NU Online News Service, Jan. 18, 8:16 p.m. – Annuity and Life Re (Holdings) Ltd., Hamilton, Bermuda, says it has started arbitration proceedings against its first, and only, big annuity reinsurance customer and expects the proceedings to take about two years.

Annuity & Life is accusing the insurer that wrote the annuities of running a bad customer retention program and generating low returns on deposits. Because of the high lapse rates and low capital levels, Annuity & Life says it is planning to spend at least $33 million to cover the cost of meeting minimum interest guarantees for customers who gave up on their annuities in the fourth quarter.

The problem annuity reinsurance arrangement has accounted for most of the Annuity & Life annuity reinsurance program since it was set up in October 1998, and it accounted for more than 80% of the $1.9 billion in liabilities on the company balance sheet at the end of the third quarter of 2001.

Rating analysts who follow Annuity & Life for Standard & Poor’s New York, and Fitch Inc., New York, say their companies have known the name of the primary insurer all along, and know that it is a large insurer that is not related to Annuity & Life.

For now, ordinary shareholders and members of the public who want to know the name of the primary insurer are out of luck

Because of a confidentiality clause in a contract, “we’re unable to divulge the identities of the parties involved,” Lawrence Doyle, president of the company, said earlier this week at a public teleconference.

When one company sues another company in court, the details often come out in open court pleadings.

In arbitration proceedings, the details often remain secret.

But Doyle left some hope open that more information might come to light.

“We did send [the primary insurer] a letter telling them to preserve all records,” Doyle said. “I.e., an Enron-type letter. They’re on notice.”

Annuity & Life was incorporated in December 1997 and went public in April 1998. Its shares now trade on the New York Stock Exchange, under the symbol ANR, and XL Capital Ltd., Hamilton, holds about 13% of the stock.

The company announced in September 1998 that it had agreed to reinsure at least $1.25 billion in annuity deposits from a “premier insurer.” The company later described the product reinsured as a “general account fixed deferred annuity.”

During the teleconference, Doyle and John Burke, the chief financial officer, said Annuity & Life decided to end the arrangement in June 1999 because they felt that the program was too big for a small reinsurer and that the lapse rate on the annuities was too high.

A large, “top five” reinsurer took over the reinsurance program and now assumes 16% of the risk, leaving the primary insurer with 20% and Annuity & Life with 64%.

Doyle said the ceding company replaced a respected outside fund manager in late 2000 with its own managers, without complying with a clause that required it to seek approval for such a move from the reinsurers.

Roughly 70% of the assets are now in convertible bonds, and managers at the primary insurer achieved much lower returns than the old manager achieved, Doyle said.

Annuity & Life executives said the company now reinsures $960 million in contract asset value, down from a high of $1.7 billion.

Annuity & Life has been assuming an annualized lapse rate of about 24%.

The surrender rate has been so high that one bright spot in the third-quarter Annuity & Life earnings statement was a big increase in “other income,” which consisted mainly of revenue from a 7% surrender fee that annuity holders had to pay to cash in their annuities. “Other income” increased to $13 million for the quarter, from $5 million for the third quarter of 2000, Annuity & Life says.

The lapse rate has improved in recent months, because the guaranteed minimum interest rate of 3.5% now looks more attractive, company executives said.

But Doyle said the current low interest rate environment has discouraged his company from reinsuring other annuity programs.

“We have been very, very defensive in the development of our annuity business for the past two years because of the low interest rate environment, and we have no plans to write any annuity business in the near future,” Doyle said. “The annuity business basically dried up.”

Annuity & Life says it now depends mainly on revenue from ordinary life reinsurance arrangements.

The company has reported a net loss of $14 million for the first three quarters of 2001 on $264 million in revenue, compared with $26 million in net income for the first three quarters of 2000.

In spite of the net loss, which was caused by problems with the annuity reinsurance arrangement and problems with a large life reinsurance arrangement, the company ended the third quarter with $434 million in shareholder equity and $2.3 billion in assets.

The S&P and Fitch analysts emphasize that Annuity & Life is a well-capitalized company that may simply be facing the effects of a bad decision made during its first few months of operations.

“I think the company is managing the best it can,” says Rodney Clark, an S&P analyst.

Clark says his company has been asking for detailed information about many annuity reinsurance arrangements over the past two years, because of concerns about high surrender and replacement rates.

But Clark says he may now ask more questions about the investment philosophies and strategies of the managers handling annuity contract assets, in part because of the news that 70% of the portfolio backing the big Annuity & Life annuity reinsurance contract was invested in convertible bonds, and in part because of the increasing pressure on all fixed-income investment managers to achieve high returns despite low interest rates on low-risk bonds.

“You can’t really increase yields without increasing risk,” Clark says.

Ellis emphasizes that he would like to hear more from the primary insurer before drawing any conclusions about the Annuity & Life arrangement.

But signs that a primary insurer is seriously neglecting reinsured blocks of business could come up in discussions about downgrades, Ellis says.

Primary insurers “have to be able to reinsure their business going forward,” Ellis says.