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Varia

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Annuitie

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October 2000

Contact Phone

New York

Arthur Fliegelman 1.212.553.1653Scott RobinsonRobert Riegel

Summary OpinionThe number of variable annuities (VAs) outstanding has grown explosively during the past decadeas the result of strenuous sales effort by US life insurers. Moody’s believes that total account val-ues now exceed one trillion dollars.1 A by-product of this growth is that insurers have increasinglyturned to aggressive product guarantees in an effort to differentiate their variable products in afiercely competitive market. These guarantees often take the form of guaranteed death and/or“living” benefits that are marketed as protecting the policyholder from equity downturns.

As intended, these innovative features have made variable products increasingly attractive toconsumers and agents and spurred new sales and contract exchanges. However, Moody’sbelieves that these benefits are difficult to impossible to effectively hedge or fully reinsure. Evenworse, these benefits are rarely diversifiable since they are codependent upon one common fac-tor – equity market performance.

Specifically, these guarantees typically have a “cliff type2” risk profile that provides seeming-ly lucrative returns for insurers, but can be extremely costly in unlikely, but still plausible scenar-ios. All looks well until a major adverse market move strikes, and by then it is too late for theexposed insurer to take any realistic ameliorative action.

Moody’s believes that left unhedged, or improperly hedged, that these guarantees can repre-sent significant non-diversifiable risks to insurers with large variable product exposures.

Moody’s believes that many company’s price and allocate capital to stochastic results at the95% or even 98% percentile levels, and we do not believe that this is an adequate degree of con-servatism. Moody’s historical default 5 year default rate for Aa3 rated issues are 41 b.p, which isequivalent to a 99.6% percentile standard. This seems to us to be the minimum standard that acompany should aim for, although Moody’s recognizes that insurers often have other resourcesnot in included in these product line analysis that can be used to help offset any potential losses.

Bells and Whistles: Credit Implications ofthe New Variable Annuities

Special Comment

1. See Moody's Special Comment, Riding the Wild Bull, Variable Annuity Growth Continues, May 1999.2. See Appendix D for a detailed description of any bolded items.

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2 Moody’s Special Comment

© Copyright 2000 by Moody’s Investors Service, Inc., 99 Church Street, New York, New York 10007. All rights reserved. ALL INFORMATION CONTAINED HEREIN ISCOPYRIGHTED IN THE NAME OF MOODY’S INVESTORS SERVICE, INC. (“MOODY’S”), AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISEREPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FORANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIORWRITTEN CONSENT. All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and reliable. Because of the possibility ofhuman or mechanical error as well as other factors, however, such information is provided “as is” without warranty of any kind and MOODY’S, in particular, makes norepresentation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information.Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to,any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees or agents inconnection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct,indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of thepossibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings, if any, constituting part of the information containedherein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NOWARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OFANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or otheropinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user mustaccordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it mayconsider purchasing, holding or selling. Pursuant to Section 17(b) of the Securities Act of 1933, MOODY’S hereby discloses that most issuers of debt securities (includingcorporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODY’S have, prior to assignment of any rating, agreed to pay toMOODY’S for appraisal and rating services rendered by it fees ranging from $1,000 to $1,500,000. PRINTED IN U.S.A.

Author

Arthur FliegelmanScott Robinson

Editor

Michael D’Arcy

Associate Analyst

Ellen Fagin

Production Associate

Brett Love

Table of ContentsSummary Opinion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1

Understanding the New Guarantees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4Guarantee Minimum Death Benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4Guarantee Living Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

The Short, But Colorful, History of Annuity Secondary Guarantees . . . . . . . . . . . . . . . .5

History of the Annuity Secondary GuaranteeReinsurance Market: Buckle Your Seatbelt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6

GMDB Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6GMIB/GMAB/VIA Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6

Sell! Sell! Sell! … Shhhh! Did Someone Say Risk? . . . . . . . . . . . . . . . . . . . . . . . . . . . .6

Regulation Lags Innovation: Reserves and Capital Charges . . . . . . . . . . . . . . . . . . . . . .7GMDB Reserves Are Here . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7The Basics of GMDB Reserving . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7GLB Reserves Are Still to Come . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7The Framework For GMIB Reserves: The “Keel” Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8Adequate Reserving Does Not Eliminate All Risk: Capital Requirement Calculation is Inadequate . . . .8

To Hedge Or Not To Hedge: The Price Is The Question . . . . . . . . . . . . . . . . . . . . . . . . .8Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8Capital Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9Self Funding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9

Credit Implications Of Annuity Secondary Guarantees: Moody’s Views . . . . . . . . . . . .10

A Focus On Product Design and Pricing Assumptions . . . . . . . . . . . . . . . . . . . . . . . . .10Key Risk Factors: Experience versus Pricing Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10Key Pricing and A/L Modeling Assumptions For Contracts Containing Secondary Guarantees . . . . . .11Key Product Design Features For Contracts Containing Secondary Guarantees . . . . . . . . . . . . . . . . . .11Risk Transference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13

Does the Company Understand the Risk? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13Pricing the Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13Stress Testing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14

The Scenarios: The Good, the Bad and the Ugly . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14The Good . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15The Bad . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15The Ugly: The Improbable Becomes Reality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16

Appendix A: Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17

Appendix B: Determinants of Annuity Secondary Guarantee Risk Profile . . . . . . . . . .18

Appendix C: Guaranteed Minimum Death Benefit Illustration . . . . . . . . . . . . . . . . . .19

Appendix D: Guaranteed Minimum Income Benefit Illustration . . . . . . . . . . . . . . . . .20

Appendix E: Guaranteed Minimum Accumulation Benefit Illustration . . . . . . . . . . . .21

Moody’s Special Comment 3

These developments are also not limited to the U.S. market. Insurers in other countries have increas-ingly married separate account based products with guarantees in an effort to satisfy local market demandsfor equity related exposure while limiting policyholder risk.

