Size does matter: in the variable annuity market, economic forces are making it harder for midsized and smaller players to compete with top-ranked companies.

The thriving equity markets of the 1990s spawned a host of popular insurance products, with customers jumping at the promise of rapid returns and flexible investment options. Variable annuities were the most successful, experiencing a compound annual growth rate of 22.5% from 1995 to 2000, the fastest growth of any life insurance product in that period.

But with the market meltdown of 2001 came a new climate. Insurers were left with write-offs of deferred acquisition costs and diminished fees from variable annuities (and, to a lesser extent, variable life insurance). Even now, with the equity markets showing signs of renewed life, the fate of many variable-annuity issuers remains uncertain. Manufacturers are losing revenues to independent distributors and seeing their margins drop. In addition, the Bush administration's new tax plan poses a threat to future variable-annuity sales by lowering the maximum rate on capital gains for competing investments such as mutual funds and individual securities. The plan puts higher-cost variable annuities--in which withdrawals of investment gains are taxed at the investor's income rate, not the capital gains rate--at a disadvantage.

For many manufacturers of variable annuities, the economics of the business have become unsustainable. With variable annuities, size matters. Smaller insurers increasingly are disadvantaged against larger rivals, whose size gives them a negotiating edge with distributors and asset managers. The smallest players simply don't have the economics to compete in the business over the long term.

Midtier companies also will have ramble going toe-to-toe with the market heavyweights; our research suggests that margins on new business written by large insurers are five to eight times those of midtier players. Midtier insurers can pursue a few options, including making "protected" acquisitions or leveraging captive distribution, which might enable them to sustain their current business. Some of these midsize companies, however, are likely to decide that the risks outweigh the potential rewards in an uncertain variable-annuity environment, and they will exit the market, following the lead of Skandia, CNA Financial, Allmerica and others.

Weakened midtier players looking to sell their variable-annuity businesses present the best opportunity for large players that choose to stay in the variable-annuity game for the long haul. These large players must think even bigger. Our research shows the scale of an insurer's variable-annuity business--driven by advantages of scale in asset management, operations and, to a lesser extent, sales--will go a long way toward determining its future success.

The key for these large players is determining how to increase their advantages of scale in a stagnant environment. Since organic growth in excess of the market's underlying rate of growth has proved extremely difficult, acquisitions might be the best option for market leaders pursuing a sustainable strategy for growth. Yet potential acquisitions must be vetted carefully for adequate pricing of contract features such as guaranteed retirement income benefit and guaranteed minimum death benefit.

The lure for players that choose to fight remains the size of the prize: Despite two years of moribund performance, total net assets in variable annuities still are around $800 billion.

The Scale Advantage

Understanding the impact of scale in the variable-annuity business is critical when considering strategic options for growth. In the traditional economic sense, a scale curve shows that as a company's sales increase, its margins follow suit. In creating a similar scale curve for the variable-annuity business, we compared economic value margins--calculated by dividing the present value of future cash flows by the present value of premiums--with assets trader management to see how these margins correlate with the size of the business.

The clear advantage in this case lies with the eight to 10 largest players--those with at least $25 billion in assets trader management and $4 billion in annual sales. Midtier players (assets trader management of at least $6 billion and sales of at least $1 billion) increasingly are at a competitive disadvantage, while smaller players clearly have unsustainable economics.

We've identified two primary causes of these scale effects:

Asset management--Insurers often use third-party asset managers to manage the underlying funds in their variable-annuity products. The more assets the insurer can bring to the table, the more leverage it has in negotiating pricing from fund managers. We believe large insurers have an economic value margin advantage of 50 to 60 basis points over midsize insurers. This advantage is becoming more pronounced as large players decrease the number of asset managers with which they do business. Consolidating fund managers increases assets under management per manager--resulting in more favorable terms for carriers.

Operations--Variable annuities require both new business processing (such as opening the account and entering customer information) and ongoing servicing (including maintenance and overhead costs). Efficiencies in scale enable large carriers to drive down expenses in these areas, giving them an economic value margin advantage of 10 to 15 basis points over midtier players. Hartford Financial, for example, has leveraged its scale to drive down unit operating expenses significantly. In 1992, when it had $6 billion in assets under management, Hartford's variable-annuity administrative cost ratio was 43 basis points. By 1999, as its assets under management approached $80 billion, its variable-annuity administrative cost had fallen to 21 basis points.

Sales operations also provide an advantage of scale, albeit a much smaller one than asset management and administrative operations. Manufacturers that can leverage a large wholesaling force to support the broker-dealers and banks that sell variable-annuity products, or those that can develop a larger captive distribution force to build and support a more valuable brand, can gain an economic value margin of 1 basis point over smaller competitors.

The implications of advantages of scale for larger players are twofold. First, they have more available margin to invest in distribution, meaning they can pay more for distribution than other players while still meeting financial-return targets. Second, they can extract more value from acquisitions. Not only can they afford to pay a higher price and still make the purchase successful, but as large, sophisticated players in the variable-annuity marketplace, they also are in a better position to evaluate the pricing of embedded options for each block of business.

Outlook

Lacking efficiencies in these areas, subscale variable annuity players will have a difficult time capturing market share from leaders, particularly through important independent channels. Success will be impossible for small players and difficult for midtier players. Only the very large can compete credibly. As changes to past size rankings show, it's difficult to move up the ladder ("Top Variable Annuity Players," left).

