Prudential, Hartford, Other Life Insurers May Be Selling Away Their Future

U.S. life insurance companies are asking for a federal bailout to prevent a capital crisis -- but they're also still pushing complex benefit guarantees that could threaten the industry's viability for years to come.

First, some background. These products, generally known as "guaranteed minimum benefits," have played a big role boosting sales of variable annuities by life insurers. Such annuities allow buyers to invest premiums in mutual funds in exchange for a regular payout -- usually in retirement -- based on the value of the underlying portfolio. Minimum-benefit guarantees enhance the security of these annuities by ensuring the full value of the original investment; more elaborate versions even guarantee specific annual increases in portfolio value.

Such guarantees helped push sales of variable annuities to $184 billion in 2007 from $133 million in 2004, during which time insurance companies courted annuity buyers with increasingly lavish guarantees. (Sales declined again last year as financial markets tanked, despite the guarantees.) Some estimates suggest that nearly 70 percent of variable annuities sold over the last five years included some type of guarantee. Prudential Financial and Hartford Financial Services, which have already applied for bailout funds, are pioneers in these guaranteed annuities. Hartford, in fact, is one of the top ten variable-annuity writers in the U.S.
Minimum-benefit guarantees, however, carry some significant risks that many life insurers don't appear to fully appreciate. Even insurance companies that do have a handle on those risks could still have trouble protecting themselves by hedging these guarantees or reinsuring them.

Here's why. Guaranteed variable annuities are an easy sell to baby boomers looking for certainty in retirement, but they require insurance companies to juggle a series of put options and complex structured securities that revolve around stock prices and mortality. Much like the role subprime mortgages played in banking, these guarantees helped insurers boost sales and gain market share while times were good. But they also left life-insurance companies exposed when the music stopped.

For instance, insurers have been desperately trying to hedge away the risk they assumed on their customers' behalf -- and that worked fine so long as the market remained calm and hedging was cheap. But the cost of hedging rises exponentially with market volatility, crippling insurers' ability to offload the risk.
Life insurers are likely to face problems with guaranteed annuity risk for the forseeable future. A recent report by Standard & Poor's points out that the current cost of hedging living variable-annuity guarantees exceeds what insurers are charging for the guarantees. Worse, an alternative risk-management strategy involving limited reinsurance to cover the guarantees has also collapsed, since the reinsurance market has "hardened" -- the insurance term for rising rates and declining availability.

Some life insurers have responded by raising the price of the guarantees. Fees could increase as much as 30 basis points in some cases, S&P says. But that won't help the billions in guarantees currently on insurance-company books.
Even insurance brokers -- not usually the most cautious sorts around -- are starting to get alarmed. A majority of financial advisers surveyed recently by Merrill Lynch said they were concerned with the risks life insurers had assumed with annuity guarantees. A third also suspect that the insurers themselves don't understand the risks. In fact, the authors of that Merrill survey told the WSJ that slumping demand for guaranteed annuities -- at a time when the guarantees ought to be particularly attractive -- may well reflect widespread "concern about the financial health of the life-insurance industry."

The insurance industry has been often criticized in the past of writing new policies for less than actuarially sound rates -- which are called "underwriting losses" -- in order to gain market share. While usually targeted at the property/casualty side of insurance, guaranteed annuities may well be an underwrting loss event for the life side. And so far, no one seems to know just how big the problem might be.

Musical chairs image via Flickr user makelessnoise, CC 2.0