Deficiencies in the regulatory and financial reporting standards for these products are also widespread.Recognizing these deficiencies, regulators have made the development of appropriate reserving standardsand capital requirements for these products a priority.

Moody’s focuses in our analyses upon understanding the specific terms and risks of products sold byrated insurers. Seemingly similar products can have markedly different risk profiles dependent uponcharacteristics such as product design, investment options, asset allocations, customer behavior andother parameters.

Moody’s also pays careful attention to understanding how insurers measure and manage theseassumed risks.

Moody’s does not currently expect near term rating actions to arise from our reviews. However,Moody’s does believe that, over the long run, the risks of these products are one of the most significantchallenges that insurers face in maintaining their creditworthiness. Our ratings will incorporate these risksas appropriate.

Understanding The New GuaranteesIn analyzing annuity secondary guarantees it is instrumental to break the product into its componentparts. After stripping off the “bells and whistles” of modern variable annuity, what remains is a taxdeferred savings vehicle with a simple death benefit3 and a conservative annuitization guarantee. Chargesthat can be included in these products are asset-based fees composed of mortality and expenses (M&E)charges and investment management fees, administrative fees, and annual contract charges. Most compa-nies also assess a surrender charge that is applied to early contract surrenders and which grades down asthe contract ages.

Additional features may be included in the base product, or in some products they can be purchased onan elective basis for an additional charge. From a financial engineering perspective, these can be viewed asbuilding blocks added to the basic product. Using modern financial techniques, companies can price theincremental cost of the options they have provided to the policyholders.

GUARANTEED MINIMUM DEATH BENEFIT (GMDB)The existence of a GMDB feature in a VA can fill a useful role in the sales process by making the prospec-tive purchaser comfortable with the equity risk assumed by purchasing the product. However, while theGMDB guarantee might offer the purchaser psychological comfort from equity market volatility,Moody’s believes that it is doubtful that any significant economic value is added by this feature.

For a product containing a GMDB feature, the amount at risk to the insurer is the difference betweenthe guaranteed death benefit and the account value. Different product designs offered by different insurerscan offer significantly different GMDBs, which in turn produce very different risk profiles.

A modestly risky product design for an insurer is a death benefits guaranteeing a return of premiumsless any withdrawals previously made. More aggressive guarantees provide a minimum rate of return onpremiums less any withdrawals.

Another popular guarantee provides an exotic option analogous to a “look back” option with a sto-chastic exercise date (death). The insurance jargon used to describe these guarantees – standard return ofpremium, roll-up, ratchet, and the greater of the ratchet or roll-up – is decoded in Appendix A.

Enhanced GMDBs, such as rachets, also serve as a product conservation mechanism in certain marketenvironments. A VA product containing a rachet that has undergone significant economic appreciationcontinues offering a meaningful death benefit when an alternative contract with only a return of premiumdeath benefit no longer offers meaningful death protection. Prior to the introduction of these types ofbenefits, a policyholder would have had to exercise a 1035 product exchange to reinstate meaningful deathbenefit protection. A ratchet thereby removes one motivation to exchange the contract.

3. Technically, a death benefit is not required for an annuity to be classified as insurance.

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4 Moody’s Special Comment

The risk to the insurer in these benefits is partially mitigated through mortality diversification. Even ifthe benefit is in-the-money, the insurer need pay the benefit only if the contract owner dies. If the con-tract holder instead surrenders or annuitizes, the risk to the insurance company is terminated. However,given the vast amount of business written to date, even paying out 1% of the in-the-money options couldbe a significant financial burden to the insurer.

In some products, enhanced GMDBs are offered along with the GLBs described below.

Unfortunately, since very little empirical data is publicly available regarding the amount or nature ofthe GMDB actually outstanding in the market, Moody’s is unable to make an even reliable estimate of theamount of risk assumed by the industry in offering these products.

GUARANTEED LIVING BENEFITS (GLB)The term GLB refers to an array of products including GMIBs (guaranteed minimum income benefit)and GMABs (guaranteed minimum accumulation benefit)4. These products all include guarantees to thecontract holder while he or she is alive, unlike GMDBs where the guarantee is triggered only upon thecontract holder’s death.

Products including GLBs permit the consumer to have equity participation while also supplying somedownside protection. Moody’s believes that of these types of products, that GMIBs have by far the great-est market penetration in the U.S., followed by GMABs. While Moody’s has not been able to identifyexact industry amounts, we estimate that each of these types of secondary guarantees represents approxi-mately 5 to 10% of new VA sales.

