Due To Market, VA Benefits Now Giving Issuers Headaches

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Given the current fist-clenching stock market gyrations, the question is: Who has the whiter knuckles–life insurers, contract holders or stockholders?

Life insurers may well be hanging on the tightest if the market continues to plummet, according to interviews, earnings conference calls and rating agency outlooks.

Sobering news from companies is leaving no doubt that if the market continues to drop, guarantees–particularly the guaranteed minimum death benefit in variable annuities–and deferred acquisition costs are going to hurt life insurers and, if the companies are public, their shareholders.

Guaranteed death benefits are immensely popular with consumers, interviews suggest.

Currently, 596 of a total of 600 variable annuity contracts offered by insurers, have, at the very least, a death benefit of return of premium, according to Rick Carey, editor of the VARDS Report, an Info-One service, in Roswell, Ga. The guaranteed minimum income benefit is also quickly becoming a popular feature, with 122 of 600 contracts offering them, he adds.

As these guarantees have gained in popularity, their costs have been lumped into an accounting liability called “deferred acquisition costs” along with bonuses and upfront commissions. DAC allows an insurer to amortize a cost over time rather than to recognize the expense during a given accounting period.

In a strong equity market, assets grow and liabilities can match that larger total. However, when the market drops, assets under management follow suit and liabilities must also fall to match assets. Consequently, DAC deferrals are accelerated and large expenses start to show up on the income statement.

These factors were threaded through a review of second quarter results last week when Nationwide Financial, Columbus, Ohio, and Hartford Financial Services Group, Hartford, Conn., fielded questions from analysts during their respective conference calls.

Hartford Financial said individual annuity operating earnings were down 7% over last year due to lower asset fees. The VA sales environment is “challenging,” the company said, with year over year sales down 7%. Hartford said it remains comfortable with its DAC and GMDB exposure.

On its call, Nationwide said its exposure to GMDB claims is $5 billion, 15% of a $33 billion book of VA business. Of that total, $2.9 billion or 58% is reinsured and 42% or $2.1 billion is backed by reserves.

Nationwide also addressed its DAC exposure. It currently has $3.3 billion of DAC on the balance sheets, of which 60% is accounted for by individual annuities.

Should the equity markets continue to reflect July performance, Nationwide said it is possible there could be a 4th quarter 2002 or 1st quarter 2003 impact to earnings of between $175 million and $200 million after-tax. If that were to happen, the company said, full-year earnings estimates of $3.25-$3.40 per share in 2002 would be revised downward to $3.15-$3.20 per share.

The two calls followed a downgrade of Allmerica Financial Corp. by Moodys Investors Service, New York, and negative outlooks on several companies from Standard and Poors Corp., New York.

S&P issued negative CreditWatch warnings on American Skandia Life Assurance Corp., Shelton, Conn.; The Phoenix Cos., Hartford, Conn.; Sun Life Assurance Co. of Canada, Toronto; and Allmerica Financial Corp., Worcester, Mass., because of the markets potential impact on their equity-linked products.

Info-Ones Carey, a variable annuity veteran, says the current environment is a “real-time test” of the product, accounting issues related to it and the relationship of VA issuers with their brokers.

“There will be a significant shakeout” over the coming years, Carey predicts. Products, product features and related accounting practices that dont pass muster will be gone, he adds.

Part of that change will be an assessment of insurers relationships with their brokers, he continues. Under the current model, Carey says that contracts sold through brokers have a shorter time period to recoup commissions: 5-6 years as opposed to 8-9 years for a captive agent. Brokers have to have new products to offer customers and do not want to be in products as long, he explains.

Colin Devine, managing director, with Salomon Smith Barney, New York, says the good news is that GMDBs “did put value in the product and we are seeing that now.”

But there is also more than enough bad news. As Devine explains, treatment of DAC will be a problem for many insurers.

If you are putting up 10%-12% upfront for bonuses, credits and commissions, and pricing products on a 10% market appreciation, and youve lost money in the first three years of a contract, and there is a 35% surrender rate, Devine asks how can you expect to make that up in the remaining four years of a contract?

One thing that companies need to do is to look at how they compensate producers, Devine says. They need to look at a level commission because “the upfront commission is just not working,” he continues.

In addition to a potential uptick in claims with minimum death benefits, statutory reserving might need to be increased, according to Devine, who says this could hinder corporate decisions such as stock repurchases.

And further, he says, all contracts with these features sold in the last year, and probably the last three years are in the money, or likely to be triggered.

GMDBs, DAC, and uncertainties surrounding insurers investments could result in a 2002 earnings showing that is the worst in five years, Devine says.

Even if insurance stocks look cheap, when earnings estimates become clearer, they might look expensive, he adds.

One saving grace, he notes is the popularity of universal life and fixed annuity products that have higher profit margins and will improve ratios such as return on assets.

Investors skittishness is evident from money moving into fixed income products as well as guarantees, according to Pam Schutz, president and CEO of GE Life and Annuity.

At GE Life and Annuity, a unit of GE Financial Assurance, Richmond, Va., there was a 47% sales increase year over year in fixed income products and a 37% increase year over year for single premium immediate annuities, she says.

GE has not lost money on GMDBs, says Schutz. A risk analysis has also shown that the GMIB is not a feature the GE wants to offer, she adds.

“Clearly the GMDB is a benefit today for the consumer” and belies the argument that VAs are too expensive and do not bring value to a consumer, she says.

Schutz also notes that when the impact of a GMDB on a company is considered, the equity markets are just one factor among a host of considerations that include lapse and mortality assumptions as well as pricing.

Another factor that can make a big difference in exposure to GMDBs is reinsurance, according to Stan Tulin, vice chairman and chief financial officer with AXA Financial Group, New York.

AXA uses significant amounts of reinsurance so that it can offer GMDBs and GMIBs as VA features, he adds.

Tulin says that until 2001 GMDB guarantee costs were under $1 million and due largely to choice of funds in subaccounts. In 2001, it was large enough to notice and currently, it is more material but will not be a drag on earnings, he adds. There will be no changes to reserves, he continues.

Product development has included input from AXAs financial department and consequently, no short-term changes to these features are anticipated, says Deanna Mulligan, AXA executive vice president, product and market development.

AXA has a mix of customers who have guarantees and those who do not, a fact that can help limit costs during a market downturn, says Tulin.

But, he notes, customers “most definitely want us to be doing it. The fact that the market is down will make customers want the feature more. It is an opportunity for us.”

It reinforces the idea that “these companies do have value and thats what insurance companies are supposed to do–to provide protection to people.”


Reproduced from National Underwriter Life & Health/Financial Services Edition, August 5, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.