The Pipeworks

Sales of variable annuities with living benefit riders have become a star product on Wall Street, quietly allowing insurance companies to become dominant players in an otherwise bleak market, not just for equities but for all financial markets. So much so, in fact, that variable annuities with living benefit riders are strengthening the ability of insurers to compete with mutual funds, which cannot provide guarantees on yields.

“The target market is those investors who like equity markets,” with the potential upside, in a play on words, “that it provides downside protection,” according to Neil Strauss, vice president and a senior credit officer at Moody’s Investors Service.

But the flip side is that the industry, analysts, rating agencies and even regulators are riding the wave with caution. And, interestingly, it appears everyone is on the same page with the issues presented with the strong demand for these riders in VAs.

They are quite aware that providing guarantees on equity products got the industry into a whale of trouble in late 2007, when the economy and markets turned south to an extent unprecedented since the Great Depression.

“I think insurance companies can book this business profitably, but it is not a walk through the park, because there are market pressures,” said Andrew Kligerman, a life insurance analyst at UBS Securities in New York said.

Insurers felt a great deal of pain when investment markets tanked in 2008 and 2009 because of the living benefit products they had written before then, Kligerman said. He noted that when writing this kind of business, insurers need to be mindful of deferred acquisition charges, capital charges, living benefit reserve and death benefit reserve charges.

The business can be written profitably—but it is a company-dependent process,” he said. “I think they will do it better this time.”

Another interesting issue associated with the new trend is that the market has become concentrated, with three players—MetLife, Prudential and Jackson Life—dominating. All three offer lower yields than their competitors.

But, while the rest of the industry offers higher yields, they are controlling their risk by limiting their distribution. They are also adjusting product offerings continually in order to maintain market share while minimizing risk, according to Moody’s and Morningstar.

The focus on VAs with living benefit riders became clear last week when LIMRA, based in Windsor, Conn., which tracks insurance market statistics, revealed third quarter statistics.

“While third quarter VA sales were two percent lower than second quarter results, VAs performed significantly better than the market, which was down 15%,” according to Joseph Montminy, assistant vice president for LIMRA’s annuity research.

He said the “equity markets in the third quarter were the most volatile we have experienced since the financial crisis began in late 2008, yet consumers’ demand for guaranteed lifetime income helped sustain VA sales.”

LIMRA said VA sales have experienced six consecutive quarters of positive growth—the last three in double digits.

Also consistent with LIMRA, Morningstar Director of Insurance Solutions Frank O’Connor, speaking for the IRI, said the surge in net sales “is a very positive development, indicating rapidly growing interest in the use of variable annuity guaranteed income benefits as an important component of a portfolio designed to produce sustainable income throughout one’s retirement.”

By contrast, fixed annuity sales continued to struggle in a hyper-low interest rate environment, and insurers said they  are lowering steps on annuities with living benefit riders in order to protect profitability, LIMRA said.

Fixed annuity sales fell 6% in the third quarter and down one percent for the first nine months of 2011, according to LIMRA. AIG Companies paced sales in this category with $6.9 billion in sales in the third quarter.

Total fixed annuity sales equaled $20.2 billion in the third quarter and $61.9 billion in the first nine months of 2011, LIMRA said.

Indeed, Morningstar, which tracks all consumer-oriented financial markets, says annuity sales because of living benefit riders could allow insurers to equal or perhaps exceed their prior high in annuity sales, $184 billion in 2007.

“The reason is that the insurance industry is providing guarantees not available anywhere else, said Strauss of Moody’s.

“The key here is the guarantees,” Strauss said. “Even if the equity markets don’t do well, you get some sort of return. Generally, that is not available anywhere else.”

He said they have been charging a higher fee for the guarantee; and they have also done more hedging of the equity and interest rate risk in the product.

Strauss said insurers have also changed the product somewhat so that the policyholder may have less asset-allocation choices.

“Policyholders are being forced to allocate their assets in a less risky fashion, more towards fixed income securities under certain circumstances,” Strauss said.

“If the equity markets are doing badly, the insurers could require the policyholders to invest less in equities and more in bond funds,” he said.

For insurers in general, the trend is toward the company having greater control and the policyholder having less opportunity to allocate the investments as he or she might desire, Strauss explained. “For the consumer, there are less choices, more limitations,” he said. “These initiatives provide protection to the company in a stress scenario,” adds Strauss.

“This appears to be an industry-wide trend, at least among the larger players we monitor, and provide ratings for,” Strauss said.

Federal regulators are very much aware of the growth in demand for VAs with living benefit riders.

In a conference sponsored by the American Bar Association for insurance industry lawyers, the top cop for insurance products sounded the alarm.

Eileen Rominger, director of the SEC Investment Management Division, told the lawyers what the SEC is keeping an eye on them regarding VAs with living benefits.

These concerns include the disclosures related to VAs with a living benefit feature that use derivatives to enhance yields, about the “guarantees” included in these products, and about living benefit products that limit the investment options offered to purchasers.

Rominger “encouraged” insurers and their lawyers to assess the effectiveness of disclosures in VAs that feature living benefits and use derivatives to enhance yields.

She said that this should include elimination of boilerplate disclosures that do not reflect the actual use of derivatives in a fund’s portfolio.