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The Trials and Tribulations of the Variable Annuity Business

The increased inclusion of 'alphabet soup' enhanced benefits has required insurers to curtail their variable annuity sales.

Judith A. Hasenauer, 04/05/2012

Recent weeks have seen some insurers curtailing their sales of variable annuities while others have totally withdrawn from the variable annuity market. These highly publicized events have shaken many financial services professionals who have long relied on variable annuities as mainstays of their practices. It is important to explore the reasons for the retreat by insurers from this important product line and the implications to the financial services industry.

Variable annuities originally appealed to insurers because they took the insurer out of the investment risk business. The original designs of variable annuities shifted all investment risk from the insurer to the contract owner. It was this shift of investment risk that prompted the United States Supreme Court to decide that variable annuities were "securities" for purposes of federal securities laws and not eligible for the exemption from such laws that was afforded to traditional annuities. Although the insurer retained the element of mortality risk that was inherent in the guarantee that the annuitant would not outlive the payments provided for in the annuity contract, the insurer did not guarantee any element of investment performance.

Shortly after the advent of changes in the federal income tax laws that permitted public school teachers to purchase "Tax-Sheltered Annuities" in 1962, the insurers offering variable annuities began to include "Minimum Death Benefits" in their products. This benefit was quite simple: If the contract value of the annuity was less than the purchase price, less any withdrawals, at the death of the owner, the insurer would make up the difference. This protected variable annuity owners from losses when dying during a down market.

As sales of variable annuities began to increase during the mid-1980s, insurers began offering "Enhanced Minimum Death Benefits" with their products. While these enhanced benefits varied from insurer to insurer, most consisted of an increased benefit to some previous market high, which would be paid in the event that the contract owner died while the market value of his variable annuity was lower than the value at the previous high of the contract value.

These enhanced minimum death benefits paved the way in the 1990s and up to the present time for insurers to offer benefits that were intended to reduce market risk to variable annuity contract owners. Thus, we have "Guaranteed Minimum Income Benefits" and "Guaranteed Minimum Withdrawal Benefits" and a whole plethora of other "alphabet soup" benefits commonly known by their initials. These additional benefits were designed to help insurers differentiate their products from all the other variable annuities available in the market. It did not take long for all insurers desiring "shelf space" for their products in the various chains of distribution to have to offer these enhanced benefits or face loss of market share.

It is the increased inclusion of these "alphabet soup" enhanced benefits that has required insurers to curtail their variable annuity sales. The reserves underlying a variable annuity are the assets contained in the separate accounts that underlie the product. There is no market risk to the insurer so long as the only benefit offered is based on the value of such separate account assets.

When enhanced benefits were first offered in connection with variable annuities, little thought was given to the nature of these benefits and what effect they might have on the insurer's general account. However, although enhanced benefits may be measured by the value of the assets held in variable annuity separate accounts, the liability for such benefits is an obligation of the general account of the insurer.

So long as the stock market progressed upward, there was little concern about the liability of the insurer with respect to these benefits. But since the wild fluctuations in the market over the past few years, regulators and rating agencies have addressed these liabilities and taken action to require insurers to create adequate general account reserves to cover them. This has led to arguments about the actual amount of reserves that should be required. Most insurers have established programs to "hedge" the investment risk inherent in the offer of these enhanced benefits, but there is not agreement among experts as to whether all of these hedging strategies actually work.

Faced with the necessity of creating new reserves to ameliorate the risks to contract owners, insurers have seen their capital and surplus decrease at a time when investment income for insurers in general is at the lowest in recent memory. The resultant squeeze on earnings has prompted the curtailment of variable annuity sales.

Why not just eliminate the enhanced benefits and go back to offering variable annuities where the contract owner bears the complete investment risk? It is because the sellers of variable annuities have become so accustomed to using these enhanced benefits to create sales that insurers doubt if their products would be sold without the enhanced benefits. Thus, it is easier to curtail sales than to eliminate the benefits.

These enhanced benefits present other concerns for the financial services professional. Traditionally, variable annuities are not covered by the guarantee funds provided by state insurance statutes that are available to other fixed insurance products. Although these enhanced benefits are general account obligations and therefore should be covered by guarantee funds, it is not completely clear that they might not be excluded. It will probably take an actual insurer insolvency before the question can be tested in the courts.

What does all this mean to the financial services professional aside from the potential loss of a valuable product to sell? It serves to illustrate the principle that it is necessary for everyone in the financial services business to understand the financial basis for the products they offer to their customers. Due diligence screening should include taking a product apart in order to understand the pricing inherent in the product and whether such pricing is adequate to cover the risk to the issuer. Such due diligence should also explore whether government guarantees are available to protect customers.

This does not mean that anyone should panic about their customers who already own variable annuities with enhanced benefits. We do not believe that any variable annuity insurers are even close to insolvency. Moreover, these benefits are valuable--as illustrated by the move of insurers to withdraw them from future sales. Such valuable benefits should be carefully protected because it is unlikely they will be seen again for quite some time.

Judith A. Hasenauer, JD, CLU, is an attorney with the law firm of Blazzard & Hasenauer, P.C. She devotes her practice exclusively to the financial services industry, providing consulting on the development and regulatory clearance of products, compliance issues, distribution issues and related matters, such as advisory activities and industry initiatives.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.
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