When Weiss Ratings recently calculated profits at the country’s largest life and annuity insurers had dropped a whopping 84 percent in 2011, it definitely caught our eye.
To grasp the reasons behind this drop‑and what it means for the industry as a whole‑LifeHealthPro.com spoke with Gavin Magor, left, senior financial analyst at Jupiter, Fla.-based Weiss Ratings, an independent agency that rates U.S. insurance companies and financial institutions.
LHP: What’s behind the decline in profits?
Gavin Magor: Apart from the obvious movement toward reserves being increased, what we think is probably driving it, and it’s hard to be specific, is a movement away from affordable rates, meaning the affordability for the insurers to maintain the guaranteed rates to the annuity holders, given the lower yields that are achievable on investments at present.
Many of the larger insurers had guaranteed minimum rates of return on variable annuities that are higher than the companies can achieve. This clearly has affected the insurers that also have guaranteed minimum withdrawal or income benefits at a high level that is not currently achievable. It appears that there has been greater demand, and they have not been able to keep up with that.
LHP: Yet you say there is no risk of failure. Why?
Magor: At this stage, the life insurers as a broad group have been extensively well capitalized and have performed exceptionally well even through the financial crisis. From that perspective, this isn’t a threat to their financial viability. If it continued beyond this year, and they continued to increase reserves to the same extent they have had to, we would have to reassess the impact on the overall financial strength of the insurers. However, for the larger ones, they certainly have the capacity for that. It’s not desirable but they have the capacity for these losses. Yes, they’ve got to do something about it. But we have to see if the 2012 development of reserves stays the same and see what it does to their profitability. If it goes beyond 2012, there may be something that needs to be changed.
Magor: It’s tough for them, because they are fairly constrained by what they might be able to do, apart from the obvious of bringing in the cash for payments, which isn’t really the issue for them. Cash flow isn’t the issue. It’s really to improve their yields and that means taking a page out of the property and casualty insurers’ book, which has essentially been a movement toward more low-rated bonds and investments generally. That carries some degree of risk, of course, but then gives you those high rates of return. There have been two schools of thought on it. There are those that are staying conservative and maintaining a very high-quality portfolio and those who are moving toward a more productive portfolio with greater risk. The question is whether being conservative is actually creating more risk. You are essentially going to be taking a known hit to your profitability and ultimately to your balance sheet in this particular case. Those that are investing in a slightly more diverse portfolio are perhaps not able to quantify their risks, but their yields are definitely higher. P&C insurers have definitely moved to a riskier investment portfolio. I know the two are not exactly comparable, but if they took a note from that playbook, then maybe the ultimate risk would be lower.
LHP: Several carriers have either exited or scaled back their variable annuity business. Why and what impact does that have on the industry?
Magor: It can make sense for an insurer to do that. At this time, though, perhaps the customers would like to see a variable annuity because the more [an annuity is] fixed at this stage, the less they are going to see in the future. So there are two completely contrasting interests there. I can understand an insurer saying if we do fixed annuities, we know what our risk is, we can quantify it and in the end rates will rise and we will be able to produce these larger yields and we will be able to cover those. With a variable annuity they are probably adding a level a risk they don’t particularly want or feel they can control.
LHP: Why does it make sense for some insurers?
Magor: Depending upon the structure of their future liabilities it may make perfect sense for them, even if it’s for the short term. I wonder whether some of these withdrawals are going to be temporary. I don’t think this will be long term, more than a couple of years or so. I suspect that once the markets turn around and the demand is there, and you find yourself not offering a product that is available through everybody else, most insurers will come back into that market.
LHP: How can insurers project or reserve for annuity payouts, especially with the longevity risk?
Magor: Well, that’s where actuaries are supposed to earn their money. I’m not sure that they’ve necessarily have had it wrong in the past. Lifespans have been growing, and I’m sure they’ve been taking that into account. Of course, there are going to be anomalies. Frankly I think it depends on where your exposure is. If you are focused on one particular area of the country where longevity is the norm, you might find that is having a larger effect than if you have a spread of customers through the whole of the country. This is what the actuaries do, and for us to second guess them is probably a bit unfair.
LHP: Anything else you can tell us about your recent research?
Magor: There is definitely a challenge out there. We were actually quite surprised to see this huge difference between the largest insurers and the smaller ones. And the only thing we do wonder is whether the larger insurers are being ultra conservative and preparing themselves for something and the smaller insurers have been able to take things a bit slower, perhaps haven’t had such a commitment to the guaranteed rate situation. But we will be interested to see what happens with the smaller insurers during 2012. And when I say smaller, some of these are large companies, but [are small] relative to the largest ones. There is such a disparity in performance that there has to be either something unique about these larger ones or we are going to see a change perhaps to the performance of the smaller ones this year.
LHP: Why the difference between large and small?
Magor: The [bigger ones] were able to be more aggressive in the past. They had that flexibility of size. This has enabled them to more aggressive in what their plan offerings have been. And that’s potentially what has led them to dominate the market. Now, perhaps, some crows are coming back to roost.