Companies must be careful in developing their guarantees. In some poorly thought out cases, the con-tract holder can have the incentive and ability to arbitrage the insurer due to the nature and pricing on theguarantees granted.

A GMIB provides the contract owner the right to annuitize a prescribed accumulated account value, ata guaranteed annuitization rate, after a contractually stated waiting period (typically seven or more years).Often, the right to annuitize is limited to a time period immediately following the contract’s anniversarydate. Aggressive guaranteed account value earning rates are typically offset by conservative annuitizationrate guarantees, priced using both low interest rates and low mortality rates. In effect, the insurer gives abenefit with one hand (the accumulation guarantee) while partially or wholly offsetting it with conserva-tive assumptions used in computing the annuitization benefit.

The charge for the GMIB is highly dependent on the specific terms of the guarantee; in most cases itis upwards of 30 basis points (b.p.) annually.5 Recently insurers have become more innovative in theirdesigns in an attempt to offer additional tangible value to contract holders. One increasingly commonGMIB feature is a step-up guarantee, a type of path dependent option, which enhances both the valueand risk profile of the product.

A GMAB gives a floor on guaranteed account value return over a given time horizon, often ten yearsor longer. As with the GMIB, the GMAB can include a type of step-up guarantee. The GMAB is expen-sive, with most companies charging fees for to the insured for this guarantee of up to 100 b.p. or more.Moody’s believes that this cost is a primary reason while GMAB have remained relatively unpopular inthe marketplace.

The Short, But Colorful, History Of Annuity Secondary GuaranteesOriginally, the investment options included in VAs were proprietary funds, sponsored by the insurancecompany, and permitted the insurer to differentiate its product offerings with unique investment funds.Now almost all insurers also offer or exclusively offer non-proprietary funds sponsored by well-knownthird party money managers such as Vanguard, Fidelity, and Janus. Consequently, it is not unusual to havethe identical fund offered by multiple insurers, which then forces the insurer to attempt to differentiate itsproduct in other ways.

4. Variable Immediate Annuities, payout annuities with payments linked to investment account performance, are not addressed in this Special Comment. However, we believe that the VIA market has the potential to grow significantly as VA contract holders begin needing retirement income. Insurance companies can assume meaningful risk by guaranteeing a minimum payment regardless of investment account performance.

5. Please see the section on Pricing the Risk for an explanation of how companies determine charges.

Moody’s Special Comment 5

A few companies, including TIAA-CREF Life, Fidelity, Lincoln National and Vanguard/PeoplesBenefit, have responded by offering bare bones, low cost annuities. They have attempted to capture theattention of cost conscious shoppers. Other companies have instead opted for “fully loaded” annuities, andattempt to use innovative features to differentiate their products.

History Of The Annuity Secondary Guarantee Reinsurance Market: Buckle Your Seatbelt

GMDB REINSURANCEThe reinsurance market for annuity secondary guarantees has a tumultuous history. The market forGMDBs began about six years ago. Initially, several large participants wrote almost all of the GMDB rein-surance business. In a short period during the summer of 1998, all of these reinsurers withdrew from writ-ing any additional GMDB reinsurance business, although previously entered into treaties remained inforce. Moody’s believes that these withdrawals occurred because the reinsurers decided that they hadalready accumulated enough equity exposure from this business, and that they did not want to add stillmore. Strong equity market appreciation also played an important factor by mushrooming these reinsur-ers’ dollar exposures even without new sales.

Needless to say, the simultaneous exit of the market’s major participants left a vacuum and the primarywriters in a predicament. However, as the reinsurance market firmed and prices improved, other reinsur-ance companies began to enter the market selectively and cautiously.

While the market remains more expensive than previously limited reinsurance coverage remains avail-able. In addition reinsurers are very selective about the structure of the deals that they will assume andwhich contracts they will reinsure.

GMIB/GMAB/VIA REINSURANCEThe GMIB and GMAB reinsurance market began developing about two years ago. As is the case with theGMDB reinsurance market, the reinsurance market for GLB guarantees has also tightened.

Moody’s believes that several large early writers of this product have been able to reinsure much oftheir GLB risk. However, more recent entrants are unable to procure similar reinsurance and have writtenthis product, typically in small amounts, without reinsurance. Some companies have made a calculatedrisk/reward decision to retain this risk. Even the companies that managed to reinsure their GLB risk willneed to reevaluate the economics of this decision for new business as their reinsurance contracts come upfor renewal.

Sell! Sell! Sell! … Shhhh! Did Someone Say Risk?Although insurers have a long history of managing interest rate and mortality risk, equity market relatedguarantees are relatively new for them and little experience exists. Nonetheless, insurers rush to bring VAsto market with the latest features in an effort to attract visibility and “shelf space” from broker/dealers andbanks for their products.

