Annuity investors watch insurers

Retirement plan executives are worried that some big insurance companies won’t be able to pay claims on the annuity products sold to benefit plans.

“One big issue is the safety of guaranteed annuities,” said Thomas Woodruff, director of the retirement and benefits division at the Office of the Connecticut State Comptroller, Hartford. “I believe that a fresh look needs to be taken at the insurance industry that backs up these guarantees. The nature of these guarantees is very important to the future of the DC system.”

Connecticut has $2.15 billion in defined contribution assets, comprising a $250 million 403(b) plan, a $1.5 billion 457 plan and a $400 million 401(a) plan. All three plans offer annuities.

Several large insurers — Prudential Financial Inc., Newark, N.J.; Metropolitan Life Insurance Co., New York; The Hartford Life Insurance Co., Hartford, Conn. — have been hit by the crippling effects of the ongoing liquidity crisis. The three companies constitute 20% of the individual variable annuity market, according to Craig Buck, U.S. life actuarial leader at Watson Wyatt Worldwide in Philadelphia.

These companies are stepping up their emphasis on annuities as a way to meet the need for more secure retirement funds and increasingly are marketing annuities to both defined benefit and defined contribution plans.

James Langenkamp, vice president at Corpus Christi, Texas-based Whataburger Inc., said he was watching the health of the insurance industry “prudently,” given the stressed conditions in the financial markets. Mr. Langenkamp oversees the company’s $63 million defined contribution plan. The worry over the health of the insurance industry dates to the early 1990s, when Los Angeles-based Executive Life Insurance Co. suffered heavy losses and was unable to pay its annuity claims as a result of huge junk bond investments. When the junk bond prices plummeted, policyholders fled Executive Life and California’s insurance commissioner seized control of the company’s unit in the state, triggering other state commissioners to follow suit. The company eventually was liquidated and some claims were honored while others remain in litigation.

Christopher Neczypor, research analyst at New York-based Goldman, Sachs & Co., downgraded major domestic life insurers such as Prudential and Lincoln Financial Group, Fort Wayne, Ind., to sell from neutral and gave Hartford a sell recommendation from not rated, having already downgraded the entire sector to cautious from neutral in a Nov. 11 research note. Mr. Neczypor wrote that in the next 12 to 18 months the insurers’ balance sheets will be affected by more asset deterioration — particularly from commercial real estate, where they are heavily invested and because they stand to take increased losses from guarantees of variable annuities. The insurers already have taken big hits on their balance sheets from their holdings in mortgage-backed securities, and they have had a hard time raising equity capital.

As a result of deteriorating balance sheets, insurers will likely face heightened capital requirements in a tight lending environment, Mr. Neczypor wrote. “Weak equity markets will decrease fee income, dislocated credit markets will negatively impact spread business and heightened scrutiny by rating agencies and regulators will likely result in increased capital requirements,” he wrote.

Mr. Neczypor placed a sell recommendation on Hartford and Prudential but not MetLife as that company was the least likely to need an immediate capital infusion.

Deutsche Bank, New York issued a buy recommendation for Hartford, but a hold on Prudential and MetLife; and Atlantic Equities LLP, London, has a neutral view on all three.

Watson Wyatt’s Mr. Buck said insurance companies, despite exposure to real estate and securities backed by real estate such as collateralized debt obligations, tend to purchase the highest-quality tranches of these securities, the ones that are least likely to default and produce losses for investors. Furthermore, insurance companies hedge their annuity guarantees by using derivative contracts and options.

“Those guarantees are hedged and in the money — in essence the companies are buying put contracts, so as the equity market declines the (call) options they sell are more in the money as well,” Mr. Buck said. “The total balance sheet is somewhat immunized.”

William Mullaney, president of institutional business at MetLife, said his firm meets current reserve capital regulations, saying MetLife’s risk-based capital ratio is 35 to 1, meaning it has 350% more than it needs to meet its capital requirements as set forth by the National Association of Insurance Commissioners.

“We believe we’ve been transparent in terms of risk, our risk management and investment portfolio,” said Mr. Mullaney. “If I were looking at moving pension plan assets and/or liabilities to an insurance company, I’d do my due diligence, too, on their financial strength.”

Theresa Miller, vice president in global communications at Prudential Financial, wrote in an e-mail response to questions that Prudential has a healthy balance sheet and maintains appropriate reserves and risk control procedures to ensure its clients’ assets are protected.

Hartford Life is financially stable and sufficiently capitalized to meet its long-term policyholder commitments, according to Timothy Benedict, director of public relations.

None of the representatives would comment on reports their companies had requested money from the government’s $700 billion bailout fund as a means of acquiring additional capital. Despite their financial strength, counterparty risk remains an issue for insurers, some industry experts said.

Deanna Garen, principal at Garen Consulting LLC in Hartford, Conn., said insurance companies’ hedging strategies are driven by actuarial methodologies that are not perfect.

“The hedging strategies can be entirely risky, such as using derivative strategies — credit default swaps, interest rate swaps, etc.,” Ms. Garen said. “A good measure of the security to pay claims is also in their (insurance company) ratings, and I’ve heard there are in-depth discussions with ratings agencies discussing these issues.”

According to an Oct. 29 10-K regulatory filing for the third quarter, Hartford said its hedge program left the company with a $116 million loss as annuity guarantee liabilities bested hedging gains and “hedge losses to date have significantly exceeded those sustained in the third quarter given the absolute level of liability movements. Continued equity market volatility could result in material losses in our hedging program.”

Insurance ratings company A.M. Best Co. Inc., Oldwick, N.J., despite having a negative view on the entire insurance industry because of worsening economic conditions, maintains a positive outlook on several insurers with regard to their ability to back up the guarantees on annuities and other retirement income investments.

“What it really comes down to is risk management and how effective the hedging programs are that surround the guarantees the insurance company makes,” said RoseMarie Mirabella, manager of research and emerging issues at A.M. Best. “Strength is about capital and liquidity — having provisions to maintain these two elements through these volatile times. This is where the focus of our ratings (is). Can they (insurers) weather the storm and is liquidity sufficient to meet their short-term obligations.”

Ms. Mirabella said A.M. Best rates Prudential Financial, MetLife and Hartford Life A+ for financial strength. Both Prudential and MetLife also have “stable” outlook rankings, while Hartford Life has a negative outlook.

Douglas Meyer, managing director at Fitch Ratings’ Insurance Rating Group in Chicago, said Prudential Financial and MetLife have financial strength ratings of AA while Hartford Life is AA-.

“We think the industry benefits from strong capitalization and relatively high asset quality and favorable liquidity positions, relative to other financial institutions such as Lehman Brothers Holdings,” he said.