Brokers Fear Many Insurers Are Ignorant of Annuity Risks

Leslie Scism
Wall Street Journal
April 6, 2009

More than 70% of financial advisers in a recent survey said they were concerned about the risks insurers have taken on with guaranteed-minimum variable annuities -- and nearly a third said they doubted the insurers themselves understood those risks.

These are among the key findings of the fourth annual survey of Merrill Lynch advisers, conducted in February by analysts at what is now Banc of America Securities-Merrill Lynch, a unit of Bank of America Corp. Merrill has long been one of the largest distributors of retirement-income products.

The advisers were polled amid a steady drumbeat of ratings downgrades for some of the biggest names in the U.S. life-insurance industry. About two dozen insurers saw their financial-strength ratings fall one or two notches during the first quarter, although most remain at least for now in categories denoting capitalization that is "strong" to "very strong." The ratings firms assigned a negative outlook to many of the insurers for the next 12 to 18 months and put some on watch for possible additional downgrade over the next few months.

In most of the downgrades, the ratings firms have cited big losses, tied to the overall financial crisis, in the insurers' investment portfolios. At some insurers, the ratings firms also have cited losses tied to the minimum-return guarantees of the companies' variable annuities, which are a tax-advantaged form of investing in mutual funds. In a competitive frenzy that began about five years ago and was continuing even as the market began its slide last year, insurers sold increasingly generous guarantees. The most basic ones promise that investors won't lose their original investment, while the more-generous ones promise annual increases of 7% or more in the guaranteed amount.

The Merrill survey suggests increasing wariness among advisers for whom the annuities are a significant portion of their business about "the risk profile" of the insurers creating the products, according to the survey authors, Edward Spehar and Roman Leal. Some 71% said they thought the insurers had taken on greater risk with recent versions, up from 68% the year before. In addition, 32% agreed that insurers "do not adequately understand the risks that they are assuming in the variable-annuity business," up from 17%.

As the survey results were being tallied, the landscape was starting to change: In recent weeks, numerous big insurers have dialed back the aggressiveness of their offerings, many citing the soaring costs of the financial hedges they buy to offset their market exposure. Some have tweaked guarantees to offer less-generous benefits at higher prices to new customers, while others have suspended sales of certain guarantees as they await regulatory approval of more fundamentally retooled versions. Consultants and analysts say it is too soon to tell how far-reaching this trend will be.

Merrill brokers sold $5.9 billion of variable annuities from an array of insurers in 2008, a decline of 23% from 2007. Industrywide, variable-annuity sales slumped 15% for the full year, to $155.6 billion, and dropped 30% in the last three months of the year, according to Limra International, a Windsor, Conn., organization of life insurers and other financial firms.

The authors of the Merrill survey noted that variable-annuity "demand has not held up nearly as well as we have expected it would during a bear market," given the downside-protection features that "would seem to have appeal in a challenging market environment." One factor that may have hurt the sales, they concluded, "is concern about the financial health of the life-insurance industry."

More than nine out of 10 Merrill brokers who are among the biggest annuity sellers for the firm identify the size and financial-strength rating of the issuing insurer as an "extremely important consideration" in determining which products to sell to their clients, up from about eight out of 10 the year before, the survey found. The survey doesn't detail which insurers the brokers favored.

According to numbers crunched by research firm Morningstar Inc. showing sales of variable annuities through all distribution channels, including stock brokerages and insurers' own agents, MetLife Inc. hauled in more fourth-quarter sales than any other insurer selling the performance guarantees. The largest U.S. life insurer by assets, it widened its variable-annuity market share to 10.5% from 8.5% at the end of 2007. MetLife retains double-A standing at most of the major ratings firms, with a stable outlook, but Standard & Poor's dropped it a notch to double-A-minus, with a negative outlook, in its February wave of downgrades.

The U.S. life-insurance units of international giants AXA SA of France, Manulife Financial Corp. of Canada and ING Groep NV, of the Netherlands ranked behind MetLife in the fourth quarter, in that order, as each of those issuers of guaranteed-minimum variable annuities also gained market share, according to Morningstar.

Randy Binner, an insurance-stock analyst at FBR Capital Markets, says that foreign-based insurers and those owned by their policyholders seem to have an advantage in this market, as the woes of the publicly traded U.S. life insurers have been so publicized. Independent agents and stockbrokers "have a lot of companies to choose from," he says, "so why go through the hassle of explaining a company that has gotten bad press?"

Hartford Financial Services Group Inc. showed one of the biggest drops in fourth-quarter sales of variable annuities, falling to 12th place from fourth at the end of 2007, according to Morningstar. Its market share was more than halved, to 3.6%. The decline came as the company obtained a $2.5 billion capital infusion from German insurer Allianz SE, and the main life-insurance unit faced multiple downgrades of its financial strength. In the coveted double-A category before the market meltdown, it was cut most recently by Moody's Investors Service, to A3, from A1, last week.

A Hartford spokeswoman pointed to recent comments by the company's chief executive, Ramani Ayer. In comments to analysts in December, he said the insurer had "ceded a lot of market share over the last several years because we felt that the annuity arms race was so strong and so aggressive," adding that he wished it "had pulled back some more." The goal now is "to ensure that we are derisking our annuity business" to "substantially reduce the risk and capital strain." Of the Moody's downgrade, he said last week: "We believe the Hartford's capitalization is stronger than what was reflected in the actions taken by Moody's." The insurer says it "remains well prepared to meet" commitments to customers.

Hartford is hardly alone in trying to wring out risk. Variable-annuity issuers industrywide are grappling with the sharply higher hedging costs, tied to market volatility and lower interest rates. Many are "furiously ratcheting down the strength of the guarantees" in their product lineups as they also boost prices, says Kenneth Mungan, a practice leader at actuarial and consulting firm Milliman Inc.

"The retooled versions are going to differ, so some companies that were leaders in the past will drop down, and some at the bottom of the pack will move up," he says.

Big players that have suspended sales of certain guarantees, reduced benefit levels or made other changes to reduce their risk include units of Allianz and AXA, as well as Fidelity Investments and Pacific Life Insurance Co. In general, the insurers cite the need to maintain a balance between guarantee features and their cost to provide that protection under the tough capital-market conditions.

"This proactive move is consistent with the prudent long-term risk-management strategy of the company," the U.S. unit of Allianz said in a comment echoed by the other insurers.

Fixed-Annuity Sales

MetLife gained ground in sales of fixed annuities as well. As a result, it moved to first place for combined sales in 2008 of variable and fixed annuities, according to Limra's annual rankings. Fixed annuities include a popular version that competes against bank certificates of deposit. Across the industry, sales of fixed annuities surged 79% in the fourth quarter to end 2008 at a record $109.4 billion, up 49% for the year.

MetLife displaced American International Group Inc., whose near-collapse last September prompted the biggest single bailout effort by the U.S. government. AIG slipped to second place on the combined list. New York Life Insurance Co., a triple-A rated company owned by its policyholders, rose to second place in overall fixed-annuity sales, from fourth in 2007.

TIAA-CREF, a nonprofit known for sales of low-cost investment products to the education and nonprofit worlds, claimed the No. 1 spot on the full-year variable-annuity sales chart, moving up from third in 2007. TIAA-CREF, also triple-A rated, doesn't sell performance guarantees on its variable annuities.

"Many are seeking stability in the market turbulence and see TIAA-CREF as holding higher ground," says Bertram L. Scott, a senior executive at the firm, echoing comments by MetLife and New York Life on their sales gains.

[Investing in Funds: A Quarterly Analysis]
[Investing in Funds: A Quarterly Analysis]

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