The ability of insurers to provide such guarantees6 is a significant competitive advantage they haveover providers of alternative products such as mutual funds and managed accounts that are unable toextend guarantees. Moody’s believes that appropriately managed, these guarantees can assist insurers ingathering assets. However, Moody’s believes it is imperative that insurers fully comprehend the risks theyhave assumed and have realistic and adequate plans to measure and manage these exposures. The cliff riskprofile of these guarantees makes it more difficult, if not impossible, to adequately hedge the risksassumed through diversification. This is unlike many of the more conventional risks assumed by life insur-ers that can be managed in large part through diversification.

The high correlation of the values of the options written by the insurers reduces the normal risk mini-mizing value of diversification. Consequently, even with a large book, the insurer could be exposed toheavy potential losses in an adverse scenario. This is especially true for GMABs, where the option has a

6. We note that a handful of mutual funds also offer GMDBs. Interestingly, mutual fund GMDBs are typically priced on a more sophisticated basis than are VA GMDBs. The mutual fund guarantee is priced based both on the age of the contractholder and the volatility of the investment selected.

6 Moody’s Special Comment

zero value for all but an extreme and very costly scenario, and GMIBs, where the variable annuity holderafter a given waiting period can select against the insurer.

Regulation Lags Innovation: Reserves And Capital Charges

GMDB RESERVES ARE HEREActuarial Guideline 34 (AG 34), which addresses reserving standards for GMDBs, was effective at the endof 1998 and is being phased in over a three-year period.

Continued strong equity market performance could mitigate the impact of Guideline 34 for someproduct designs. However, if equity markets decline, those companies without reinsurance could experi-ence a meaningful increase in reserves; for blocks of business with aggressive guarantees, the requiredincrease in reserves could be up to 1% of account value.7

GLB RESERVES ARE STILL TO COMEHowever, regulators have not kept pace with GLB marketplace developments. Consequently, actuarieswere forced to rely upon professional judgement in setting appropriate reserve and capital levels withoutexplicit regulatory guidance.

While Moody’s believes that the company’s Appointed Actuary should have discretion in settingappropriate reserve levels, Moody’s also believes that it is essential that a basic framework be in place forregulators and others to have a base from which to evaluate reserve adequacy.

In Moody’s opinion, there are two main explanations why regulators have been slow to address thedevelopment of products with GLB features. First, regulation is naturally a slow and reactive process.

More importantly, aside from some recently developed actuarial guidelines – 34 for GMDBs, and 35 forequity indexed – the insurance industry has had limited experience in setting and implementing reserves forproducts containing equity based guarantees. Furthermore, limited data on policyholder behavior makes itdifficult for actuaries to develop methodologies for pricing and evaluating these products.

THE BASICS OF GMDB RESERVINGAG 34 provides a standard for actuaries calculating GMDB reserves. In simple terms (and ignoringreinsurance), under AG 34 the actuary calculates two reserves – the separate account reserve, andanother that integrates the death benefit with the separate account reserve.

The separate account reserve is based on the Commissioners Annuity Reserve Valuation Method(CARVM), where the reserve is based on the maximum present value of future liability, calculated on apolicy-by-policy basis. The integrated reserve is calculated under the same methodology, but the deathbenefit net amount at risk is added to the benefit stream. The difference between the separate accountreserve and the integrated reserve is the GMDB reserve that is held in the company’s general account.

It is important to note that in calculating the integrated death benefit reserve, the actuary assumes adrop in account values followed by a specified recovery, both of which are dependent upon the perfor-mance of asset classes backing the account values.

7. The ultimate impact on a company depends on many factors, including specific product features and the composition of the company’s annuity business.

Moody’s Special Comment 7

ADEQUATE RESERVING DOES NOT ELIMINATE ALL RISK; CAPITAL REQUIREMENT CALCULATIONIS INADEQUATEWhile the GMDB reserve standard and the “Keel Method” are conservative, especially in assumptionsregarding policyholder behavior, there remain extreme scenarios under which an insurance company needsto rely upon additional capital resources to fund the guaranteed liabilities. Moody’s believes that this isespecially true with products including aggressive enhanced death benefit and GLB guarantees. We believethat these products have considerably more downside risk than may be captured by the reserve calculation.

Capital requirements, which are designed to provide resources for extreme scenarios, are largely in thedevelopment stage for GLBs. We believe that many companies are holding minimal capital to back theseguarantees. Furthermore, we believe that the formulaic approach used by some companies to calculateGMDB and GLB exposure is an inadequate measure of tail risk. Instead, company specific stress testing isessential to quantify the real risks that are being assumed.9 In addition, the “tail risk” that a company iswilling to assume is a key factor, and is almost never disclosed.

To Hedge Or Not To Hedge: The Price Is The QuestionThere are three options for dealing with the risk for a company selling an annuity with a secondaryguarantee:

REINSURANCEThe company can seek out reinsurance in an effort to transfer the risk to another insurer more willing orable to assume this risk. This is often the primary insurers first choice, as it facilitates the use of reinsuranceaccounting which is well defined, gives the ceding company access to the reinsurers’ expertise, and leaves noresidual basis risk at the ceding company. The primary drawback to this approach is that the primary com-pany is wholly dependent upon the available capacity, pricing levels, and the creditworthiness of the rein-surer. Of course, even if the primary insurer relies upon reinsurance, the reinsurer is still faced with thesesame fundamental choices: retrocede, hedge in the capital markets or assume the risk unhedged.

