Here is another stark example of why I don’t like variable annuities. When insurers mis-read the market and their hedges don’t work someone has to lose money. Moody’s Investor Services reports:

Unpredictable behavior by variable annuity policyholders will continue to pressure US life insurers going forward, says Moody’s Investors Service in its new special comment, “Unpredictable policyholder behavior challenges US life insurers’ variable annuity business.”

US life insurers’ inability to predict policyholder behavior including lapse rates led to mispricing that continues to be a weak spot for the industry, says the rating agency.

Variable annuities allow customers the ability to invest in a variety of investment options of their choice, subject to certain limitations. Since the early 2000s, insurers started selling variable annuities that guaranteed minimum withdrawal and income benefits, with these benefits soon becoming very popular.

“Variable annuity sales boomed until the onset of the 2008-2009 financial crisis as customers flocked to the new product; largely due to the product’s ability to offer customers equity-like returns, a guarantee and a deferred tax benefit, all in one product,” said Moody’s Vice President Neil Strauss, an author of the report.

Experience to date shows that companies selling VA’s with guarantees misestimated and underpriced the lapse rates on this product, as policyholders held on to their policies at a greater rate than the insurance companies anticipated. This miscalculation forced insurers to take significant, unexpected earnings charges and write-downs over the past year and a half, notes Moody’s.

“Life insurance companies correctly assumed that during adverse market conditions, when the guarantees became valuable, policyholders would hold on to their policies”, added Strauss. “What companies didn’t anticipate and price for was that policyholders would lapse even less frequently than they had expected.”

Moody’s points out that though equity market declines are generally seen as the biggest risk in VA contracts, most insurers effectively hedge much of that risk via derivatives. The lack of hedge instruments for policyholder behavior, particularly lapses, is currently the bigger and less manageable risk. The decreasing number of US companies offering this product highlights its’ inherent pricing and risk management challenges.

Large, legacy blocks of rich guarantees and risky VA’s with guaranteed living benefits remain on companies’ books. Moody’s expects that if interest rates remain low, equities markets fall, and guarantees stay in-the-money, similar behavior by policyholders will continue. This will force companies to take charges in recognition of lower prospective profitability. Although it is difficult to identify the size, timing, and likelihood of potential individual company charges, the industry impact could be in the billions of dollars given the size of this business and the associated reserves, says the rating agency.