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.