8. Minimum Guaranteed Benefits for Variable Annuities: Implementing Guidelines, Session 25 transcript.9. Please see Moody’s Special Comment, One Step in the Right Direction: The New C-3a Risk Based Capital Component, June, 2000.

THE FRAMEWORK FOR GMIB RESERVES: THE “KEEL METHOD”At the request of the National Association of Insurance Commissioners (NAIC), a Work Groupappointed by the American Academy of Actuaries is developing a reserve standard for GLBs. TheWork Group has only released preliminary findings to date.8

The Work Group intended to make use of the work done for AG 34, using a similar CARVM inte-grated benefits approach. However, they have found that two key adjustments are necessary. First,since the greatest risk for GLBs is a prolonged market downturn, the sharp drop and gradual recoveryused in AG 34 produced very few claims. Thus, the Work Group developed another method for fore-casting the net amount at risk. The resulting “Keel Method” is named after the shape of the keel on aboat. The graph of the sharp downturn and very gradual recovery of the account values results fromthe application of a lognormal distribution to project account values at the 83rd percentile for capturingthe worst account value performance. Expected returns and volatility differ, based on the assets back-ing the account values.

The Work Group used a stochastic process to analyze the adequacy of the resulting calculatedreserves. The CARVM integrated benefits approach with the Keel Method used to project netamounts at risk worked well for most GLB designs.

A notable exception was for GLBs with path dependent options, such as a GMIB with a reset option.For these products, the Work Group anticipates that the Appointed Actuary will be held responsible fordeveloping a deterministic method for setting reserves. Importantly, it is anticipated that the actuary willbe required to use stochastic testing to verify the veracity of the deterministic method.

8 Moody’s Special Comment

CAPITAL MARKETSThe primary insurer can use capital markets to hedge the market risk through the use of instruments suchas futures, swaps, options and other derivative instruments. In doing so, the insurer is likely to reduceexpected profitability in an effort to stabilize the results of the more extreme scenarios. This approach islikely to have a lower expected cost than reinsurance, but is also likely to leave the insurer with moreresidual risk due to market inconsistencies.

This approach is especially challenging to implement because the markets for long-term options thatare needed to offset these risks are extremely thin at best.10 In addition, an insurer’s exposure oftenchanges, and this in turn requires regular and costly portfolio rebalancings. Given that there exists a largepotential market that is only going to increase in size over time, Moody’s expects that investment banks,consulting firms and reinsurance companies will invest significant resources in an effort to developimproved hedging techniques. In addition option costs are likely to be volatile primarily because of move-ments in underlying economic factors (interest rates, expected volatility, etc) and secondarily because ofbid-ask spread changes.

Yet another approach is selling index futures. This approach permits an insurer to replicate a putoption. While this approach may be economically favorable at certain times, as it currently is, but it isunfortunately also extremely difficult to explain to regulators and other interested parties.

The implementation of a hedging approach faces the additional obstacle that the vast majority of avail-able hedging instruments are indexed based but the investment options offered in the product are prepon-derantly actively managed. Any attempt by the insurer to hedge the actively managed funds with indexedbased hedging instruments will, at a minimum, leave the insurer with a considerable degree of basis risk,and in some cases might even increase rather reduce the risk assumed.

A potential drawback of the use of derivatives for hedging this risk is the resulting financial reportingvolatility. Statement of Financial Accounting Standards 133, which governs GAAP financial reporting forderivatives and hedging, has strict standards that must be met before companies are permitted to usehedge accounting. However, reported income volatility will be reduced when the insurer is hedging bene-fits that must be marked to market or the insurer voluntarily chooses to mark to market benefits that canbe carried on a historic cost basis.

SELF FUNDINGAnother option is for the insurer to fund the exposure itself or self insure the risk. Moody’s believes thatthis has become a more popular option, especially with GMDBs as reinsurance prices have risen. In addi-tion, regardless of the price of reinsurance, large product writers may not be able to find sufficient reinsur-ance capacity to totally reinsure their business since reinsurers want to limit the size of their exposure tothese risks. For this reason, Moody’s believes that some of the larger variable annuity writers have littlechoice but to retain at least a portion, if not much more, of their secondary guarantee exposure.

To help offset this risk the VA writer has access to the full range of the various fees and contractcharges contained in the annuity. From this perspective, the primary insurer is more effectively positionedto assume the secondary guarantee exposure than a reinsurer who is limited to a smaller income stream onthe product.

In some cases, the insurer may be able to internally hedge the exposure by offsetting the risk with anopposite risk on the same or another product. One such example is an extra cost option made available toVA purchasers that pays their income tax on the VAs appreciation at the contract holders death. Thebeauty of this option is that the payoff pattern is the opposite of that for GMDBs. The tax benefit pays offwhen only when the market has increased while the GMDB pays off when the market declines. While thebalance is unlikely to be perfect, it does reduce the overall risk exposure of the insurer.

10. While in theory dynamically managed short-term options could also be used to hedge this long-term risk, Moody’s believes for a number of sound and practical reasons that such an approach is very unlikely to be relied upon by an insurer.

