A Changing Variable Annuity Landscape -- What to Watch for in the Next Few Years

This is the second part of an interview with variable annuity industry analyst and consultant Ryan Hinchey

The first part of the interview, which can be found here, addressed the consumer perspective on variable annuity products.

Q: Again, 2008 was an incredibly difficult year for many insurers, and certain variable annuity companies were hit especially hard.  Providers of variable annuity products are able to hedge their risks in order to provide the products.  Can you briefly comment on how effective some of the hedging programs were in 2008?

Ryan: Analysts have mentioned that hedging programs among variable annuity companies contributed to the preservation of approximately $40 billion in capital.  This translates to a 93% level of effectiveness – in extreme markets – typically more effective in more stable markets.

Q: The financial crisis appears to be separating the stronger and weaker players in the variable annuity industry.  Can you comment on the relative strength of some of the insurers and the possibility of industry consolidation?

Ryan: Most companies are stronger than what is perceived by the general public.  That said, certain insurers are simply in defense-mode and are looking to shore-up capital and ratings.  The defensive companies may be looking to essentially sit out the next round.

It is interesting that Sun Life has strengthened their wholesaler network to increase their market presence.  New York Life has made some noise about getting involved in the guaranteed space. Prudential seems to be in a relatively strong position.  In part, Prudential attributes this to their dynamic asset allocation strategy.  MetLife’s CEO recently commented about the company’s earnings and attributed part of their strength to their focus on guaranteed minimum income benefits (GMIB) versus guaranteed minimum withdrawal benefits (GMWB).  MetLife is very strong on GMIB and feel it is less risky. 

Q: Is the possibility of industry consolidation and capacity constraints a negative for the consumer? 

Ryan: Insurers are a bit more cautious and conservative.  The best prices and rich guarantees are gone for near-term.  In this new era we will see more insurer responsibility and reassessment of product lines.  There is still value out there for consumers who want upside potential with guarantees.

Q: What about innovation in the variable annuity industry? What might be in product pipelines?

Ryan: Product simplification will be a major focus.  One of the first of a potentially new breed of variable annuity products would offer more simplistic benefits.  For example, reducing benefit features by forcing policyholders to delay withdrawals for 5 years and limiting ratchets to a 5 year minimum.  Also, limiting the range of investment choices will come into play.

Product simplification or losing all bells and whistles might result in M&E and rider fees that total 174 basis points plus 3% front-end load.  But the load is because there is no surrender charge.

Also, there is discussion of a volatility index (and possibly interest rate index) that is specifically for variable annuity products.  The rider charge or the withdrawal percentage would be based on the indexes.  Insurers would be able to charge true market price to consumers rather than modifying features.  That said, this would also introduce another level of consumer complexity. 

The index concept is in early development.  The main objective of the concept involves attempting to fix the disconnect between the price charged to policyholders and the costs insurers incur in manufacturing the guarantee.

Q: What, in your opinion, gets the variable annuity industry to the next stage where companies are beyond the crisis and self-preservation mentality? 

Ryan: The markets must improve.  Volatility must decrease and interest rates must increase.  Until that day comes insurers will be very cautious with products they design.

Q: Can you provide some thoughts and comments on what you think the industry might look like five years from now?

Ryan: The answer is very path dependent, uncertain and market driven.  Insurers need to be in a position where they can make profits on these products.  If existing players are profitable in the next few years, I would expect more players in the market—more on the insurer than the asset management side. 

There is potential for guarantees to get richer, but tough to say in what capacity. 

Coupling annuities with long-term care seems likely.  There is also very big opportunity to add living benefits to 401k plans. 

Asset managers will focus more on dynamic allocation to attempt to keep fund volatility more constant.  There will be more passively managed fund options and exchange traded funds with lower fees.  There will likely be fewer overall fund options.

There is very little reinsurance in the market now.  This may change in the future if the market turns around and insurers design products with less risk.  This will help to reduce capacity constraints that primary insurers have. 

Q: Any last thoughts or comments?

Ryan: In general, this is a very interesting time in the variable annuity industry. There is a new wave of products that covers the entire spectrums of simplicity versus complexity and price versus features.  Ultimately consumers and brokers will decide where the best value proposition lies on these spectrums.  Capital markets will determine path of industry to great extent.  The industry is at a cross-road—it will be interesting to see what lies ahead.

Key Phrases Manual: 


What is a ratchet and how would limiting a ratchet to a 5 year minimum make a variable annuity product simpler?

Ratchets are mechanisms that increase the benefit base value to the account value during up markets. This in turn would increase the lifetime guaranteed withdrawal level available to the policyholder.

To give an example, lets say a Guaranteed Lifetime Withdrawal Benefit (GLWB) product has an annual ratchet, and it guarantees the policyholder can withdrawal 5% of the benefit base per year for life.

The policyholder initially deposits $100,000 which is invested in mutual fund like "sub accounts." At this time, the benefit base is set equal to the account value of $100,000. The guaranteed lifetime withdrawal amount is 5% of 100,000 or $5,000.

At the contract anniversary (1 year after the purchase date), lets say the account value has grown to $110,000 due to the positive fund performance of the underlying investments. For a product with a ratchet, the benefit base will increase or ratchet up to the account value, since it is higher than the existing benefit base. So now, the benefit base = $110,000, and the lifetime withdrawal amount is 5% of $110,000 or $5,500 a year.

Conversely, if the market had declined to say $90,000, the benefit base would have stayed at $100,000. Therefore, this allows upside participation and downside protection of the guaranteed lifetime income.

However, the rider fee is typically a percentage of the benefit base. So, when benefit base increases, so does the dollar amount of fees. If the rider fee was 1%, then the policyholder would have paid 1% of $100,000 or $1,000 in fees in the first year, and 1% of $110,000 or $1,100 in the second year. This fee is deducted from the account value, but does not effect the lifetime withdrawal amount.

When shopping for products in the market, the frequency of ratching may differ. In the above example, I illustrated an annual ratchet. However, there are products that offer more frequent ratcheting, such as quarterly, monthly, or even daily. Also, some products have less frequent ratchet, such as once every several years, or just once at the 5th anniversary. In addition, while this is not the norm, some companies may add a cap to the ratchet, such that the maximum amount the benefit base can increase in any one year can not be greater than say 10% of the existing benefit base. Therefore it is important to understand how the ratchet may differ when comparing several products.

Feel free to follow up if any of this is unclear.