In the last 10 months, many external forces have imposed stress on the annuity world. The responses taken by insurers may suggest a direction for continued success.

Equity markets have slid 20% since their recent high in October 2007 and have experienced volatility as well. The immediate impact has been on variable annuities, which grew minimally in 1st quarter 2008 and were flat in 2nd quarter 2008.

Though that’s not good news to the VA industry, those numbers do show that sales today are not as dependent on equity returns as in past years–e.g., when the markets of 2000 and 2001 saw sales declines in double-digit percentages.

What is the fundamental difference between 2008 and 2001 that might explain this? A big part of the answer is the presence of living benefit guarantees on VAs, such as guaranteed minimum withdrawal benefits, guaranteed lifetime withdrawal benefits, guaranteed minimum accumulation benefits and guaranteed minimum income benefits. These features have the impact of allowing potential purchasers to feel comfortable with buying VAs, even during a period when they might not have done so in the past.

Obviously, other differences from 2001, such as demographic changes and decreased focus on defined benefit plans, are present too. But living benefits still account for some of the stable VA sales environment.

The increased focus on VA guarantees prompts another question: how are insurers managing the risk of the guarantees, particularly during volatile periods?

The vast majority of insurers writing VAs with living benefits are using hedging in one form or another. The volatile equity markets of the last 10 months have applied a significant test to the dynamic hedging of VA guarantees. But apparently, VA hedge programs are largely performing as expected, according to a recent Milliman survey of 16 of the top 25 VA insurers. The respondents were a mix of United States, European and Asian insurers representing $468 billion of assets under management. Most (88%) reported gains or unanticipated losses of 10 basis points or less.

As the sliding equity markets have made VAs less attractive to some potential annuity buyers, they have made traditional fixed annuities (FAs) and fixed index annuities (FIAs) relatively more attractive. Here, changes in investment yields have been even more important. Based on industry statistics, FA sales in 2nd quarter 2008 were up more than 50% over the same year-earlier period. FAs virtually doubled, but FIAs rose approximately 5%.

The primary reasons for the huge FA increase were a significant steepening of the Treasury curve and large increases in spreads between corporate bonds and Treasuries. The 7-year Treasuries increased their advantage over 1-year Treasuries by 1.05% in the last 10 months. This works to the advantage of FAs over bank certificates of deposit, since FAs tend to take advantage of longer investing while most CDs do not.

Meanwhile, in the same period, corporate A bond spreads over Treasuries have increased approximately .8% and corporate BBB bonds have increased 1.2%. This also aids FAs.

During the period, FA credited rates increased very slightly while 1-year CDs and 5-year CDs dropped significantly. This spurred a large increase in annuity sales in banks, where competition with CDs is most direct.

Sales of annuities with market value adjustments (MVAs) benefited from the steepening of the yield curve. This improved the value proposition for buyers wanting to lock in longer term guarantees.

Although the FIA sales increase was modest, it is a favorable sign after 2 years of flat sales. Their sales benefited from the same factors that helped fixed-rate sales and had the additional advantage of a drop in London Interbank Offered Rates. This factor helps increase attractiveness in benefits for purchasers.

FIAs are also building a bridge to the emerging need for retirement income planning. GLWB features are at the heart of FIA competition; this is making the benefit ever more attractive.

However, the Securities and Exchange Commission proposed a new rule in June 2008 that would classify virtually all current FIA designs as securities. If adopted, it could apply to all sales early in 2010. This has led FIA insurers to start mapping out new product strategies in event they cannot continue with current products.

A major lesson from all of the above is that diversification of annuity lines is critical. FAs, including MVA products, are an important alternative when VA sales show weakness. FIA writers should have alternative product lines, particularly fixed-rate products. And of course, creative product improvements help soften the blow of any external influence.