Moody’s Special Comment 9

Credit Implications Of Annuity Secondary Guarantees: Moody’s ViewsMoody’s has paid increasing attention in recent years to variable annuities with equity guarantees in our rat-ing process, especially as they become a sizable part of a company’s liabilities. As part of our rating process,we review the nature of the company’s products and identify the options that the insurer has granted.

The nature of the company’s asset/liability management process is a critical factor in this review,although not in the traditional interest rate oriented sense. Moody’s believes that companies must be ableto monitor their overall exposure on a continuous basis and properly quantify downside scenarios if theyare to offer these products prudently. An improperly priced, unhedged product can pose a considerablerisk to an insurer’s financial position and quickly erode the company’s policyholder surplus.

Moody’s has a higher level of concern on these secondary guarantees as a greater credit issue for insurerswith a large amount of these type of liabilities relative to their financial resources. While diversity of risksassumed always benefits a company, it is especially important when the risks assumed by the company arelikely to be highly correlated such as product guarantees dependent upon equity market performance. Also,in addition to examining the composition of the company’s current business, Moody’s takes a prospectiveview, and considers the pace and product composition of the products the company is currently marketing.

We note that the long-term nature of these guarantees limits their potential short-term liquiditydemands upon the insurer, traditionally an important risk. Insurers will need to post extra statutoryreserves and capital to offset their exposures as equity markets fall and guarantees become increasinglyvaluable. While this can cause some surplus strain, it is important to note that any payments that must bemade to policyholders are likely to be paid out over a considerable time period giving the insurer ampletime to assemble the necessary funds.

Moody’s recognizes that the claims related to a block of business will not be paid out at once butinstead will be spread out over a considerable time period. This helps mitigate the credit risk involvedwith offering these forms of guarantees to more manageable levels.

A Focus On Product Design And Pricing AssumptionsThe relationship of a company’s actual product experience to original pricing assumptions is a crucial fac-tor in determining the product’s ultimate profitability. The product’s profitability can vary greatlydepending upon how experience varies from assumptions.

Moody’s analysis focuses primarily on reviewing the more aggressive guarantees offered since they

have the greatest risk to the insurer.These would include roll-ups with 4%or higher guaranteed annual returns;annual or even more frequent ratchets;generous GMIBs; and GMABs whichguarantee more than 100% of principal.Moody’s discusses how the companiesmonitor and control these risks andattempts to get a sense of the level ofrisk being assumed in extreme circum-stances.

Moody’s reviews both pricing andA/L assumptions for these products, aswell as key product design features.11 Abrief discussion of these issues and fea-tures can be found in accompanyingsidebars.

11. See Appendix E for a breakdown by product.

10 Moody’s Special Comment

Key Risk Factors: Experience versus PricingAssumptionsNegative Impact on Profitability

GMDB GMIB GMAB

Mortality Higher Lower LowerInterest Rates NA Low NALapses Lower Lower LowerEquity Market performance Lower Lower LowerEquity Market Volatility [1] Higher Higher HigherDiversification Lower Lower Lower

How to read this tableIf actual experience is higher/lower than the relevant pricing assumption, this hasa negative impact on profitability.For example, if mortality experience is higherthan that assumed in the pricing assumptions for the GMDB, this has a negativeimpact on profitability.[1] Higher equity volatility increases hedging costs

Key Product Design Features For Contracts Containing Secondary GuaranteesThe following are key product design features for contracts containing secondary guarantees. It isthrough product design and careful incorporation of features into these products that an insurer is ableto control the level of risk it is exposed to in these products. Features that Moody’s pays special atten-tion to include:

• The level of guaranteed returns – Lower levels of guaranteed returns present less risk to theinsurer than high guaranteed returns. However, the complex nature of many guarantees sometimesmakes determining the level of risk contained in the guarantees difficult to determine precisely.

Also, the higher the product’s M&E charges and investment management fees, the higher is thegross investment return that is necessary in order to not trigger the guarantee. For example, aninvestment fund with 2% in related asset based charges needs to earn a gross return of 7% in orderto cover a 5% net return guarantee. Whether or not an insurer is better off with a higher grossreturn and higher fees at the same net return is a function of how these fees are distributed to thevarious parties to the product such as the insurer, the asset manager, and the product distributor.

The risk level embedded in the guarantee also depends upon the investment options offeredand the distribution of funds among these options. As an example, consider two investment allo-cation strategies for an enhanced GMDB. A contract 100% invested in emerging markets invest-ments is much more volatile than one 100% invested in US Treasury securities since the variabil-

12. Lower interest rates increase the value of the payout guarantee as the present value of the payment is worth more at a lower discount rate.

Key Pricing And A/L Modeling Assumptions For Contracts Containing SecondaryGuarantees

• Lapse rate – Policy lapse rates can significantly impact the profitability of a block of business.Companies can justify widely varying pricing lapse assumptions since little historical experienceexists on which to predict future policyholder behavior. With GMDBs, GMIBs and GMABs,increased lapse rates can often have a favorable impact on the company’s credit risk profile, sincefewer options now have the potential to expire in-the-money. Nonetheless, Moody’s believesthat insurers are almost always best off with this product when lapse rates are low and persistencyhigh. Additional product fee income can quickly compensate the carrier for the guaranteed ben-efit risks. While lapses to date have not generally related to the efficient exercise of contractholder options, this may change over time if advanced option evaluation technology becomeswidely available to contract holders. Such a possibility could dramatically increase the risk toinsurers of offering these products.

