A.M. Best Report - Variable Annuity Risks: Secondary Guarantees.

OLDWICK, N.J. -- The life insurance industry has undergone an evolutionary, even revolutionary, change in the past two decades, as major insurers shifted their focus from protection-based businesses to accumulation and retirement savings products. Many factors contributed to this transition, including demographic trends, regulatory changes and the robust equity markets of the late '90s. Most major insurers now compete in the broader financial-services marketplace against banks and investment firms, according to a special report released by A.M. Best Co.

Among the industry's biggest innovations over the past 10 to 15 years has been the variable annuity. As the 1990s moved along and the stock markets rose, newer features were added to these products. In many cases, however, carriers did not adequately understand the potential pitfalls of such a heavy reliance on ever-increasing equity markets, according to a special report released Sept. 20 by A.M. Best Co. Since March 2000, insurers have begun to realize the full impact of the features they offered and what happens when the industry experiences a low-probability, high-cost "tail" event.

Variable annuities offer tax-deferred accumulation of investment funds that can be annuitized or withdrawn at a later date. In the late '90s, as competition for customers increased, companies began offering more differentiating features, secondary guarantees, to increase market share. These guarantees are benefit riders that have been added to the base annuity policy and provide policyholders with guaranteed minimum benefits based on the types of features they choose. These can be split into two main categories: guaranteed living benefits and guaranteed death benefits.

These secondary guarantees are, at their root, long-term put options that are sold to the policyholder for an ongoing basis-point fee. The policyholder's ability to exercise these options depends on the feature offered, while the strike price of these options changes over time based on accumulation attributes of the benefit guarantees.

The companies offering these benefit features are subject to two major risk categories that are outside of the company's control: policyholder-based behaviors and capital-market-based risks. Based on the differing nature of the benefit trigger, each type of benefit exposes the company to varying levels of adverse policyholder behavior. The capital-market risk is derived from the fact that the insurance company is guaranteeing certain returns on the assets invested. These guarantees put some of the investment risk, which variable annuities previously had passed on to the policyholder, back onto the insurance company's balance sheet.

This will be the first in a series of articles to explore the issues affecting variable annuities and how A.M. Best will review this segment as a part of analyzing variable annuity writers. This report outlines the basic features of secondary guarantees available in variable annuities and focuses on the risks of offering these features. In addition, this report outlines some of the risk-mitigation techniques available to companies. Finally, A.M. Best discusses how it views these items and how they will be incorporated into the rating process.

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For more information, visit A.M. Best's Web site at http://www.ambest.com.