong” and increased slightly from 2013, but these increases were more than offset by increases in surrenders and aggregate reserves.

However, the FSOC reported that the 10 largest publicly-traded insurance-based corporations, held 70 percent of total consolidated assets for all such firms at year-end 2014.

The report said that for 2014, insurers make up nearly half of the 26 financial firms whose assets exceed $200 billion. They hold assets of $4.6 trillion representing 27 percent of the total assets of these firms.

The Federal Insurance Office (FIO) and the Office of the U.S. Trade Representative continue to work on the possibility of pre-empting state authority to establish collateral rules for reinsurance, according to the report. In December, the FIO said it was doing so because international reinsurers control more than 60 percent of the U.S. reinsurance market, and because the inability of states to achieve uniformity on collateral rules has the potential to raise the cost of insurance in the U.S.

The FSOC has no authority to act directly against insurance companies to mitigate the financial risk it talks about. The agency’s report notes that the states are working through various groups to better understand and mitigate the potential risks posed by captives to the solvency of insurers that the FSOC cites.

For example, the FSOC report said that the agency recommends that state insurance regulators and the National Association of Insurance Commissioners (NAIC) continue to work to improve the public availability of data, including financial statements relating to captive reinsurance activity. In addition, the FSOC recommends that FIO continue to monitor and publicly report on regulatory issues relating to captive reinsurance, “which FIO previously noted as an area of concern in its Modernization Report.”

Moreover, the report said, “Regulators and rating agencies have noted that the broad use of captive reinsurance by life insurers may result in regulatory capital ratios that potentially understate risk,” and added that efforts to address these concerns with regulatory reforms are ongoing.

Specifically, the report said that the states, through the NAIC, are moving toward “establishing a more consistent regulatory framework for life insurance affiliated captive reinsurance transactions relating to certain term and universal life insurance products.”

Despite the FSOC’s lack of authority with insurance companies, its report is addressed to Congress, which does have the authority to enact laws dealing with insurance regulatory issues which might affect insurer solvency. Or Congress could move to ask the FIO or the FSOC to provide more information or pass laws giving the FSOC authority to deal with these issues.

Moreover, as noted at a Bipartisan Policy Center briefing on international issues this week, the Federal Reserve already has the authority to oversee one-third of life insurance industry assets, and 25 percent of property and casualty insurance industry assets.

InsuranceNewsNet Washington Bureau Chief Arthur D. Postal has covered regulatory and legislative issues for more than 30 years. He can be reached at [email protected].

InsuranceNewsNet Washington Bureau Chief Arthur D. Postal has covered regulatory and legislative issues for more than 30 years. He can be reached at [email protected].