Now even some of the most venerable companies of the insurance industry have been sucked into the maelstrom of the financial crisis. Highly respected icons of the insurance industry such as Hartford, Prudential and Met Life are seen scrambling for capital and watching their stocks being hammered into oblivion. The Hartford took in $2.5 billion from Allianz SE, but it was not enough. The entire insurance industry has been down-graded by investment analysts and rating firms. Now, the largest companies are getting in line for part of the federal bailout. What has caused these seemingly strong companies to show such signs of weakness?

Unfortunately, the financial accounting and operations of insurance companies are not transparent enough for any outsider to really understand the specifics of this crisis, but one thing is sure. The need for additional capital, the battered stock value and the panic restructuring to qualify for bailout funds means that even the management of these companies recognize that under current conditions they are incapable of meeting the promises and guarantees they have made to policyholders.

Not being able to keep its promises or meet its guarantees is a death knell for any insurance company.

The American life insurance industry has survived and prospered through good times and bad for one simple reason – the credibility of a guarantee. A guarantee that promises made will be kept. The offer of an inviolate guarantee became a sacred bond between the insurance company and its policyholder that encouraged generations of Americans to trust and rely on the insurance industry to be a bulwark of strength and security when crisis emerged. Keeping the promise of this guarantee translated into remarkable levels of success for the insurance industry. Now there is a risk that this hallowed bond could be broken, and if so the results are guaranteed to be disastrous.

Chided for being boring, the life insurance industry and its agents have been the perennial butt of jokes for many comedians and films. Do you recall Ned Ryerson, the persistent, pestering life insurance agent in Groundhog Day? Or in Planes, Trains and Automobiles, Steve Martin, seeking the ultimate insult, telling John Candy he would rather endure hours and hours in an insurance seminar than listen to him chatter? The assumption of many is that if there is nothing left for a person to do, do insurance. I could go on and on, but you know it is true.

Being consistent and boring in good times is an invitation to ridicule. However, when times turn bad it has been the guarantees of the insurance companies that have been there to see people though the tough times.

• The guarantee that if you die, the funds will be available so your family or business can survive.
• The guarantee that in sickness or disability the income will be there so that your life can go on.
• The guarantee that money deposited with an insurance company will be returned intact.
• The guarantee that income for retirement will always continue, no matter how long it is needed.

For over a century these guarantees and promises were taken seriously and treated with respect by the insurance companies. During the Great Depression of the 1930s, not one policyholder lost one dollar held by an insurance company. So sacred has this promise been that when one company was in danger of failing on its guarantee, other companies would step in to make good on the promise.

Making Good on Guarantees

Insurance companies were in a position to make these guarantees because of their strict adherence to a conservative philosophy of risk that boiled down to three principles: 1) Never put the company in a position to be anti-selected against, 2) Never assume a risk that is not understood and, 3) Never take a risk that cannot be managed.

Now there are indications that decreased regulation, the pressure of competition, the allure of short term profit and the optimism of a seemingly never-ending economic boom have caused the management of some companies to lose sight of the principle of the guarantee and take actions that has put the promise at risk. If the promise of the guarantee fails, the insurance industry and all those associated with it will lose what is most valued – the confidence of the customer – and may never recover.

There are two products the insurance companies are selling that treats the guarantee in a cavalier fashion and endangers both the promise made and the very future of the companies, not to mention the industry. Those products are both annuities – fixed and variable.

The fixed annuity is an example of a once simple (boring) insurance product – easy to understand and simple to guarantee – that has become complicated and risky, for both the policyholder and the company. The fixed annuity is an insurance contract into which a policyholder can deposit funds for an insurance company to manage. The insurance company promises a minimum rate of interest and to return the funds when the policyholder wants them back or to use the funds to provide a stream of income that lasts as long as long as the policyholder does.

In addition to the minimum guaranteed rate of interest credited to the annuity funds, the insurance company promises to credit the highest possible current rate of interest to the funds. Because the annuity encourages people to save money, the government offers an incentive to buy the product by allowing the funds to grow on a tax-deferred basis. This product is simple, easy to understand, offers a reasonable return and best of all it’s guaranteed to do what it promises to do.

Gilding the Rose

Pressured by competition from investment products insurance companies began to change the simple fixed annuity to make it appear to be something it is not – an investment. It is a mixed metaphor and a recipe for trouble to make a guaranteed product perform as an investment.

Insurance companies began the attempt to make the fixed annuity sexier by tying the rate of interest credited – not to the investment performance of the insurance company portfolio – but to an outside index such as the S&P 500. If the index moved up, then so did the interest rate credited to the annuity. If the index tanked, well, then the policyholder had the guarantee of the minimum interest and the promise that no funds would be lost.

