Taking a punch: insurers never anticipated a bear market so long and deep that it would ravage their variable-products businesses--and cause them to rethink how they conduct them. (Life/Health: Annuities).

When economic times are bad and investment portfolios get hammered, most insurers can at least charge more for their products.

That option isn't available to writers of variable annuities, which generate revenues based on assets under management. These companies suffer the extra burden of lower revenues from their product portfolios, lower sales and the detrimental effects of greater amounts at risk. Some industry leaders say the losses will drive the most significant changes in variable-annuity design in the past 15 or 20 years.

Only three years ago, variable annuities were a nearly $1 trillion industry as measured by total net assets. By Sept. 30 of last year, that figure had fallen to about $750 million.

How have variable-annuity writers been hurt by this deepest of bear markets since 1929 to 1932? Let's count the ways:

* Sales have dropped. Three major gatherers of variable-annuity statistics--Limra International, the Variable Annuity Research and Data Service (VARDS) and Tillinghast Towers-Perrin--independently have reported premiums failing from a high of about $137 billion in 2000 to somewhere between $111 billion and $113 billion in 2001. They report sales of $83 billion to $88 billion through the first three quarters of last year.

* Fee income has fallen in line with assets under management. The fees linked to assets include mortality and expense charges, enhanced-benefit charges and fees paid to managers (often third parties) of a contract's subaccounts. Administrative fees usually are flat charges.

* Higher costs to cover greater exposure to death benefits and living benefits. Variable-annuity premium was greater in 1997 through 2000 than in all of the product's prior history Most of those sold in the four years of that recent bull market now have death benefits that are "in the money," the phrase the industry uses to describe its net amount at risk. That means the amount the investor paid in premiums less any withdrawals is greater than the current value of the contract. In some cases, however, the net amount at risk is greater because insurers provided death benefits equal to the highest anniversary value, a guaranteed growth rate compounded annually, or some other mechanism.

The exposure to these higher benefits is costly in a couple of ways. One is that under generally accepted accounting principles, insurers are allowed to amortize over many years the expense of acquiring the business as long as the business meets profit projections. When profits fall short, insurers must account for these deferred acquisition costs sooner, thus impairing their reported earnings. Insurers using statutory accounting must have reserves protecting the benefits. Although there is no formula for calculating reserves uniformly across all 50 states, the National Association of Insurance Commissioners and the American Institute of Certified Public Accountants are working on one that would be required under both GAAP and statutory accounting.

* Less availability of reinsurance. Some insurers have reinsured the death-benefit risk, but industry experts report the availability of this reinsurance has fallen sharply.

* Greater use of insurers' fixed accounts within the variable-annuity contract. These fixed accounts have rates that insurers have guaranteed never to fall below a certain amount. Some are as high as 4%, and the higher utilization of these accounts represents another drain on insurers finances.

Financial Repercussions

A.M. Best Co. downgraded the financial strength of six insurers during 2002 and January 2003 due to variable-annuity related issues: Allmerica Financial, American Skandia, Merrill Lynch Life, Cigna, Sage Life and Axa Corporate Solutions Life Re. Companies with negative outlooks due to variable-annuity issues are MONY and Transamerica Canada. Overall, A.M. Best downgraded 53 life/health companies and upgraded 19 during the 13-month period.

The declines in fee-based income and the drop in sales are probably the most significant factors hurting the variable-annuity writers, said Eric Sondergeld, Limra International's corporate vice president and head of its retirement research center. "These companies have been accustomed to asset bases growing--and growing rapidly--and to using them to fuel new development," he said. Product development "slowed to a crawl" during the bear market, he added.

One part of the variable-annuity business that hasn't worsened during the bear market has been surrender rates. Sondergeld said surrenders have never been high and that they fell as the stock market swooned. He attributed the reduction to a lack of attractive investment alternatives and to the fact that many death benefits "came into the money."

Sondergeld found some irony in the death-benefit situation. "These benefits were kind of poked at by the press, and now these benefits have value," he said. "That's a good thing. So it's a kind of blessing in disguise. It demonstrates the risk associated with the markets, and here is a feature that currently has some value."