• Asset Allocation and Asset Class Returns – Asset allocation of these investment funds, earnedreturns on these assets, and the volatility of investment returns are key determinants of the valueand cost of the product options granted.

• Mortality – High mortality rates combined with in-the-money GMDBs, or lower mortality ratesfor annuities in the payout phase diminish the insurers profitability. It is interesting to note thatadverse mortality experience may mean either higher or lower than expected mortality ratesdepending upon the specific product and guarantee under consideration.

• Election rate – The rate which policyholders elect to exercise an option that is granted to themby the terms of the policy. This is relevant for GMIBs where the contract holder may or may notelect to exercise an in-the-money guaranteed annuity income option. However, the higher thecurrent value of the option, the more likely that the option will be exercised.

• Interest rates – Lower than anticipated interest rates12, combined with poor long-term equityperformance, increases the value of the contract’s GMIB option. The correlation between inter-est rates and equity performance – a very subjective input – has a significant impact on the pric-ing and valuation of a GMIB option.

Moody’s Special Comment 11

ity of returns is much higher for the emerging market fund. Consequently, the associated risk tothe insurer of guaranteeing a minimum rate of return could be higher for the emerging marketfund, but this could be offset by the higher expected return of the emerging market fund.Contracts invested in a diversified series of relatively independent investments will generally bethe least risky of all. In many products, the level or the pricing of the product guarantee is inde-pendent of the contract investments and can encourage the policyholder to anti-select against theinsurer such as by purchasing several separate contracts for each investment selected.13 However,Moody’s is not aware of evidence indicating that policyholders efficiently exercise their optionsagainst the insurer and we doubt that this the case.

• Return ceilings – One common method to controlling the risk assumed by the insurer on theproduct is to set a ceiling on the ultimate guaranteed account value, such as two times the origi-nal account value. These could be implemented for GMIBs and GMDBs. However, thisapproach also encourages the policyholder to surrender the policy once this level has beenreached since the investment in the product is effectively no longer being guaranteed eventhough the guarantee cost may still be being charged for in the product pricing.

• Waiting period – The guaranteed return is always set at a level lower than the expected long-runasset return less fees. Therefore, the longer the waiting period before the GMIB or GMAB can beexercised, the more likely that the option will expire worthless. However, long-run expectedreturns on equity markets is a hotly debated topic which is unlikely to ever be satisfactorily resolved.

• Age limitations – Limits on the accrual of benefits for GMDBs, such as prohibiting ratchets orroll-ups at a maximum age such as 80, can reduce the insurer’s risk exposure. As mortalityincreases at higher ages, it is far more likely that a GMDB that is in-the-money will be “exer-cised” (by death) by an older contract holder. Maximum annuitization ages for step-up GMIBsand maturity ages for GMABs can also help reduce exposure.

• Insured diversity – Diversity of contract holder by age, sex and maturity (of GMABs) can helpreduce potential exposure to a catastrophic scenario. Moody’s believes that it is critical to monitorthe demographic profile of the block of business being written, particularly for enhanced GMDBs.

• Pricing to prevent anti-selection – Pricing categories by age, with increasing M&E charges forolder ages for optional enhanced GMDBs, helps to prevent anti-selection against the insurer.

• Path dependent options – These increase uncertainty since it is difficult to predict policyholderbehavior. Concentration risk, or the risk that a large block of in-the-money options could beexercised near the same time, is increased with path dependent options. For example, considerthe case where a large concentration of step-up GMIB contract holders all exercise their right tostep up their account values at the same time when the market is near an all time high. Since thewaiting period for these policyholders has been restarted, the expirations of the waiting periodsfor this block of business has now become more clustered, and the insurer will be more at risk formarket movement around this new expiration date. Conversely, elections on every 3rd of 5th

anniversary would likely be favorable, since the diversification of strike dates is maintained.• Asset class limitations – The exclusion or limitation of highly volatile funds, or imposing addi-

tional investment and/or M&E charges on funds can help reduce exposure.• Diversification requirements – Requiring contract holder diversification14 across funds or asset

classes can significantly reduce the cost of the option granted and is a sensible method to helpmanage the risk assumed by the insurer.

• Maturity of options – Adequate maturity laddering is especially important for GMABs. Tightlyconcentrated blocks of business all maturing in a short time frame increases the insurer’s expo-sure and liquidity risk. GMIB exposure can also be controlled by restricting annuitization elec-tion to limited time periods around contract anniversary dates.

13. Interestingly, for an in-the-money option (after a market drop), an asset allocation shift to fixed income could produce worse expected returns for the insurer since the contract holder will not achieve expected long run market returns. For a roll-up option, the contract holder may essentially “lock in” the option value.

14. As an example, the Guardian Investor Retirement Asset Manager variable annuity requires investment according to a prescribed asset allocation. The product, called Decade, guarantees the return of principal at the end of ten years.