There are exceptions. Two of the biggest gainers on the list, Aegon/ Transamerica and Pacific Life, took different growth paths, with different results. Aegon grew through manufacturer acquisitions, primarily Providian's insurance business in 1997 and Transamerica's ha 1999. Pacific Life, on the other hand, grew through retail distribution acquisitions, including Associated Securities and United Planners Financial Services, gaining privileged shelf space and better bargaining power in newly owned channels. When equity markets were booming and investor demand for variable annuities was high, acquiring distribution made sense. Smaller insurers owning distribution could increase sales--via most-favored product placement in growing distribution channels--to compete against much larger players. Today, with variable-annuity sales sagging, that wave has disappeared.

Competition for market share in independent channels is pushing market leaders to bid up the cost of distribution--which increases the share of total economics captured by distributors. This shift is weakening subscale players' position by cutting into their economic value margins. Unless subscale players expand their distribution at a much faster rate than the market leaders--highly unlikely given their shrinking margins--they will always be at a disadvantage. As a result, they will continue to slide down the scale curve--and the gap between top-tier and second-tier competitors will widen. This downward movement likely will force more midtier insurers--and even some large-scale players--out of the variable annuity market.

Simply spending more to grow is not the answer, as manufacturers such as American Skandia have discovered. In the 1990s, Skandia made a major commitment to its U.S. variable-annuity operations, building up American Skandia's wholesaling force and creating an attractive product portfolio for the group. Its initial returns were promising: assets under management rose from $8 billion in 1996 to $25 billion in 2001. But when the bottom fell out of the equity markets, Skandia's model proved unsustainable. Despite its position as a top-10 variable-annuity player, Skandia found itself in a significantly weakened position when it sold its U.S. operations to Prudential.

Strategic Options

In this maturing, consolidating market, Skandia learned that organic growth in variable-annuity sales (other than modest growth in captive channels) was difficult to sustain. Acquisition is then the only real choice for expansion.

Because of the shifting scale curve, midtier players have almost no chance of breaking into the top 10 and thus would not be served by an aggressive acquisition strategy. Midtier carriers have five primary options:

* Pursue "protected acquisitions," or those that do not attract a large player because of incompatible technology platforms, smaller size or poorly understood risks; midtier carriers must test their own abilities to evaluate the pricing adequacy of embedded options in each block of business.

* Leverage captive distribution, which will not yield significant growth but might allow for sustainable economics over time, provided third-party products are not introduced into the channel.

* Invest in privileged independent distribution and hope that some semblance of the bull market of the 1990s returns to boost sales--an obviously risky tactic.

* Begin winding down the variable-annuity book by significantly increasing profit margins on existing blocks and allowing market share to slowly erode as distributors migrate to less-expensive products.

* Sell to a buyer looking to increase scale.

Large players executing an acquisition strategy will be able to drive even greater efficiencies throughout their businesses in the three key areas of asset management, operations and sales. Such a move can help current leaders to solidify their positions as the variable-annuity market works itself back into shape.

Top 25 Variable Annuity Players

When comparing variable annuity company rankings in 1996 to 2002's,
only one company, American Skandia, moved into the top 10 ranking of
variable annuity players. Aegon/Transamerica, Pacific Life and
Jackson National made the biggest gains on the list.

                                             2002           1996
                                     Assets Under   Assets Under
2002                                   Management     Management
Rank   Company Name                  ($ Billions)   ($ Billions)

 1     TIAA-CREF                             $229           $180
 2     Hartford Life                           61             32
 3     AIG/SunAmerica/VALIC                    50             22
 4     Lincoln National                        36             27
 5     ING Group                               34             14

 6     Equitable                               32             21
 7     Nationwide                              31             16
 8     Metropolitan/NEF/Gen Am/MLI             28             10
 9     IDS                                     24             20
10     American Skandia                        21              8

11     AEGON/Transamerica                      21              4
12     Travelers                               17              6
13     Pacific Life                            17              2
14     Manulife                                16              7
15     Sun Life Financial                      15              9

16     Prudential                              15             14
17     Allstate                                12              5
18     Allmerica                               12              5
19     New York Life                           11              3
20     Fidelity                                10              6

21     GE Financial                             9            N/A
22     Thrivent                                 8              5
23     MassMutual                               8              7
24     Merrill Lynch                            7              5
25     Jackson National                         7            0.4

       Industry Total **                     $788           $501

2002                                 1996    Change
Rank   Company Name                  Rank   in Rank

 1     TIAA-CREF                        1         0
 2     Hartford Life                    2         0
 3     AIG/SunAmerica/VALIC             4        +1
 4     Lincoln National                 3        -1
 5     ING Group                        8        +3

 6     Equitable                        5        -1
 7     Nationwide                       7         0
 8     Metropolitan/NEF/Gen Am/MLI     10        +2
 9     IDS                              6        -3
10     American Skandia                13        +3

11     AEGON/Transamerica              26       +15
12     Travelers                       17        +5
13     Pacific Life                    35       +22
14     Manulife                        14         0
15     Sun Life Financial              13        -2

16     Prudential                       9        -7
17     Allstate                        21        +4
18     Allmerica                       19        +1
19     New York Life                   29       +10
20     Fidelity                        16        -4

21     GE Financial                   N/A       N/A
22     Thrivent                        23        +2
23     MassMutual                      15        -8
24     Merrill Lynch                   20        -4
25     Jackson National                57       +32

       Industry Total **

* Merged players are reported on a combined basis in 1996

** Data is representative of the VARDS company universe only

Source: Variable Annuity Research and Data Services Report

Mark Anema is an associate and Matthew Kramer is an associate principal in McKinsey & Co.'s Minneapolis office; Cyrus Taraporevala is a principal in the New York City office.