Nancy Kenneally, senior consultant with Tillinghast Towers-Perrin in New York, identified exposure to guaranteed benefits as having the most detrimental effect on variable-annuity writers. She said some companies, particularly those that attracted buyers with high-performing funds during the bull market, face deep exposure and have increased reserves they need to hold at the end of the year. Making matters worse, reinsurance on these benefits "continues to be pretty much nonexistent," she said.

But Kenneally said that dwindling fee-based income also has been a big concern and that greater use of fixed accounts, which don't generate much in fees, has hurt writers, particularly if they are crediting an attractive rate. "Some companies have had to close their fixed accounts in certain products, particularly in C-share contracts, in which there is no surrender charge," she said. "Also, high rates in dollar-cost-averaging fixed accounts have been a drain on profitability, but we have seen those enhanced rates come down quite a bit."

Insurers set up special dollar-cost-averaging fixed accounts to attract contract buyers by offering exceptionally high rates. The buyers would then be required to invest periodically-- usually monthly--into other subaccounts in the contract over a specified period such as 12 months until the special account was depleted. Kenneally said that such accounts designed to be depleted over six months averaged rates of 6.05% at the end of June and 5.7% at the end of September.

Many variable-annuity writers have been able to offset losses in that business by writing more fixed annuities, in which they have been crediting at guaranteed rates in the range of 3.5% to 4%, Kenneally said. Insurers' earnings from fixed annuities come from rates on the money they invest that are higher than the rates they pay to contract owners.

On the positive side, any stock-market upturn this year would likely have an immediate positive effect on the variable-annuity industry. "It would rebound fairly quickly," she said. "Typically, we don't see a lag in sales. Sales follow the market." The rebound would be slower in variable life because it is more a protection product than an investment product and because the underwriting process extends the time required for a sale to hit the books, Kenneally added.

Historical Crossroads

But simply treading water until the stock market rebounds might not be good enough for the variable-annuity industry. Rick Carey, managing director of professional services at VARDS and editor of The VARDS Report, said the industry might have to retool and reprice its products to reduce the correlation between fee income and assets under management.

"This industry is at a crossroads the likes of which we haven't seen for 15 or 20 years," he said. "It will have to integrate and institutionalize the retooling of products to make profitability based on other metrics, not on account values."

During the bull market, recommendations by distributors drove product design, which was a case of "the tail wagging the dog," said Carey. Insurers felt a need to match the competition. "In the bull market, everybody was making so much money you could price these things in any shape or form," he said.

But the bear market brought clarity to the situation, "and consulting actuaries have been counseling companies that they really need to get a hold of their profitability and shareholder value," said Carey. Reining in the demands of distribution might be "part and parcel" of exercising financial responsibility, he added.

New Options

Carey said actuaries have told him this next generation of products is in the works. "These actuaries can't reveal their clients, but I understand these products are ready to be filed or already have been filed;' he said.

Part of the retooling might involve charging more for death benefits and living benefits. For example, guaranteed-minimum-income benefits are a "real bargain" for buyers today, according to Carey. "Many are priced at 25 to 35 basis points, which is not even at break-even;' he said. Guaranteed-minimum-income benefits, which come into play when contract owners are in the payout phase, are being "very well received;' said Frank O'Connor, senior industry analyst for VARDS. A typical GMIB guarantees an income floor even if the owner's variable accounts don't perform well. The newest kind of living benefit is the guaranteed minimum withdrawal benefit, according to Kenneally. It guarantees the contract owner can withdraw at least the net amount invested after the passage of a stipulated time--such as five years-- regardless of the performance of underlying investments. The owner might even be allowed to withdraw a nominal amount each year within the stipulated period. Kenneally said Hartford Life and ING have offere d annuities with the guaranteed minimum withdrawal benefit.

On the death-benefit side, new options include a 40% increase in the benefit to pay income taxes, said O'Connor. Unlike the death benefits of life insurance, those of annuities are taxable.

