Brand-name or in-house?

The most fundamental decision a variable-annuity writer must make is whether to offer funds from outside companies or to create its own funds from scratch. One is not inherently better than the other, but proprietary funds might be a better choice if an insurer wants to precisely tailor a portfolio for its annuity product, said Richard Reilly, former president of Allmerica Financial Services.

An insurer can design a proprietary fund to precisely fit into an investment style that is needed to fill a client's asset-allocation needs, said Reilly, who in his retirement makes presentations on behalf of the National Association for Variable Annuities. "If you take it off the shelf, you're getting a more generic version," he said of outside funds.

Outside funds provide instant name recognition and long performance records, but they are freestanding funds not controlled or managed by the life insurer. That means they have their own boards of directors, which are supposed to keep an eye on management and performance. If unhappy with performance, style drift, a change of managers, high expenses or changed investment objectives, an insurer is usually limited to closing the fund to new purchases by policyholders and/or not offering it in new products, said Nancy Kenneally, senior consultant with Tillinghast Towers-Perrin.

Proprietary funds, on the other hand, can afford insurers and the fund's board of directors "a clear and obvious role" in running the fund, said Reilly. In some cases, the variable-annuity writer will manage such a fund, but if the task is beyond its ability, it will hire an outside subadviser. If a fund has problems, the insurer/board of directors has more options in how to respond, including a change of managers. Most writers employ a combination of outside and proprietary funds, Reilly said. When he was at Allmerica, the company initially chose freestanding funds for its variable products, but later became comfortable in managing the fixed-income accounts, he said.

The costs of freestanding and proprietary funds are also different. Companies need seed money to create proprietary funds. Among startup costs are boards of directors and fund managers, but ongoing costs might be lower than those of freestanding funds, Kenneally said.