The question was: What changes can the insurance industry expect to see from variable annuity providers in 2010?

The answer is: To optimize variable annuities as a viable investment instrument, insurers will reassess key variables in their product design, such as the effectiveness of their hedging programs and the simplicity of product design and fee structure, to name a few.

Some insurers have already begun to retool their hedging programs to better manage unfavorable market movements and correlated changes in equities and interest rates. They’ve also focused on reducing the complexity of their current policy designs, especially in terms of policy guarantees, which have evolved from simple solutions to promises that include optional features and riders.

Moreover, insurers are now more attentive to the fact that increases in underlying fund choices available to policyholders, coupled with minimal limitations, add to the insurers’ inherent market risk and complicate hedging efforts.

For most of this decade, VAs have been one of the most popular investment products offered by insurers. The attractions of tax-deferred growth, guarantees and a broad range of investment choices made VAs one of the fastest growing products in the insurance industry.

But the financial markets crisis, which saw virtually every asset class post massive declines in the U.S. and globally, dampened enthusiasm for VAs. Recently, investors have shied away from the products in favor of fixed annuities.

However, rather than undermining the value of the product due to the recent bear market, VAs have proven their valuable benefits to investors for their unique and significant role in portfolio diversification and a source of stability for investors in or near retirement.

As the markets return to normalcy, the appetite for VAs is poised for a comeback, which will perhaps outshine the growth of the past decade.

The reason for this optimistic outlook is that many investors continue to face volatile financial markets, dwindling pensions and a money-strapped Social Security system that may be incapable of providing the income they need for a secure and, very likely, extended retirement. Given the various challenges in retirement funding within today’s risk-averse investment climate, the VA, coupled with an appropriately diversified portfolio, can serve as an important retirement-income solution.

In the end, VA providers with the best risk management capabilities should emerge from the current crisis in a stronger position with solid products that continue to play a critical role in meeting retirement needs.
There are compelling reasons to believe that a surge in demand is just over the horizon. And insurers who persist in refining their products and hedging programs should be in the best position to exploit it.

Ultimately, investors (especially baby boomers) will continue to seek ways to allocate a portion of their portfolio to the kind of guaranteed, lifelong income their parents enjoyed via their company pensions. As these investors intensify the search for defined benefit-like retirement alternatives, VAs may increasingly be seen as a vehicle of choice, given their role in portfolio diversification and providing a potential source of stable income.

Source: Ellen Cooper, a managing director at Goldman Sachs Asset Management, New York, N.Y. Her e-mail address is Ellen.cooper@gs.com.