The Wall Street Journal - October 29, 2008
Many owners of variable annuities have endured a double whammy lately: Their investment-account balances have taken a hit, as have the financial-strength ratings on the insurers that issued their annuities.
Agents and brokers say they’ve received a flood of calls from clients in recent weeks concerned about the safety of their variable annuities, in part fueled by the stock-market turmoil and the government rescue of insurer American International Group Inc.
Regulators and consumer advocates say life-insurance companies rarely have failed and seldom do so suddenly, so there is no need for alarm. And in the rare instance a company becomes insolvent, states ensure that guaranty funds protect both cash values and death benefits up to certain limits.
And taking rash action is a potentially costly move: Cashing out of a variable annuity early can invoke surrender charges, generally as high as 10% for as long as 10 years. Those who cash out before age 59½ also face tax liabilities and penalties.
In all, there were 35.1 million individual annuity contracts in force at the end of 2007, with a total value exceeding $2.02 trillion, according to LIMRA International, a nonprofit industry group that compiles life-insurance data, and Morningstar Inc. Here are answers to some common questions investors may have about annuities:
Q: How do annuities work?
A: Annuities are tax-deferred insurance contracts bought once, or with a series of payments, that offer the owners either a lump sum or a series of payouts after an accumulation period. Unlike other retirement vehicles such as an individual retirement account or a 401(k), annuities have no legal limits on tax-deferred contributions.
Q: What’s the difference between fixed and variable annuities?
A: Fixed annuities earn a guaranteed interest rate during a certain period. They are backed by assets in an insurance company’s general account, usually bonds. Fixed annuities depend entirely on the financial soundness of insurers, which are regulated primarily by state insurance departments.
Variable annuities can also come with guaranteed benefits, such as a death benefit and a minimum return, riders for which the buyers generally pay extra. In other ways, though, they’re quite different: A portion of deposits go to the insurance company to cover administrative costs and guaranteed benefits; the rest is invested in a portfolio of mutual fund-like investments. These accounts are separate from the rest of the insurance contract and belong to the annuity owner, so they’re not as vulnerable to the insurer’s fate.
Variable annuities, however, are more exposed to market risks. If annuity owners’ investments perform well, there’s the potential upside of a bigger payout. But if they do poorly, as many have recently, income falls, too. Investors can shift their fund holdings, however, to lower-volatility choices such as bond funds.
Q: How have annuities been affected by recent market conditions?
A: Many variable annuities have gone through the same gut-churning volatility as mutual funds in general. Partly as a result, while sales fixed annuities rose 39% in the first six months of 2008 from a year earlier, sales of variable annuities overall declined 6% in the same period, according to LIMRA International.
Q: Should I be worried if the share price of my insurer declines?
A: Not necessarily. In some cases, analysts say, publicly traded insurance companies’ stock prices have plunged partly because of their efforts to raise capital. And while raising capital can dilute existing shares, it also improves an insurer’s ability to pay claims. Hence, a decline in the stock value of a company doesn’t always spell immediate trouble for annuities or life-insurance policies.
Q: Should I worry if the financial-strength rating of my insurer declines?
A: Possibly. Financial-strength ratings, supplied by rating agencies, are an evaluation of the ability of a company to make good on its guarantees. A slip from an excellent financial-strength rating from one of the five agencies — Fitch Inc., A.M. Best Co., Moody’s Investors Service, Standard & Poor’s or TheStreet.com — to a slightly lower rating that is still in the secure range isn’t cause for alarm, experts say. But multiple downgrades are a good reason to keep an eye on the company.
Through Sept. 30, 6.5% of the life/annuity and health-insurance companies followed by rating agency A.M. Best had been downgraded, though most remained in the “secure” range, meaning they are still regarded as financially sound.
Of course, buyers of new annuities should only buy from top-rated companies, consumer advocates say. You can find information on financial strength of companies licensed in your state by linking to your state’s insurance department, at www.naic.org, the Web site of the National Association of Insurance Commissioners.
Q: What happens when a company founders?
A: State regulators usually monitor struggling companies and work with them to try to get additional capital — or to sell the company to a stronger insurer that can make good on all of its claims. State receivers, who include the state insurance commissioner of the company’s home state, often help find other insurers to take over the annuities from the troubled company. Annuity owners then make payments to the new company and collect payouts from it. Otherwise the terms of the annuity usually remain the same.
Q: What happens if no insurer wants to take over the annuity contracts of a failed insurer?
A: If an insurer is declared insolvent by a court and is liquidated, state laws require companies to pay annuity (and insurance policy) owners first and in full before paying claims of other creditors. State guaranty associations — funded by other insurers — then make good on the annuities and policies. Death benefits, for instance, are often protected up to $300,000. Cash values are often protected to a maximum of $100,000. (See www.nolhga.com, the National Organization of Life and Health Insurance Guaranty Associations, for state-by-state terms.)
With variable annuities, as with fixed contracts, the associations protect the death benefits, guaranteed minimums, and other contract guarantees. But investment account losses because of market declines generally aren’t covered.
Q: What are my options if my insurer is at risk of insolvency?
A: Regulators and consumer groups warn that annuity owners, especially those who bought contracts recently, often stand to lose more when rashly surrendering an annuity than they would risk from the insurance company’s failure. That’s because the guaranty funds protect their money up to legal limits, while surrender charges and other penalties can take a chunk of an annuity’s balance.
Check with your state insurance department for updates about the financial strength of insurers. If your annuity contract is still in the surrender period, often five to seven years, and the contract is below state guaranty limits, you may decide to wait and see if the company can muddle through. But if your surrender period is over or nearly finished, and a company has deteriorated enough to make you uncomfortable, you could consider a Section 1035 tax-free exchange, named for a section of the Internal Revenue Code, into another annuity contract from a higher-rated insurer. Don’t forget, however, that starting a new contract will involve a new surrender period and charges, new commissions and new fees.
Don’t allow a sales rep from a competing company to scare you, however, into replacing an annuity. There are state laws against “poaching” customers by making false claims about the financial condition of another insurer.
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