So far so good, but the problem is that the movement of the index is an uncertain risk that cannot be predicted. To counteract this uncertainty insurance companies “outsourced” the risk to investment firms who (being used to gambling with customer funds) were willing (for a price) to “hedge” or “counter” this risk. Basically the “counter party” (an investment firm) agreed to cover the risk of the index moving above a certain point. This arrangement allowed the insurance companies to maintain the guarantees of the product while selling a product that promised to perform more like an investment.

This whole concept works very well – in theory. However, should the index hiccup and the “counter party” become unable to perform, then the liability falls back on to the insurance company. Of course, the insurance company was not worried about this potential risk because the companies making the promise were highly rated investment companies like Bear-Sterns, Lehmann Brothers and Merrill Lynch, which of course would never run into financial problems. The insurance companies were lucky in this instance because of the precipitous fall of the indexes, but there is potential for disaster.

There is another risk the insurance companies are taking that also has the potential for problems. Instead of selling fixed annuities with the return tied to an index, the insurance companies are now offering a guaranteed interest rate (much higher than the minimum) for as long as 10 years. No one can predict what interest rates will be for the next 10 days, let alone the next 10 years. Insurance companies may also be hedging this risk with “interest swaps,” but one must ask how safe and sure these will be in the future. The last company to make a major effort to guarantee interest rates for an extended period on a fixed product was The Equitable that sold “guaranteed interest contracts” with a 10-year guarantee. That approach virtually bankrupted the company and drove them into the arms of AXA.

The real risk that insurance companies have taken is in the guarantees that have been added to a true investment product – the variable annuity. The irony is that these guarantees have been added to investment annuities in an effort to make them look and perform more like fixed annuities.

In an effort to increase sales of variable annuities, the insurance companies have added the guarantee of a minimum death benefit, a minimum income benefit and even a guaranteed minimum principal. All of these guarantees entail some risk that they cannot manage. A risk that cannot be managed is a gamble. As a result, unless these risks can be fully and safely hedged, the companies selling these products with risks that cannot be fully managed are gambling with the future of both the company and the policyholder.

Unfortunately, current regulation – both state and federal – does not require the transparency that allows outsiders to identify the type and extent of risk the insurance companies are taking. AIG’s failure is an anomaly in that it is at the holding company level rather than at the insurance company and is the result of the stupidity of management. However, when we see market action hammering at companies that sell large amounts of variable annuities, such as Hartford, Prudential and Met Life it is a good signal that these companies have taken a significant amount of uncovered risk in order to make “guarantees” to the policyholder. This belief is reinforced when these companies scramble to raise capital. Hartford recently acquired a small savings and loan, for example, in order to qualify for federal bail-out funds.

It is clear that the current financial crisis and the foolish risks assumed by insurance companies will trigger a fall-out and consolidation in the life insurance and annuity industry. Companies that have been weakened by the action of weak management who were cavalier with the promises of a guarantee in a short-term effort to chase sales and profits will pay a high price. Fortunately the totality of the insurance industry is deep and financially strong and it is unlikely policyholders will lose funds. However, these will be difficult and uncertain times.

And the moral of the story is …

The insurance companies should get back to what they do best and do it. Recognize there is both a need and a market for the security of a guarantee. Take this opportunity and obligation seriously in order to protect and regain the confidence of the consumer.

Since some insurance company managements have shown that they cannot be trusted with the obligations of the guarantee, then new regulations should be implemented requiring transparency as to the type of risks being taken and the counter-actions that seek to mitigate those risks.

For those who sell the products, the first concern must be for their clients. The agents and representatives are on the front line when it comes to guarantees offered to the consumer and based on the actions we’ve seen, can no longer blindly rely on the word of the companies they represent. Those who sell the product should demand more information and transparency from the companies. No longer is it enough to know “what” the company promises the product will do, but to also understand “how” the company will fulfill the promises they make.

The consumer should be wary. When making a decision to buy a policy, it is no longer adequate to simply rely on the financial ratings of a company. Because it is not possible nor should it be required that the consumer understand the internal workings of the insurance company, consumers should consider not putting all their eggs in one basket. Most of the companies are well run and financially strong, but there is no way in the current environment to really know which ones those are. If an individual is considering putting their future in an annuity – fixed or variable – the prudent action is to spread the risk among several companies.


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  2. Interesting post. I have worked for the past 23 years in the distribution of annuities. I believe your comments are spot on, but you do raise some confusion when referring to equity index annuities as fixed annuities.

    On another note, you have used the corporate logo of Prudential PLC, not Prudential. These are different companies. Prudential PLC is based in England and owns Jackson National among their subidiary firms.

    Otherwise, solid post. I think you have a strong grasp on this issue.

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