Annuities Punishing The Stag

For nearly a decade, surging sales of variable annuities helped life insurance companies reap record profits.

As Baby Boomers hunted for the best annuity deals for retirement, insurers competed for market share in the accounts that rely heavily on the performance of underlying equity investments.

Most annuity contracts seemed reasonable in normal times. But when the stock market cratered in September and October, insurers that were heavily committed to aggressively priced variable annuities had a problem.

That is one widely overlooked reason why The Hartford Financial Services Group reported a $2.6 billion loss in the third quarter and announced that it would lay off 500 employees, including about 125 in Greater Hartford.

The Hartford Life Insurance Co.’s variable annuity business suffered a pre-tax operating loss of $552 million in the quarter, compared with a $365 million gain a year earlier.

Those poor results, along with sour investments in Fannie Mae, Freddie Mac and Lehman Brothers as well as catastrophe losses, have shaken the foundation of Connecticut’s third largest private employer.

$2.5 Billion From Allianz

The stunning downturn has raised deep concerns about the company’s capital position and prompted certain analysts to question whether the company will be able to maintain its independence. The company recently raised $2.5 billion from Allianz SE, Germany’s largest insurer.

Heavy exposure to variable annuities, in particular, raise questions about whether that injection will be enough to cushion the shocks from a volatile stock market.

“This essentially makes the [Hartford’s] stock very dependent on the performance of the equity markets and suggests to us that the company is better off partnering with a larger, more diverse company that can withstand potential capital charges levied by its large variable annuity business,” Credit Suisse analyst Thomas Gallagher said in an Oct. 29 note to investors.

The Hartford has been trying to reassure analysts and investors that the company remains fundamentally sound. Last week, Chief Executive Officer Ramani Ayer said the company’s “capital position is more than sufficient for current market conditions.”

But market volatility is particularly rough on companies like The Hartford because of its variable annuity products.

Those annuity contracts have many variations. But typically, an investor puts money into a mutual-fund-like portfolio with the expectation of receiving guaranteed payments for life. The insurer makes assumptions about the portfolio’s likely long-term performance and sets guaranteed payouts based on actuarial statistics.

Such guarantees promise a minimum repayment to the investor no matter how the stock market performs. In the market’s recent nosedive — the Standard & Poor’s 500 has fallen nearly 35 percent since January — many equity portfolios held by annuity customers underperformed the guarantees.

The situation is particularly serious with the company’s 3Win variable annuity product offered in Japan, which allows policyholders to withdraw some of their investment if the value of the policy declines by 20 percent or more. Virtually all have fallen that far, and policyholders are taking payouts. That will cost the company $185 million to $225 million in the fourth quarter, the company told analysts.

The market decline has also taken a large chunk out of the company’s variable annuities’ assets under management, and that reduces fees collected over time on the products. Individual annuity assets under management for The Hartford fell to $103 billion in the first quarter, down 11 percent from the previous quarter and 23 percent from the same quarter last year.

Most insurers rely on the long-term fees to cover the high up-front commissions over many years. When those fees shrink, companies are forced to take a deferred acquisition charge. In the third quarter, The Hartford took a $932 million charge related to annuity-related deferred acquisition.

If the market recovers, variable annuities will likely be only a short term drag on profits, Andrew Davidson, a senior director at Fitch Ratings, told the Hartford Business Journal.

Even so, analysts repeatedly questioned executives of The Hartford in an Oct. 29 conference call about the vulnerability of their annuities if the market doesn’t improve.

Retooling Annuities

One analyst asked Ayer if he felt the company had a better handle on risk after the company named Robert Paiano as its new chief risk officer earlier in October.

Ayer responded, “Forecasting in these kinds of markets, even if I have the smartest risk officer is a great challenge.” Such abrupt shifts in the equity and credit markets are difficult for anyone to anticipate, he said, adding, “Candidly, I don’t know if we could have called that.”

Kim Johnson, the company’s senior vice president for investor relations, and John C. Walters, president and chief operating officer of The Hartford’s life operations, assured the analysts that the company was retooling its annuity products in light of recent market events.

But some remained skeptical. In a research note written hours after the conference call, analysts at Deutsche Bank responded: “This tail-event scenario…of severe credit and equity market deterioration we are experiencing today seems to have exceeded management’s worst expectations. Management needs to rethink its risk appetite for credit and variable annuity equity market guarantees.”

Davidson of Fitch said The Hartford’s risk management was strong.

But the day after the conference call attended by more than a dozen Wall Street analysts, shares of The Hartford fell 52 percent to $9.62.

They have since rebounded into the high teens, but remain well below the $60 level they traded at before September. And still skeptics remain.

Speaking about The Hartford on his Mad Money TV program last week, Jim Cramer said: “I want you to sell this thing right now. I don’t like the annuity business. I think they are all in over their heads.”