Life insurers probably will be better off if they design variable annuities (VAs) carefully rather than rely on complicated hedging programs to manage VA risk, rating analysts say.

The analysts, at Moody’s Investors Service, New York, write about the merits of hedging programs and product design in a set of answers to frequently asked questions about variable annuities.

The market turmoil that started in 2008 has scared some insurers away from theannuity clock - it's later than you think! VA market and helped others build sales for what should be lower-risk products, the analysts say.

“Certain products automatically dampen risk by changing asset allocation according to market conditions or by linking guarantees to the capital markets and interest rates,” the analysts say.

The analysts cite the example of a VA guaranteed withdrawal benefit with a withdrawal amount linked to the current interest rate.

Rather than simply guaranteeing a fixed payment stream, “the new product will pay more when interest rates are high (i.e., when it is cheaper for the company to provide the lifetime benefit) and less when they are low,” the analysts say.

Insurers also seem to be making good use of sophisticated risk hedging programs, the analysts say.

But “good product design, which includes risk sharing with the policyholder, is much better protection against a downside economic scenario than relying on a robust hedging program to mitigate the tail risk,” the analysts say.

Although hedging programs can provide some protection, it is not clear how the programs now in place will perform in times of severe market stress, the analysts warn.

A hedging program helped one insurer get good profits from its VA business even in 2008 and 2009, but the market slump seemed to put some pressure on the VA program of another insurer with a strong hedging program, the analysts say.

The analysts also write about the captive reinsurers life insurers use to back VA risk.

The captives appear to need more than $10 billion in additional capital to handle scenarios in the worst 2% of scenarios, which could include damaging moves in interest rates and extreme policyholder behavior, the analysts report.

“In our opinion, the modeling required by state insurance regulators under VACARVM and C3 Phase II does not adequately capture these risks, and companies need to perform additional sensitivity testing to properly quantify their exposures,” the analysts say.

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