The second quarter of 2007 brought two significant milestones to the VA industry: A new record for sales and a long awaited resurgence of strength in net cash flow.

Variable annuity new sales of $46.4 billion were 15% higher than first quarter new sales of $40.4 billion, and 13% higher than the previous record of $41 billion set in the second quarter of 2006.

Net cash flow of $8.8 billion, while slightly lower than the $9.3 billion recorded in the 3rd quarter of 2006, nevertheless marks only the third quarter since the beginning of 2005 that quarterly net cash flow has exceeded $8 billion. Net cash flow as a percentage of new sales was 19% for the 2nd quarter vs. 16% in the 1st quarter, a marked improvement.

MetLife led the industry in sales for the 2nd quarter, moving into the #1 position with $4.2 billion in new sales and a 9.3% market share. This marks a substantial jump for MetLife, which rose from the 3rd ranked position in the first quarter. AXA Financial was close behind with $4 billion in new sales and a market share of 8.6%, followed by TIAA-CREF with $3.6 billion and 7.6% of the market.

Assets continued to rise, ending the quarter at $1.45 trillion. Asset growth in variable annuities has been almost entirely driven by investment returns, as net flow is quite low relative to assets under management. Virtually all major (i.e. top 25) carriers reported substantial increases in assets, led by Jackson National with a quarter over quarter increase of 10.8%.

Assets in variable annuities show some interesting trends. At the peak of the tech bubble that burst in 2002, aggregate VA assets were distributed quite differently than today. Large Cap Growth, for example, held 18.6% of all VA assets at the end of the 2nd quarter of 2000. That’s almost one-fifth of all assets allocated to a single category. Contrast that with only 9.2% of assets in that category as of the middle of 2007–less than half the 2000 exposure and less than one-tenth of total assets.

Certainly the collapse of unsustainably high valuations played a part in the reduction in allocation, but there is definitely more diversification into fixed income and international investments today than there was in 2000. There hasn’t necessarily been a huge shift into most of these asset classes, but enough to indicate much broader exposure to different investment types than there was 7 years ago at this time.

Anecdotally, much of this shift is driven by the requirements of living benefits, where the investor is often required to elect and adhere to a model portfolio or a fund of funds investment option that provides diversification through the allocations to underlying funds. “Staying the course,” so often recommended by investment tomes and advisors, is not a matter of choice when one wishes to preserve the value of a living benefit, but rather a requirement that also happens to have a higher probability of success in the long run.

Variable annuities are often described as too expensive and loaded with features that are not worth the additional cost, but it just may turn out that “forced diversification,” so to speak, will be something a lot of investors may wish they had paid for when the next bear market period occurs.

As assets continue to grow and diversify and investors become more informed and aware of variable annuity products and their usefulness in securing part of their retirement income, continued growth in net flow should be observed, but some caution in interpreting these statistics is warranted.

Over the past few years there has been a fair amount of negative press regarding low levels of positive net cash flow and the (somewhat mistaken) implication that sales are driven almost entirely by the recycling of existing contracts through 1035 exchanges.

It is important to remember–especially now as living benefit guarantees continue to gain acceptance and grow in popularity–that deferred variable annuity products are now being purchased for the express purpose of producing income. As VA owners age, the expectation should be for substantially increased outflows, with a predictable impact on net cash flow.

An increase in net cash flow, therefore, should be increasingly viewed as having more import than simply an overall increase in net sales, but as an increase in net sales that is sufficient to overcome the increased drag on net flow resulting from income withdrawals. As this new paradigm grows, net flow will become an even more important benchmark for measuring overall success in the VA marketplace.

Frank O’Connor is product manager, VARDS, at Morningstar, Inc. He can be reached via email at .