Whenever annuity expert Moshe Milevsky headlines client appreciation events these days, one overarching concern inevitably bubbles up: the solvency of life insurance companies.
"It's credit risk, but clients don't call it that. They call it: 'What happens if XYZ turns into an AIG?' There's a lot of misinformation out there. Technically, AIG didn't default on any annuity contracts, but the fear is there. You can feel it," says Milevsky, associate professor of finance at the Schulich School of Business in Toronto. "This is a big issue -- and it's not going away anytime soon."
Since the federal government bailed out insurance giant American International Group in 2008, there's been huge fallout that's landed right in the advisor's lap. Among the key questions advisors are asking:
"There's no roadmap," notes Lou Harvey, who heads Dalbar, a consulting firm in Boston. "The rules that have been established and developed over the last 100 years are essentially out the door. No wonder people are worried."
Caught in the crossfire: the annuity business.
In a special report on U.S. annuities in December, ratings agency A.M. Best reported 2009 sales, through the third quarter, were split almost evenly between fixed and variable annuities after 15 years of variable products' domination.
In response to the market meltdown, variable carriers are "de-risking" their products through higher pricing and less attractive living benefit guarantees, putting a drag on sales. Meanwhile, the report states, creditworthiness of variable products remains a concern, particularly for annuities with living-benefit guarantees.
As Briggs Matsko, an advisor with Lincoln Financial Advisors Corp. in Sacramento, puts it: "I can tell you that in my 33-year career, now more than ever I am looking at the solvency of all financial companies, to include the insurers....I believe advisors, now more than ever, have to make sure they look beyond the features and benefits of a company's products. At the end of the day and to our best ability, we must be comfortable that the firms we use can deliver on their promises."
A Regulator Responds
State insurance commissioners, charged with regulating the industry, say they have sharpened their scrutiny of life insurers -- and that overall the industry is positioned for success going forward.
"We are comfortable with the overall capital levels in the industry -- certainly much more comfortable than we were a year ago," notes Therese Vaughan, CEO of the National Association of Insurance Commissioners. "The way we think of risk has changed. We have done pretty deep dives into the companies and stressed them under various scenarios. We're looking at things at a more granular level."
Among the changes insurance regulators have put into place: a more thorough and more frequent stress-testing of companies that do a variable annuity business. When asked how frequent, Vaughan said "more than quarterly."
As an example, Vaughan says regulators are asking for additional and more frequent disclosures on lapsed rates (referring to people canceling their policies) and withdrawal rates (referring to people who cash out their policies.)
"It helps us to get to liquidity issues and whether we're seeing some reduction of consumer confidence," she says. "We're also stress-testing asset values and liabilities so we can see what the risk-based capital levels look like when asset values fall. We are digging into residential mortgage-backed securities and commercial mortgage-backed securities. As insurance regulators, we are asking ourselves: How can we do a better job of understanding the potential impact that group activities outside the insurance company could have on the insurance company?"
And at NAIC headquarters, the Financial Analysis Working Group, or FAWG as the peer review group is known, has also dialed up its focus. The group, comprised of top regulators, looks at companies referred to it by NAIC staff or by the states themselves.
"The level of activity, the number of conference calls, the number of companies looked at -- it's all been intensified," says Vaughan.
Looking back, Vaughan adds that the magnitude of the stock market collapse served as a wake-up call to companies that write variable annuities. In response, the companies have been redesigning their products to make them more conservative -- a "healthy" market adjustment that she says reflects a new awareness of risk.
As for insolvencies, Vaughan says they will occur in any given year, no matter the condition of the financial environment. At the end of 2009, seven life insurers were in "rehabilitation." Of those, three are "nationally significant" and two of the three have issues related to long-term-care policies. Three life insurance companies were in liquidation -- none nationally significant and one had troubles connected to fraud.
In the event that a life insurer has inadequate assets to cover a loss, state guaranty funds are prepared to step in, according to Vaughan. Most states cap annuity guaranty coverage at $300,000. In the late 1980s and early 1990s, when three major life insurers and a number of smaller companies failed, she adds, the guaranty funds came nowhere near to being depleted.
