Life after the fall. (Variable Annuities Life/Health).

In light of the drop in the stock market, scale will play an increasingly important role in the variable annuity market, and insurers will re-examine their overall approach to offering investment-oriented products.

After five years of a great ride in the equity markets, the variable annuity market has entered new territory in the past 18 months--a down market. The technology-led boom was the first to go in the spring of 2000, followed by an ongoing erosion in overall corporate earnings and a downturn in economic results. The tragic events of Sept. 11 provided a further jolt to the equity markets, which subsequently dropped 15% (although they have largely rebounded). In addition to the overall drop, the increased volatility in the equity markets has spooked many investors.

The cumulative effect of these events is significant:

* The drop in the equity markets has led to a decreased asset base.

* The drop in the equity markets has resulted in significant increases in exposure to companies on their guaranteed minimum death benefit and living benefit coverages.

* Sales of variable annuities have fallen in each of the last five quarters through Sept. 30, 2001, and year-to-date sales for 2001 are down approximately 20%.

* The market downturn has put pressure on companies' expense levels, as well as on their ability to retain assets, because of lower asset-based fees and lower sales.

The combined effect of lower fees, increased costs of guarantees, lower sales, higher maintenance expenses and ongoing concerns on asset retention has put a full-fledged assault on profits for variable annuity products. Although many in the industry knew that the good times of the late 1 990s would not last forever, the current downturn has been fairly dramatic, and the outlook is mixed at best. Moreover, companies are experiencing similar pain in their other variable-accumulation businesses--mutual funds and variable life.

What do the current market conditions suggest about the future of the variable annuity business? While a significant pullback among most companies is not anticipated, a certain amount of retrenching and redirection of effort will surely occur. In particular, scale will play an increasingly important role in the variable annuity market, and companies will re-examine their overall approach to offering investment-oriented products.

To better understand prospects and the role of scale for the variable annuity market, it is helpful to take a look at where it has been in the past.

A Look Back

In the article "Scaling Annuities," published in the January 2000 edition of Best's Review, we assessed the state of the variable annuity market.

At that time--a period of 15% to 20% annual growth rates--the primary focus of the variable annuity market was on growing assets and increasing market share.

New perspectives were beginning to emerge on the role of scale and the minimum level of sales and assets under management required to achieve competitive advantage in this market. There were two components to this advantage: distribution scale and manufacturing scale. Our analysis suggested that advantages of scale emerged for those companies with $1 billion or more of sales and $5 billion or more of assets under management. Companies that could reach these minimum figures were able to produce lower unit costs and, thus, generate a "scale dividend." This scale dividend could be used in one of several ways, including taking more profits to the bottom line or investing in a better offering (that is, one with better product features, more wholesalers or backed by a greater investment in technology).

Finally, we saw the potential for a market shakeout in the future most likely driven by a major economic and/or regulatory change.

The variable annuity market has changed considerably since 1999, although some similarities remain.

A major issue today is the increased cost of guarantees. Players in the variable annuity market have historically used guaranteed minimum death-benefit and living-benefit features to distinguish themselves in an increasingly crowded marketplace. In the past, a number of companies have used reinsurance to reduce or eliminate their exposure. Now, however, reinsurance availability has largely dried up, leaving those insurers to explore other options. For those companies that have retained the risk, there is a greater appreciation of the true cost of these features. Although not yet widely used, several insurers are now exploring hedging strategies as a means to manage their exposure.

Another significant trend is the apparent increase in distribution costs. In some cases, this has been driven by a handful of companies that are trying to differentiate themselves through higher commission payouts. Another contributing factor is that some distributors appear to be increasing the "toll" for selling in their systems.

Some companies are increasing overall fee levels on variable annuities. This has occurred either through increasing fee charges for certain product features (such as guaranteed minimum death benefit) or by increasing fund charges (perhaps by adding 12b-1 fees), a portion of which gets recycled back to the manufacturer.

Other companies have been reluctant to increase fee levels. Rather, they have "paid" for increased costs by accepting lower profit targets.

Variable annuity companies appear to be having a tough time living within their targeted level of maintenance expenses. This has created expense pressures that are exacerbated when viewed as a percent of assets, as fund balances have dropped.

Asset retention has taken center stage. Persistency on variable annuity contracts has been generally favorable through the end of the surrender-charge period, but then tends to spike up as distributors and consumers re-evaluate whether monies could be deployed elsewhere. Poor fund performance statistics do not help in this regard. Nor do the recently introduced bonus annuities that make the contract holder whole based on early surrenders. This issue is becoming more visible as the industry is increasingly reporting on a net sales basis. Net sales for 2000 were reported to be only 28% of gross sales, down from 45% in 1999.

We continue to see ongoing product-development activity, as carriers look to differentiate themselves. Two of the product designs that are most in vogue right now are enhancements to the earnings enhancement benefit (EEB) and the introduction of L-share variable annuities (characterized by a three-to four-year surrender charge).

Sales continue to be through fairly traditional channels, such as stockbrokers, commissioned financial planners, banks and life insurance agents. There does not yet appear to be the innovation in distribution that we see in the mutual fund market, where sales have grown through mutual fund supermarkets and fee-based financial planners.

