Recently many investors in variable annuities have experienced unanticipated losses. Since some people purchase variable annuities based on the assumption that they are immune to market fluctuations, many have learned the hard way that, like mutual funds, variable annuities invested in equity “sub-accounts” can lose significant value. However, if a variable annuity is sold to a customer with a promise of safety or without adequate disclosure of risk, the customer may have valid legal claims for fraud or misrepresentation.
Some variable annuities offer “guarantees” that can be purchased at an additional cost. But it turns out that these guarantees may also be in jeopardy. Issuers of variable annuities face mounting losses from obligations relating to guaranteed payouts or guaranteed accumulation rights sold in connection with the annuities. Rising equity markets made these obligations inexpensive to fund, but in a declining market “costs associated with hedging and increasing reserves for the various guarantee riders on products are becoming more of an issue” according to S&P Equity Analyst Bret Howlett.
Other ratings agencies agree. In late October, the ratings agency Fitch issued a report concluding that equity market performance 2008 “will have a dramatic impact on U.S. life insurers active in the variable annuity market. Persistent adverse market conditions will pressure life insurer’s earnings and risk-based capital levels for the balance of 2008 and into 2009. The industry ability to manage this growing risk exposure represents one of the most significant risk management challenges confronting U.S. life insurers.”
In other words, there is some uncertainty that the insurers will be financially able to meet their financial obligations, including making guaranteed payments.
Fitch estimated that capital (and reserves) needed to support the variable annuity business in the United States has increased by up to $15 billion during 2008 year-to-date, due to the dramatic decline in the equity markets. At the same time, earnings have been negatively affected due to lower fee income from declines in net asset values, higher hedging costs and increased reserve requirements to support the product guarantees.
Declining equity markets are already taking a toll on the companies’ earnings. As Justin Menza of S&P explains in a recent Businessweek article, companies use a process called deferred acquisition cost as a way of amortizing commissions and other sales costs associated with the annuities. If a sustained decline in equity markets reduces estimated gross profits on annuities, the assumptions used to amortize the sales costs are “unlocked,” causing the deferred costs to amortize faster. Also, such changes in assumptions may lead to increased reserves for products with guaranteed minimum death or living benefits.
Hartford Financial Services Group, the second-largest annuity seller in 2007, is suffering from the volatility in the financial markets during the third quarter. The company posted a $522 million loss in core earnings in its annuity business during the quarter, compared with a profit of $365 million a year prior. Assets under management in its annuity products fell to $103 billion in the period from $133 billion a year earlier.
As the equity markets continue to decline, variable annuities are also becoming less attractive alternatives for investors. According to data from NAVA, a variable annuity trade organization, second-quarter variable annuity sales dropped 11.2% from year earlier levels, while net assets were down 3.3% year-over-year in the period. For the first six months of the year, total sales were $83.6 billion, a 5.2% decline from the comparable period in 2007. Menza concludes this trend likely continued into the third-quarter as equity markets sold off further, making many potential customers wary of purchasing the products despite the minimum guarantees offered. Another factor contributing to the decline is sales is the likelihood that issuers will increase the costs of guarantees, according to Howlett.
Page Perry has represented numerous variable annuity investors in making claims to recover losses resulting from fraudulent sales practices or unsuitable recommendations.