As the economic recovery continues, it remains to be seen whether all of the variable annuity writers emerging from the recession will still be around in a few years’ time. That’s because many are struggling to cope with some creative (and perhaps toxic) assets on their balance sheets: overgenerous guaranteed living benefit riders.

A Moody Assessment

According to a new survey of the 20 largest variable annuity writers by Moody’s Investors Service Inc., New York, the guarantees offered by the VA manufacturers in previous years remain a threat to their company’s capital positions, despite the release of new, less credit risky products.

The VA writers’ finances would be in a healthier state today if U.S. regulators had had oversight of the companies’ offshore subsidiaries. A little known fact is that some of the largest VA players artificially enhanced their capital positions by shifting risk connected with the products’ GLBs to these “captive” organizations, many of which are situated in less regulated countries, such as Bermuda. Collectively, the offshore firms are undercapitalized by up to $10 billion.

Upshot: the captives’ “onshore” (U.S.-domiciled) manufacturers can withstand at best a 30% drop in the equity markets, observes Moody’s. If the insurers experience greater losses as a result of declines in equity values, then the companies will likely take “significant hits” to regulatory capital levels.

To offset the cost of policy guarantees, Moody’s notes, the VA writers will need to revamp their hedging strategies (techniques used to mitigate investment risk) which in some cases have failed to keep pace with the rising values of the guarantees, particularly the popular guaranteed minimum benefit and guaranteed minimum withdrawal benefit riders.

More visible to consumers today are the less generous guarantees that VA writers have implemented since the recession to strengthen their balance sheets. Annual bonuses have dropped from highs of 7% of an initial investment only two years ago to less than 5% today.

Likewise, insurers have cut back on the guarantees while boosting the charges clients pay to secure them. GLB fees have crept up an average of 15 to 20 basis points–and in some cases 50 basis point or more–on many VA products.

These moves by the VA writers have effectively end an arms race over features and benefits that left them over-leveraged. But the changes raise key questions. Among them: To what degree can the insurers continue to innovate without again putting their capital reserves at risk? What will new products look like? And will the offerings carry as much appeal for clients?

Peering into our Crystal Ball

Given recent trends, it seems clear that variable annuities will boast fewer bells and whistles than did earlier iterations. The products will be simpler in design, offering (apart from more modest guarantees) fewer investment choices in the subaccounts. They’ll also be structured so as not to rely so greatly on uncertain hedging strategies.

This return to basics among the major players can already be gleaned in the emergence of solutions that offer equity-like returns of conventional VAs. But the new products limit the risk to manufacturers and use less of a client’s portfolio to achieve a comparable result. Example: deferred (or delayed) income annuities that meld features of the single premium immediate annuity and a traditional deferred annuity.

Also gaining traction in the marketplace is a novel concept: annuity syndicates. Championed by (among others) Moshe Milevsky, a professor finance at York University in Toronto, the technique entails buying a VA from a “syndicate” of several insurers, one serving as the lead issuer.

Each of the carriers would pay a fraction of the guaranteed minimum stream, the fraction determined by the number of companies in the syndicate. If any of the insurers defaulted or became financially distressed, the others would continue the remaining payments. The consumer is thereby protected against default risk. And, in proportion to the number of participating insurers, the carriers limit their financial exposure.

Serving Notice

The recent economic downturn has been a wake-up call for VA writers that rolled out progressively more generous living benefit guarantees and became reckless with their balance sheets to remain competitive. The products they bring to market in coming years ahead, I trust, will reflect a more sober assessment of their ability to innovate.