With the Department of Labor's Conflict of Interest Rule going into effect, S&P Global Ratings is keeping close tabs on some life insurers' variable annuities hedging strategies and product design.
During a two-day conference sponsored by S&P Global Ratings, insurance company executives said they were ready for the rule's implementation. The rule is widely expected to negatively affect variable annuity sales.
Some life insurers are starting to offer richer guarantees in their variable annuity products that involve more investment risk, according to S&P analyst Katilyn Pulcher. As some insurers move away from volatility-controlled funds where hedging is performed automatically, they must start taking the responsibility for deliberately hedging the risks themselves. Guarantees in variable annuities can offer a stream of income or certain benefits, including accumulation, income stream and withdrawal benefits, all of which require more insurer investment and risk hedging to meet the promises embedded in the contracts.
Pulcher has seen richer offerings in the form of account values tied to quarterly or even daily highs rather than annual ones, as well as more simple interest rollups in which the guarantee can rise perhaps 4% each year even if the market goes down.
"Some insurers were not adequately hedging all of the risk prior to the financial crisis, so we're keeping a close eye on whether they are doing so now," she said in an email. Some policyholders have felt they were missing out on potential upside or have not been happy with more anemic returns, prompting a number of companies to see lapses in contracts, according to Pulcher. Affected insurers have in some cases turned to creating products with more exposure to equities, which spurs the need for more hedging activity.
"S&P Global does not have a house view on whether hedging should be performed inside the funds themselves ... or deliberately by the insurance company; we just want to be sure the risks are adequately hedged so losses remain within company risk tolerance," Pulcher said.
With the fiduciary rule hitting its preliminary implementation date June 9, S&P Global Ratings will be watching how much insurers are hedging on the back end to cover their risk, according to Pulcher.
Fitch Ratings analyst Bradley Ellis said in an interview that this activity may be happening "on the margin, here and there." However, he is not concerned and sees pricing as remaining "rational," especially compared with what the industry experienced immediately prior to the financial crisis.
After the financial crisis, the life insurance industry tightened its variable annuity product offerings, and raised prices for annuities with living benefits.
When it came to insurance during the financial crisis, "variable annuities were weapons of mass destruction," Federal Reserve Board Associate Director Tom Sullivan said in an interview during the S&P conference. Sullivan recalled his role as Connecticut's insurance commissioner during a time when financial markets were in turmoil and insurers like American International Group Inc. and The Hartford Financial Services Group Inc. found themselves in the middle of the crisis.
During the crisis, variable annuities played a large role for insurers. Life insurers that were issuers of variable annuity contracts that offered certain guarantees were required to increase reserves for their future obligations, an article in the Journal of Insurance Regulation noted. The paper said the impact of those guarantees on life insurance companies was "substantial." Research by Milliman estimated that, as of Oct. 31, 2008, the aggregate benefit value pledged by life insurers to variable annuity contract holders had exceeded account values by $232 billion.
But the industry's more recent recent discipline and controlled offerings do have a blind spot of sorts, according to some industry experts. Fitch's Ellis sees hedging for policyholder behavior as difficult given the complexity of variable annuities.
"Lapse and utilization assumptions are hard to hedge," he said, because insurers cannot predict when policyholders will activate the guaranteed benefits. Nevertheless, Ellis believes that variable annuity pricing is solid.