Many carriers announced all-time record sales of fixed annuities for 2008. Much of the fixed annuity product being sold today is expected to be solidly profitable to carriers.
Several factors account for this success, including disappointing equity returns, simplicity of product design, attractive credit spreads on new investments, and the guaranteed nature of the products’ returns.
But there is a problem: It is “capital,” or more accurately, the lack of capital.
Lack of capital has resulted in many carriers pulling FAs off the shelf, restricting sales at certain ages, not accepting 1035 exchange business, not appointing new agents, or capping production of FA sales.
What caused the decrease in capital levels? First, operating losses at some insurers on any or all of their lines of business have lowered their surplus position. Second, due to the economy’s troubles, the widespread downgrading of ratings on existing fixed income securities (even within the investment grade class) has increased the level of capital that must be held. Third, widening credit spreads in the investment world led to significant amounts of unrealized capital losses on older assets, even for securities without a “true” credit problem.
There is a fourth cause of capital scarcity, too. It is the capital strain generated when sizable amounts of new business are written.
Under statutory accounting, insurers must record expenses when incurred, so a fixed annuity with a healthy upfront sales commission and/or an upfront premium bonus could produce capital strain. This is because inflows to the insurer are the annuity deposits and interest earned by the company on those deposits. On the other hand, outflows are commissions and other administrative expenses, premium bonuses, and reserves established.
As a general rule, a FA featuring an upfront sales commission and overrides plus upfront premium bonuses close to or in excess of the magnitude of the contract’s surrender charge will usually have significant surplus strain.
(GAAP accounting works differently, but state regulators and rating agencies are focused on statutory accounting.)
What can be done to address capital scarcity? One option is for the insurer to invest only in very highly rated assets that do not carry a high risk-based capital charge. But while effective from a capital standpoint, yields generated by such assets may not support competitive credited rates.
Another option is to wait for general credit spreads in the market to return to normalcy. This would reverse unrealized capital losses in the asset portfolio–an appealing scenario, but one which must be passively waited out, for the most part.
What can be done at the product level? Although marginal benefits in capital efficiency can be realized by selling annuities with market value adjustments and by choosing advantageous reserve techniques, I believe the real answer lies in commission and premium bonus spreading.
Unlike variable annuities, FAs are sold almost exclusively with all upfront sales compensation. Premium bonuses are also upfront sweeteners.
This means that of the 3 legs of the proverbial stool–agent, customer, and insurer–the insurer takes on almost all of the persistency risk, and comes out of the first policy year with a statutory loss. Since most insurers price FAs using the internal rate of return as the main measure, a high upfront loss punishes insurers’ estimated profits and requires a high annual interest spread requirement.
Spread compensation (and spread premium bonuses) is a concept whose time has come.
If sales representatives want more FA capacity, here is the answer. Sales compensation spread out over 2 or more years can ultimately result in more total compensation paid to the patient agent, even when the time value of money is reflected. Product competitiveness may also improve, as IRRs will be increased since capital strain is lowered.
For the first time in my memory, I hear many agents talking about the level of upfront compensation being too high, but still needing to make a living.
Spread compensation (even over just 2 years) can make a meaningful difference in capital, IRR, product competitiveness, and even long-term compensation levels. Spread premium bonuses are just the flip side of the same capital-saving coin.
The capital scarcity issue is real, but there are actions that insurers can take besides waiting for the economy to improve.
The benefits of a multiyear spread of sales compensation and/or premium bonuses to the insurer, policyholder, and even to the sales producer are strong, provided that the fixed annuity is treated as a long-term relationship.
Timothy Pfeifer, FSA, MAAA, is president of Pfeiffer Advisory, LLC, Libertyville, Ill. His e-mail address is [email protected]