Investment market turmoil could hurt the earnings and risk-based capital levels of variable annuity issuers well into 2009.
Analysts in the Chicago office of Fitch Ratings come to that conclusion in a discussion of the effects of recent financial turmoil on variable annuity risk.
Market drops may have put more VA guarantees “in the money,” and that could force insurers to back the guarantees with about $14 billion in additional capital, the analysts write.
“Fitch is concerned that insurers are overly optimistic about the effectiveness of their hedging programs, which have not been tested under prolonged adverse market conditions,” the analysts write. “The performance of these hedge programs will suffer as pricing assumptions did not forecast this elevated level.”
Insurers have been using “stochastic” statistical forecasting techniques to determine how VA programs might perform under a wide variety of conditions, the analysts write.
One challenge is that VA products probably will be profitable under 90% of the scenarios used, but 1% of the scenarios could generate large losses and capital needs, the analysts write.
If “in the moneyness” has increased 10%, then the need for capital may have increased 55%, or $14 billion, to 2.8% of total net asset value, the analysts estimate.
Today, “reserving and capital requirements are shifting to internal stochastic models created by insurers rather than factors determined by regulators,” the analysts write.
Regulators now expect VA issurers to set aside enough capital to handle 90% of scenarios, and that level of capital probably corresponds with a BBB plus level of capitalization, the analysts write.
An AA rating corresponds with having enough capital to handle about 98% of scenarios, the analysts write.
Company-specific forecasting models have advantages, but “each model is unique, with material differences in parameters and assumptions based on human judgment,” the analysts write.
In addition, consumers could drop policies or make use of guaranteed benefits in ways not included, or not included well, in the simulation formulas, the analysts warn.
Some VA writers may simply choose to focus on other product lines while the investment markets recover, but others may have to sell or shut down their VA operations, the Fitch analysts predict.