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Lessons From The VA World

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Some features that have been added to variable annuities in the past few years have long been a concern. Our worries stem from the risks these features pose to insurers that provide financial guarantees to what are basically equity investments.

Recent events seem to have proven our concerns right.

It was not all that long ago when any consumer could have found a VA with various “alphabet soup” enhancements providing guarantees to contract values. Today, these enhancements have all but disappeared as a result of the economic chaos of the past 18 months. Insurers found the risks inherent in providing contract value guarantees for equity investments were too great and that the financial instruments necessary to hedge these risks were either not available or were too expensive to obtain.

To be sure, not all of these enhancements, as designed, had the same degree of risk. The designs varied by insurer, and some insurers restricted the investments that could underlie a VA and still take advantage of the enhancement.

Obviously, speculative equity investments with cash value guarantees provide a form of “investment anti-selection” for the VA contract owner. Many VA purchasers found themselves happy they had bought before the economy went south.

The lesson to be learned from this is an old one–that anything too good to be true will not be true.

From their very beginning, VAs were intended to provide retirement security free from the ravages of inflation. However, this design feature only works when the VA is treated as a long-term investment. When held for an extended period, investments in a diversified portfolio of American stocks have tended to protect against inevitable inflation. But, this feature requires patience.

In the short-term, the stock market fluctuates, so VA values can go down, often significantly, and that may not be what the consumer expected. That’s difficult to explain when discussing retirement funds. A retired person wants as much economic certainty as possible. While a VA may provide long-term economic certainty, it cannot do so in the short-term.

Therefore, it is essential for VA purchasers to understand the need to diversify not only at the portfolio level, but also to protect against market volatility with fixed products. That’s why virtually all VAs also have a fixed side–to provide a degree of economic certainty in an uncertain environment.

Insurers and producers also have lessons to learn from this. Producers had pressured insurers to offer ever more and better VA product enhancements in order to have a better story to tell than could be told by competitors. Many insurers responded to these pressures and offered these VA enhancements in an attempt to obtain or maintain market share. But today, these enhancements are having an adverse affect on the earnings of many insurers, and VA sales in general have not climbed back to previous levels. Instead, fixed annuities have seen resurgence in popularity and new products are coming to market almost daily.

We would hate to see a replay of the VA enhancement problems in the resurgence of fixed annuity sales.

Insurers and producers need to remember that any product feature that is not economically sound must eventually fail. Producers need to study carefully the economic basis of the products they sell and to avoid products where they do not understand the risks involved for all of the entities involved.

In the past, we’ve see insurers that offered products that were economically unsound fail. When such failures occurred, customers went looking to producers when there was no one else available to contact. So, no one is immune when financial disaster strikes.

Due diligence screening of insurers should consider not merely the company’s financial foundations but also the financial foundations of the products being sold.

It is not necessary to be an actuary to apply the test of common sense to a product. If common sense says a feature is too good to be true, sell something else. If how the product works isn’t understandable in all economic conditions and for all of the entities involved, investigate and find out! Only then can advisors be sure that they and their customers are protected.

Likewise, insurers should not be stampeded into offering features merely to obtain market share. The past 18 months have shown that there is no such thing as “normal” market conditions. Financial products held as long-term investments need to have a long-term perspective. Expect the abnormal, and you will not be disappointed. We hate to be proven right when we predict bad results!