The credit crisis of 2008, coupled with the ensuing downturn in global markets, now appears to have stabilized. Governments and central banks have employed various measures to restore calm to financial markets. Financial services firms have experienced a rebound in profits, with the partial recovery in financial markets. Insurers, aided by regulatory capital relief measures, have begun the process of rebuilding balance sheets and redefining product priorities.

In the US annuity insurance sector, 2009 could be described as a year of product "de-risking." Many carriers took a more defensive posture in their fixed-income portfolios, lowered crediting rates and/or launched fixed annuity products that pass more risk to retail customers. More importantly, variable annuity carriers significantly reduced the complexity of and risks associated with their rider guarantees. Given this ground-breaking shift to insurer sustainability in the marketplace for variable annuity guarantees, it is important to review the lessons that have served as a backdrop for the changes witnessed in 2009.

Lesson 1: Simplicity Matters
Much of the growth in variable annuity gross sales between 2002 and 2007 was fueled by elaborate promises embedded in new, complex annuity guarantees. These guarantees offered a variety of bells and whistles that were meant to differentiate carriers from their competitors. They generally increased insurer risk profiles but did not uniformly achieve the much-desired penetration at distributor firms. Indeed, net industry sales (i.e. new annuity premiums) showed little or no improvement, even as gross industry sales increased significantly.

Consistent feedback from independent financial advisers – the most promising and most elusive sales growth channel for variable annuities – was that the new guarantees were too complex to understand and sell to clients. A winning simplicity proposition will need benefits that balance easier risk management, simpler illustrations and a variety of investment fund choices against real income promises.

Lesson 2: More Risk Does Not Always Mean More Value
Many annuity carriers entered the guarantee "arms race" of years 2002 through 2007 to increase both market share and shareholder value. Indeed, that timeframe provided a great window for risk taking: Market volatility was very low, returns were positive, and interest rates were moderate.

The risky underbelly of this stable period was that some carriers became very confident of their ability to dynamically hedge complex annuity guarantees. However, the reality was that dynamic hedging programs are far less successful in preserving shareholder value under volatile market conditions.

As markets began to unravel in 2007, investors began to seriously question and adjust for residual market risks that had previously been underestimated in stock valuations and rating agency reports. As a result, third-party annuity distributors began to perceive that some companies were selling guarantees that they could not manage well. This new perception resulted in a drop in annuity sales at these carriers. The growth proposition that guarantees had previously represented to these carriers was replaced by an "unmanageable risk" perception. The consequence of these events was a substantial reduction in carrier shareholder value.


Lesson 3: Dynamic Hedging Does Not Transfer All Market Risks
Annuity insurers set up hedge programs to offload guarantee market risks as living benefits began to lift annuity sales in 2003. Many of these programs addressed just market return risks.

Now, hedging is both science and art. It comes with risks and opportunities that vary by the level of operational sophistication. For example, programs that address only market return risks require frequent, costly rebalancing whenever markets become volatile.

For insurers with this type of hedge strategy, the market crises of 2008 brought lessons learned on bank derivatives-trading desks to insurance companies: Rebalancing in periods of high volatility can result in massive losses, unless market-volatility protection is pre-purchased or volatility is skillfully managed.

Even for annuity carriers that did attempt to pre-purchase volatility protection, hedging instruments did not move in perfect tandem with underlying guarantee values. Mitigating future hedge underperformance risks will involve diversifying hedge strategies to include the use of structured derivatives and reinsurance.


Figure 1: Absolute Daily S&P 500 Index Returns in Excess of 2%
Equity markets, as exemplified through the S&P 500, exhibited minimal volatility during 2004-2006. This helped facilitate an environment of greater risk taking, which later unraveled.

Lesson 4: Capital Management Is Crucial
Statutory and rating agency capital requirements for variable annuity guarantees are pro-cyclical; i.e., they can increase significantly when markets drop. Hedges set up to offset guarantee liabilities should provide some relief in depressed markets, but substantial residual capital requirements still remain.

Some insurers had to raise scarce capital, even as their hedge programs performed well in the turbulent months of 2008. It has thus become important to plan for residual capital requirements at the bottom of the economic cycle. This could be achieved through structured derivatives or by setting aside ample capital in reinsurance captives that is well in excess of rating agency requirements.

Many current variable annuity writers are seeking to reduce market risk and to return to simplicity that embodies the key lessons of 2009. These lessons center on understanding the tradeoff between risk and value, adjusting for the limitations of hedging and the importance of capital management. These all come at a time when demand for guaranteed income solutions is at a high.

Companies will need to carefully balance the need for insurer sustainability with reasonably priced but meaningful annuity guarantees. The next phase in that challenging mission is already taking shape.
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