Variable Annuities Weigh on Life Insurers

The insurance product is subject to the whims of the equity markets

By Justin Menza From Standard & Poor's Equity Research

Variable annuities (VAs) have been big sellers for the life insurance industry in recent years, as rising equity markets and guaranteed benefits increased their popularity. Now that the equity markets are in a freefall, their luster has begun to fade.

When a customer purchases a variable annuity, typically the insurer will invest the money in a portfolio of mutual-fund like assets. This strategy exposes the variable annuity to market fluctuations, whereby the annuity holder may see a potentially bigger payout when markets are rising, but may see less of a payout when markets are falling.

Additionally, insurers tend to offer a wide range of guaranteed benefits, such as guaranteed minimum withdrawal benefits. In this case, a holder can receive an income for life regardless of the value of the underlying account. Insurers may also offer a guaranteed minimum accumulation benefit, whereby the insurer will guarantee that the account will grow at a certain percentage, typically 5% to 7%, for a period of time. Insurers had been aggressive in offering these riders as they competed for market share, and as rising equity markets made them easier to fund.

Catherine Weatherford, the president and CEO of NAVA, the Association for Insured Retirement Solutions, says "annuities including insurance guarantees provide many Americans planning for and living in retirement protection in volatile financial times such as these."

However, the current volatility in the equity markets is making variable annuities and their guaranteed benefits a tougher sell for the life insurers.

"As was the case in the bear market in 2001-2002, costs associated with hedging and increasing reserves for the various riders on products are becoming more of an issue due to the decline in the equity markets," says S&P Equity Analyst Bret Howlett. "As the equity markets tanked this past September and October, many of the portfolios held by annuity customers have underperformed the guarantees."

Declining equity markets may also hurt earnings for those insurers with sizeable VA businesses through accelerated deferred acquisition cost (DAC) amortization. Companies use DAC to defer the sales costs that are associated with acquiring a new customer over the term of the insurance contract. If a sustained decline in equity markets reduces estimated gross profits on annuities, an unlocking of assumptions may occur, causing DAC to amortize faster. Also, such changes in assumptions may lead to increased reserves for products with guaranteed minimum death or living benefits.

Howlett believes we could see the magnitude of losses related to DAC reach the levels that occurred in the 2001 to 2002 bear market. Given that most life insurers model their assumptions based on 2% growth in equities each quarter, Howlett foresees further unfavorable DAC adjustments weighing on results as equity market losses continue.

Additionally, the guarantees on the variable annuities sold during the bull market of the late 1990s are also starting to come out of the typical penalty waiting period of seven to 10 years, which could make things worse for insurers if policyholders start to exercise the guarantees. Howlett notes that the impact is hard to gauge, however.

Hartford Financial Services Group (HIG 7 HHH), the second-largest writer of individual annuities in 2007, is one insurer whose annuity business is suffering from the volatility in the financial markets during the third quarter. The company posted a $522 million loss in core earnings in its annuity business during the quarter, compared with a profit of $365 million a year prior. Assets under management in its annuity products fell to $103 billion in the period from $133 billion a year earlier.

In addition to the challenges facing the industry in terms of the living benefit riders, sales of these products have dropped since most policyholders tend to invest their VA assets in equities. According to data from the NAVA, second-quarter variable annuity sales dropped 11.2% from year earlier levels, while net assets were down 3.3% year-over-year in the period. For the first six months of the year, total sales were $83.6 billion, a 5.2% decline from the comparable period in 2007. This trend likely continued into the third-quarter as equity markets sold off further, making many potential customers wary of purchasing the products despite the minimum guarantees offered. Additionally, Howlett notes that many insurers are likely to raise prices on these riders, which may further undermine sales.

"Due to weak equity markets, we expect variable annuity sales to decrease significantly in 2008, although products with guaranteed living benefit rides should increase in popularity," says Howlett. "We believe that assets under management and fee income will be adversely affected by the turbulence in the equity markets."

Looking ahead, S&P believes that annuity sales will continue to be an important revenue source for life and health insurance companies. S&P anticipates that sales will continue to benefit from the popularity of guaranteed living benefit riders, demographic needs, and an increase in external exchange activity (moving from one contract to another). However, assets under management and fee income are likely to decline modestly, reflecting the increased equity market volatility.

Howlett maintains a neutral outlook on the life and health insurance industry and does not recommend broad exposure to the group. "The weak equity and credit markets continue to weigh on the life insurers results, and with the fourth quarter off to a rocky start (credit spreads remain wide and equity markets are down significantly), we expect earnings for the life group to get worse before they get better," says Howlett.

Menza writes for Standard & Poor's Global Editorial Operations .