Regarding distribution, Carey said there is talk in the industry of more service-based compensation models along the lines of the managed-account business, in which the individual adviser rather than the product manufacturer earns a fee based on assets managed. But changes in compensation models might be easier said than done. The hard part for the industry is that some company usually is willing to take the risk of paying higher, transaction-based commissions to increase its distribution, Carey said.

Even if the industry is able to reduce its costs of distribution, its efforts to rebuild might be stymied by any regulatory requirement for higher reserves. Carey said some companies might have to reserve 10 or even 20 times as much as they do now "If such a requirement went into effect, a lot of companies would have to ask themselves whether it is profitable to be in this line of business," he said, adding that regulators don't expect any requirements to be so onerous that they could have a significant impact on the number of insurers offering variable annuities.

Carey said there is still much uncertainty facing the industry over the next three years. Measured in terms of net flows of money coming in, the industry is in worse shape than in terms of new sales. Net flows are new sales minus exchanges from existing annuities into new ones, and that gap has become very wide since 1996. In 2001, the industry recorded $106.6 billion in new sales, but only $30 billion of that amount was in net flow, according to data by VARDS. Through the first nine months of last year, new sales were $81.8 billion, but net flow was only $23.7 billion.

"If you're looking for signs of a rebound in the industry, you'll want to see net flows improve," Carey said. "And then there's the bear market. Company executives don't know where it's going. It's still an uncertainty. It could turn out to be four years and running, and that would force more people out of the business more consolidation."

[GRAPH OMITTED]

Variable Annuity Sales by Product Type

(Jan. 1-Sept. 30, 2002)

Product Descriptions

* A-Share--Annuities with front-end loads

* B-Share--Annuities with traditional back-end loads (surrender charge period is typically 7-8 years or longer)

* C-Share--Annuities with no back-end loads (no surrender charges)

* L-Share--Annuities with short surrender charge period of 3 or 4 years

* Bonus--Annuities that credit a bonus (typically 3% to 5%) of premium to the policyholders' account value at contract issue. Presence of the bonus may come with a lengthened surrender period, higher product charges, a lower gross dealer concession, reduced profit margins or some combination thereof.

* VIA--Variable immediate (payout) annuities.

                          Total                           % of     % of
Product      # of       Premium       # of  Average  Qualified    Total
Type     Products  ($ millions)  Contracts     Size    Premium  Premium

A-Share         2          $221      1,247  $74,087        52%       0%
B-Share       147        30,020    437,572   51,033        58       49
C-Share        49        15,750    294,222   93,791        68       26
L-Share        28         3,892     43,854   77,484        56        6
Bonus          35        11,137    128,060   72,953        53       18
VIA             3           238      1,662  143,378        79        1

Total         264       $61,258    906,617  $61,507        60%     100%

Source: Tillinghast Towers-Perrin Variable Annuity and Life User
Exchange

Net Investment Returns by Fund Type

Like the stock indexes, equity funds inside variable annuities fell
sharply in the year ending Sept. 30, 2002, based on a weighted average
net return. Bond funds provided positive returns, except for high-yield
funds.

                               1-Year Weighted  5-Year Weighted
                       Number          Average          Average
Fund Category        of Funds       Net Return       Net Return

Growth                  2,186           -19.6%            -3.3%
Aggressive Growth         772           -18.6%            -4.7%
Growth & Income           854           -18.6%            -2.6%
International Stock       768           -17.0%            -5.1%
Government Bond           110             7.2%             5.9%
Corporate Bond            311             4.5%             5.5%
High-Yield Bond           206            -3.2%            -4.3%
International Bond         54             5.2%             1.3%
Money Market              188             0.8%             3.6%
Balanced                  380           -10.6%             0.4%
Specialty                 343            -5.7%             3.2%

Total                   6,172           -13.5%            -1.2%
DJIA                                    -12.5%             0.8%
S&P 500                                 -20.5%            -1.6%

Source: Tillinghast Towers-Perrin Variable Annuity and Life User
Exchange