Tillinghast has recently undertaken two studies to gain a fresh perspective on the variable annuity market. The first is the "Tillinghast Annuity Wholesaling and Distribution Cost Survey," which examines companies' wholesaling operations, including wholesaler productivity and compensation, structure, product mix, support operations and distribution costs.

Key findings from the survey include the following:

* Average wholesaler productivity has risen 17% from the 1999 study, to $79.6 million from $67.8 million.

* Average wholesaler compensation has risen 7%, to $195,300 from $182,000. It is interesting to note that the increase in compensation is less than the increase in productivity, which suggests companies are moving to rein their unit compensation costs.

* The average size of wholesaling forces has more than doubled, and four companies report wholesaling forces in excess of 75.

* Scale clearly has an advantage. Actual sales and marketing costs (including wholesaling compensation and benefits, expenses, sales desk, marketing materials and conference fees) average about 125 basis points for the survey group. But there is a significant difference in costs for large vs. small companies--defined as companies above or below $4 billion of annual sales. (Sales include fixed annuities, mutual funds and qualified plans, in addition to variable annuities). Large companies were found to have unit-distribution expenses approximately 50 to 100 basis points below those for small companies.

The second study is Tillinghast's "Annuity Expense Survey." It is designed primarily to examine product-manufacturing expenses, including maintenance and overhead. Some of the key findings include the following:

* Maintenance costs on variable annuities appear to be somewhat difficult to control. The average expense for 2000 was $98 per policy in force, which is up 26% from the 1998 result of $77 per policy. But when expressed as a percent of assets, the increase is not as significant, increasing only three basis points to 20 from 17.

* The survey provides evidence of scale on the manufacturing side. The chart below shows per-policy costs for large companies (defined as companies with $10 billion or more of assets) vs. small companies. This advantage holds for each of the two primary components of the maintenance function: service and data processing/technology

* Another component of manufacturing is overhead. Here, the scale results are inconclusive. This may reflect differences in companies' allocation procedures and/or differences in the relative size of their variable annuity business vs. other businesses.

Looking Ahead

Going forward, we see several trends that will shape the variable annuity market.

Profit pressure will intensify. We suspect that most companies will be less willing to invest significantly in the variable annuity market to grow market share. There already appears to be some rationalization in wholesaling forces, as companies strive to achieve their unit cost goals. Additionally, we believe that some smaller subscale players will be forced to exit the business or participate in a different way.

The battle for strategic shelf space continues, and distribution relationships are changing. More and more of the "independent" broker-dealer firms are now owned by life insurers. While they still maintain their independent orientation, owners of these systems are increasingly looking to them as bargaining chips to trade access into other distribution outlets. While carriers must "best of breed" status in their variable annuity offerings, owning retail distribution can be a powerful tool in growing variable annuity business.

Variable annuity manufacturers/wholesalers are broadening their product portfolios. Wholesale operations are expanding to support additional products, including mutual funds, 401(k), life and fixed annuities. This model facilitates the cross-selling of products, which has become a goal of several organizations looking to support a broader range of products. While product portfolios are expanding within the wholesaler operation, specialization is still common at the individual wholesaler level, particularly for the more complex life and pension products.

Clearly, insurers will be taking a closer look at the guarantees they provide on variable annuity contracts and methods to mitigate the risk. We see continued growth in the FEB feature, as it serves as a counterbalance to the guaranteed minimum death-benefit feature (that is, it costs less as markets decline). We also believe that more and more companies will look to hedge a portion of their guaranteed minimum death benefit exposure to reduce earnings volatility. At this point, we do not see any companies willing to lead the move to reduce product features, although we suspect this may be under review

More attention will be paid to fee levels, which have generally increased. We suspect consumer pressures will discourage continued increases. The industry will need to consider ways to avoid future increases and may need to explore the potential to decrease them.

The annuity market has reached a new stage in its life cycle. The promise of unlimited growth that characterized the late 1990s has given way to the new realities of today's marketplace. In the face of a more demanding market, annuity manufacturers must return to the basics--understanding and managing the underlying risk of the business, building and managing an annuity wholesaling and manufacturing operation capable of achieving and exploiting scale and delivering a portfolio of products to its distribution partners and consumers that meets customer needs and risk appetites.

In short, it is time for the market to separate the pretenders from the contenders.

John M. Fenton is a principal of Tillinghast-Towers Perrin in Atlanta and head of the firm's financial-services product suite practice. Eric Speer is North America regional manager for Tillinghast-Towers Perrin.

2000 Actual Costs of Variable Annuities Per Policy In Force

Scale provides advantage for each of the two primary components of the
maintenance function.

By Function

                            Large Companies (*)  Small Companies  All

Servicing                   $47                   $65             $51
Data Processing/Technology  $44                   $51             $46
Total Maintenance           $91                  $116             $98

As % of Assets

                            Large Companies (*)  Small Companies  All

Total Maintenance            19                    25              20

(*)Large companies are those with $10 billion or more of assets.

Source: Tillinghast Towers-Perrin

Note: Table made from bar graph