Wednesday, December 3, 2008

The Full Story on Annuities

Annuities and their issuers have been all over the news lately - getting a lot of bad press. It's one thing to report the truth about the industry, but its another thing to talk negatively about a subject an author doesn't understand and put out misguided information to scare investors (there is a time and place for this sort of behavior, but it requires running for a political office).

One misconception that I hear a lot involves the cost of variable annuity guarantees. Some say they are too expensive. Others say they don't charge enough. Well, which one is it?

Also, lately I've heard a lot of negative comments that hedging doesn't work. Insurers don't understand the risks they are taking and don't know how to manage them. Similar comments have been made addressing the capital infusions insurers are requiring.

Well, here is the full story: annuities are complex products and pricing and hedging annuities is even more complex. In order to draw conclusions on pricing and hedging these products, you need to understand how they work and what the goal is. In addition, the capital requirements and accounting rules that va sellers must abide to have inefficiencies, that weren't fully realized until current markets, and as a result they have penalized insurers in unintended ways. Discussions are currently underway to correct these inefficiencies. This is not to say that insurers aren't hurting right now and insurers don't need more capital, but there's more than meets the eye.

For financial advisors and individual investors, it is extremely important that you understand the whole story on these issues in order to form your own opinion on the strengths of these companies and their products. My goal is to deliver you the full picture on a number of these "hot topics" over the next few weeks.

The first topic I will dive into is the effectiveness of companies managing annuity guarantee risk. I'll set the scene and provide some (optional) background reading on this issue below, but to keep this blog at a manageable length, I will put the meat in my next blog.

There were two reports put out earlier this year that have investigated the effectiveness of hedging, one was by Moody's (August 2008 - Link to summary)and the other by Milliman (May 2008 - Link). They both concluded that hedging works in periods of "market turmoil' as stated in the title of Moody's report.

Well "market turmoil" is a relative term, or else what what do you call the last 3 months since that report was published. Milliman just published a new report (link), looking at how hedge programs have performed in September and October, during the period of "really really really bad market turmoil" (I had to answer my own question above). It is a bit technical, but a great report that provides a lot of incite. I would encourage a read (and please let me know if you have any questions).

While, many have heard of Moody's, one of the top rating agencies, I doubt many have heard of Milliman, so let me tell you a little bit about them.

Milliman is one of the top independent insurance consulting companies in the world. They are the global leaders in variable annuity financial risk management and have a market share of about 70% (which is huge). I would say two things about these guys. They understand hedging and its effectiveness better than anyone else. They also are critiquing their own work in a way, which some may say adds bias. However they use real, factual data from insurer hedging programs in their report to draw their conclusions, and I believe everything they say to be true. In addition, Moody's previous report drew similar conclusions to Milliman's May report. However, I would also say, that in a report like this, it takes a trained eye to dissect how they say things to read in between the lines, which I will add commentary on.

For full disclosure, I would add that Milliman is my former employer, and while I have much respect for the people there, I do not have any vested interests in the company.

Please read my next blog entry (above) to get the full story on hedging variable annuity guarantees.


Anne Morrison said...

You explained this point very well and clear. Annuities have their own setbacks as well, depending on the market and insurer. Planning for annuities should be done carefully especially in deciding which insurer to go with.