In response to the S&P’s Supercomposite Life & Health Insurance Index falling 60% in the past year on costs to back variable annuities, we decided to ask some questions. For this, we turned to Doug Dannemiller, senior analyst at Aite Group, LLC, who focuses on wealth management and retail investment.

How does risk vary by annuity type offered by insurers?

The risk that the insurers are taking is the risk of downside market movement. What they’re doing under the three general classes of benefits in a variable annuity is either paying out that risk in a one-time payment in a GMAB [Guaranteed Minimum Accumulation Benefit]. So, if you’re in seven years and the market’s down 10%, they said you wouldn’t lose any principle – you’re now free to move about the country with your money and the GMAB is 10% of the money. They pay it up and off you go.

The other two options of risk are the GMIB [Guranteed Minimum Income Benefit], which is at that same “after seven years, you’re 10% down.” Well you now have the option to annuitize with that insurance carrier, which will turn your principal into an income stream for life at a conversion factor that is at a spot rate, as opposed to a rate that was set seven years ago. That conversion equation happens, then the insurance company obviously takes the entire amount of principal but pays out on the amount that would’ve been 10% higher.

So, depending on how they account for all that, there’s a book of profit involved in the annuitization equation as well as the sort of marking up to the 10% gain. So that’s a slightly different transaction for the insurance company.

The third general class of guaranty doesn’t involve annuitization, nor does it involve “you take the money and you’re free to move about the country.” It is one where you keep it in accumulation phase and you can withdraw up to 7% for a certain period of time without risk of running out of money. It neither involves the booking of profit, nor does it involve having to gross it up all at once and, in this final scenario, the assets are still invested in the market, so you’re essentially extending the time period that you’re guaranteeing from a minimum of seven years on to something like 12 or 14 years.

So those three scenarios, just on the product differentiation are significantly different.

What is the severity of the risk in regards to these annuities?

The severity of the risk is that if it was sold in the last seven years, they’re most likely “in the money” in terms of that option, that guaranty. So, the insurance carriers are on the hook to make up the difference between market value and guaranteed value. The risk is that they have to make those payments.

How will insurers in general be impacted by this?

New sales are the lifeblood of any product line and it used to be that advisors were looking at the richness of the guarantees offered on these annuities to make these selections. They’re still doing that, but they’re also putting equal weight behind the question: what is the long-term viability of the insurance carrier that is backing these guarantees. The advisors say, “OK, this is the gurantee, but are they going to be able to meet this seven years down the road?” So, insurers are being viewed more as a long-term investment, as opposed to just being a product provider. The credit quality of the insurer is now more of a commodity; I think it’s a differentiator now.

How can insurers hedge against such risk?

They can use futures and options. Sophisticated programs were put into place at a few of the insurers to do so. And I think the basic issue is that they were charging somewhere between 50 and 100 basis points for these guarantees. My estimate is that it would be much more than that to completely hedge the risk.

Warren Buffet has said that life insurers “took on an ungodly amount of risk.” Do you agree with this statement?

I would put it differently. I don’t think they were appropriately compensated for the risk that they did take. I say it that way because I think that the product is actually at the right price, both good for the consumer and the insurance carriers.

What do you see in the future in regards to life insurance and variable annuities?

I think annuities, especially with guarantees, are important products for utilization in a well thought-out financial plan for retirement. Having a downside guarantee with five or six years to go until you plan to retire and needing that money to grow a little bit, I think is a good idea.