"We have never, in the history of the system, come anywhere near breaching the capacity of the life guaranty funds," she said.
In the aftermath of the financial system's meltdown, advisors need to do something critics say the insurance companies have failed to do themselves: clearly respond to client concerns about the financial soundness of the insurers.
"During the last year we struggled to find brochures or talking points we could use with clients that clearly and simply answered concerns about financial soundness," observes Matsko. "In all fairness, though, the regulatory environment does not always make it easy for companies to do so and the complexity that surrounds reinsurance and all the different state reserve requirements make it difficult to not only understand as an advisor, but to try to explain it all to the average client."
Milevsky agrees that there's a bridge that needs to be gapped.
Yet in conversations he himself has had in the corner offices of life insurers, executives have bristled when he's inquired about credit risk and financial soundness.
"They're deeply offended if you bring it up," he says. "It's the equivalent of cursing someone's mother. But the point is they need to do a better job explaining the protections consumers have when they buy annuity contracts."
As for the due diligence advisors should do when considering annuity contracts, ratings agencies -- despite the hit they've taken to their credibility -- should remain a part of the equation, according to experts.
"I simply do not know of a reasonable alternative," notes Joseph M. Belth, a life insurance industry watchdog and editor of The Insurance Forum. "In other words, you can't ask agents or consumers to do their own financial analysis of an insurance company."
Meanwhile, the insurance ratings agencies themselves haven't altogether ignored the new landscape. A.M. Best, for example, has not changed its overall process, which involves credit analysts' interactions with company executives, an understanding of a firm's operations and history, and access to confidential information. But A.M. Best, which rates 1,164 health and life insurers, has changed what vice president Andrew Edelsberg calls its "focus."
"We didn't change our process at all, but we changed our areas of focus based on what areas need to be drilled down further," he says. As an example, he explained, in the past when analysts attended ratings meetings, they would talk about operations, capital structure, the holding company, product design and investments -- and discussion about the investments in the insurer's portfolio would usually occur in an afternoon session and take 45 minutes to an hour.
Nowadays, he says, the investment discussion is first on the agenda, and usually takes a minimum of two hours. "We're spending a lot more time on issues that are the most critical," he adds.
When considering an annuity, advisor Victor Hazard, who heads Hazard Financial in Lomita, Calif., uses a system recommended by Belth, assessing a life insurer's soundness by ranking it against all four major ratings agencies: A.M. Best, Moody's, Fitch and Standard & Poor's. He's also careful, as a diversification measure, to put spouses in annuities held by different companies.
"The biggest legitimate concern is credit risk," says Hazard, whose firm is associated with H.D. Vest Investment Services. "If you're dealing with Western Podunk Annuity Co. offering agents a 15 percent commission and promising 10 percent Madoff-like returns -- and we get these solicitations from time to time -- throw them in the trash where they belong. But the fact is our clients need growth in their portfolios and annuities allow growth, but provide for the inevitable down market cycle. There's a need for them."
While ratings remain important, Vaughan says they're just one piece of information and that financial advisors need to be paying close attention to a lot of variables in the market.
"You can't dismiss ratings, but as we've learned, it's not the whole answer," she says. "Advisors need to do some of their own research. You never know when something might pop out." On her watch list: balance sheets and income statements and a look at trends in risk-based capital over time such as unusual accounting methods or changes in an investment profile or mix of business.
Advisors should also stay on top of what the insurer, analysts and the press are saying -- with one caveat. "You can't believe everything you read. There was a high level of concern this past year that not all that was written about the industry was legitimate," Vaughan adds. "It's also good to pay attention to how a company responds and how regulators respond."
Finally, Vaughan says financial advisors more than anyone else are in a good position to read market signals. Is the insurer writing a lot of business -- or more business than other companies? Is the firm underpricing competitors? Is it paying higher commissions?
"These are market signals that can be very valuable, and might be something regulators only find out about later," she notes. "Regulators don't always see that right away. A tuned-in advisor does."
Editor's note: Beginning with our next issue, Annuity Analytics columnist Moshe Milevsky initiates the first in a series of candid annuity product reviews, specifying what he likes and dislikes about a VA, along with recommendations for improvement.