Higher Reserves for Variable Annuities Hinge on Hedging

Amid sharply declining and volatile stock markets, some U.S. life insurers face hits to profits in their lucrative variable annuity business. Factors fueling the problems include lower fee income from managing clients' assets; big charge-offs related to the cost of acquiring new business and higher hedging costs.

Industry watchers and regulators are eyeing whether companies will be forced to boost reserves for these retirement-income products to ensure they can deliver on the guaranteed future payments to policyholders. That hinges on companies’ hedging programs.

"The major risk here is, the hedging doesn’t work,” said Steven Schwartz, an equity analyst with Raymond James in Chicago. A clearer picture on hedging effectiveness for VAs with guaranteed benefit riders will emerge at the end of the fourth quarter, he said.

Over the past five to 10 years, many life insurers added these features to VAs, intended to protect policyholders against downside equity market risk. These include guaranteed minimum death benefits and living benefits, such as guaranteed minimum withdrawal benefits and guaranteed minimum income benefits.

Some companies are likely to boost reserves, said Cary Lakenbach, president of Actuarial Strategies, a consulting firm. Some may have been "overly aggressive" with respect to certain assumptions, such as hedging costs, he said. They may be taking losses because there's "potentially serious amounts of VAs that are in the money" for policyholders, Lakenbach said.

Hedging is one of the factors regulators look at when making sure reserves are in place to pay for any losses in companies' VA business, said Wisconsin Insurance Commissioner Sean Dilweg, vice chairman of the National Association of Insurance Commissioners life insurance and annuities committee.

"I feel confident in the companies that are out there having the reserves in place for these types of losses," he said. However, “we will be watching it, obviously, over the next six months."

Prudential Financial and Hartford Financial posted net losses in the third quarter, while Lincoln National and MetLife reported sharp declines. Included were millions in charge-offs related to deferred acquisition costs.

Andrew Edelsberg, vice president in the life/health division of A.M. Best Co., said VA writers are taking considerable charges due to DAC unlocking. This is mainly due to the downturn in the equity markets, which impacts the future profitability of VAs as these products are largely fee-based, he said.

DAC represents the cost to a life insurer of putting new business on the books. Schwartz described DAC unlocking, which falls under U.S. GAAP accounting rules. If someone buys a $100,000 VA and the life insurer pays a 6% commission, amounting to $6,000 that $6,000 isn't recognized as an immediate expense but amortized over time, in line with the "expected present value of future gross profits" of the policy, assuming the stock market will appreciate at a certain rate, he said.

In the hypothetical scenario, the expected present value of future gross profits is $18,000, Schwartz said. The $6,000 divided by the $18,000 would be 33%, a figure called the "K factor," Schwartz said. If the stock market declines 25%, that $18,000 shrinks to $13,500, meaning DAC wasn't amortized enough because the K factor should have been 44.4% — not 33%, he said.

It's dubbed "unlocking" because assumptions are "locked in until they are no longer sustainable," Schwartz said.</p>

Companies are taking those expenses faster to catch up to their current assumptions, said Jeremy Alexander, president and CEO of Beacon Research, a firm that tracks sales of fixed annuities.

Larry Bruning, chairman of the NAIC's life and health actuarial task force, said reserves for the living benefit guarantees are currently addressed by actuarial guideline 39, which will be replaced by AG-VACARVM when it takes effect. VACARVM doesn't take effect until Dec. 31, 2009. This guideline, when developed, was to be a temporary solution to reserving for these guarantees until a more "risk focused" solution could be developed, which is VACARVM, Bruning said.

Whether VA writers will need to boost reserves depends on the type of guarantees and to some extent the level of the market at the time the guarantee was written, he said. If the payout is several years in the future, the impact on the reserve increase could be less than if the guarantee had to be paid out tomorrow, Bruning said.

Howard Mills, chief adviser for the insurance industry group at Deloitte, said insurance regulation with regard to reserving has been "so conservative" that the industry should weather this storm well. About a year ago, the industry was concerned with "redundant reserving," he said. "No one is going to talk about redundancy in reserving again for a very long time," said Mills, the former insurance superintendent of New York.

(By Fran Matso Lysiak, senior associate editor, BestWeek: [email protected])