12 Moody’s Special Comment

RISK TRANSFERENCEMoody’s reviews a company’s risk transference program. This could include reinsurance, hedging or acombination of both. In some cases a company will hedge only part of the risk or might retain a substan-tial residual basis risk. As is the case with any reinsurance program, a diversity of reinsurers spreads riskand reduces the credit risk associated with reinsurance recoverables.

Does The Company Understand The Risk?Any company selling a product containing embedded options should understand the cost and risk profileof the options being sold. This seems elementary but companies have been known to market products thatthey are not able to fully evaluate. They typically add additional product features in an effort to takeadvantage of what they believe are unmet market opportunities or to attract attention in a crowded mar-ket. Insurers may make a rough estimate of the cost of the guarantee based on other companies’ productcharges for the same or a similar guarantee, or they may consider the cost of the guarantees granted asbeing included in the basic M&E charge and not explicitly price it.

One academic effort to value the GMDB options illustrates how the cost of these options could varydependent upon specific details15. As an example, for a 60-year-old male, the researchers calculated thatthe annual cost of a GMDB for a standard return of premium at 9 b.p., a roll-up at 5% at 38 b.p., and anannual ratchet at 56 b.p., respectively16. However, as we previously indicated, Moody’s credit concerns aremost directed at by catastrophic scenarios, a circumstance in which the roll-up is likely to perform theworst. The roll-up can annually cause increasing loses to the insurer every year, even if the market doesnot actually decline, but simply does not increase at least at the guaranteed rate.

PRICING THE RISKProperly pricing an annuity secondary guarantee is a sophisticated undertaking. Many insurance compa-nies perform “realistic” stochastic tests17, and price the option so to obtain a target return on equity. Theexpected value of the option is based upon the actuarial present value obtained, and capital is assignedsuch that the insurer can cover losses the vast majority of the time, such as with a 95% probability.However, it is also not unusual for a reinsurer and the primary insurer to arrive at substantially differentcost estimates for the same guarantee.

This occurs in part because these models are heavily assumption dependent and model results can bevery sensitive to even slight changes in assumptions. This is especially true at the tail end of the payout distri-bution pattern, where the secondary guarantees are “in-the-money” and are, therefore, of the most interest.

Moody’s is generally interested in seeing the results of companies’ stochastic product testing since ithelps identify the level and nature of the “tail risk” embedded in the product’s design. Also useful is thefact that stochastic testing identifies the types of scenarios that are likely to be of particular risk to theinsurer in offering the product.

Other pricing approaches may also be used by the insurer, in addition to or in place of “realistic” sto-chastic testing. A company using “risk neutral” pricing18, as if it were hedging the guarantee, may arrive ata different result than a company using an “expected return” pricing approach.19 Under “risk neutral”pricing, one of the most important assumptions in realistic Monte Carlo simulations, expected return, isnot even used as an input.20 Equity options traded on the major stock exchanges are all valued using sometype of “risk-neutral” pricing. The researchers calculating GMDB costs in the previous example also usedrisk neutral pricing in their analysis.

15. M. Milevsky and S. Posner, The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds, April 4, 2000, and is available at http://www.yorku.ca/milevsky.

16. Assumption: 200% cap on the 5% floor, volatility at 20%, risk free rate of 6% and termination age equal to 75.17. The use of “realistic” or “risk neutral” scenarios in pricing certain insurance products is the subject of some debate. For a discussion

of the issue, please see the Society of Actuaries’ Investment Section newsletter, Risks and Rewards, September, 2000.18. A company could price the option by generating risk neutral scenarios. Milevsky and Posner develop closed form solutions

assuming risk neutrality.19. Note that companies pricing based on risk neutral valuation implicitly assume that they are able to hedge annuity secondary

guarantee risks (or pass the risk to a reinsurance company at the calculated cost plus a profit margin for the reinsurer) in efficient and complete markets. As we have discussed, we believe this is not the case in today’s markets.

20. See J.C. Hull, Options Futures and Other Derivatives, Prentice Hall, Englewood Cliffs, New Jersey, third edition, 1997 for a discussion of option pricing.

Moody’s Special Comment 13

Moody’s believes that the majority of companies use a “realistic” stochastic analysis approach to priceand evaluate their exposure to annuity secondary guarantees. Certain advanced companies use a value-at-risk approach to assign capital and quantify exposure in extreme scenarios. These companies assign capitalat a level such as the 95th percentile21; however they evaluate potential loss at an adverse experience levelsuch as at the 99th or even higher percentile. For example, they calculate the product’s pricing based onoverall expected return plus a risk charge and then evaluate the risk they are exposed to based on howmuch of the allocated surplus they would lose in the 990th worst scenario out of 1,000 total scenarios. Asseen from the hypothetical risk profile below, the non-symmetric nature of the guarantees may make eventhe 99th percentile an incomplete picture of the actual risk. A company may lose much more of its surplusat the 99.8th percentile than the 99th percentile.

From a credit perspective, Moody’s is particularly interested in downside scenarios. Companies charg-

14 Moody’s Special Comment

ing more than what they believe to be the “correct” pricefor unhedged or improperly hedged products can still bevulnerable to severe losses in a plausible yet unlikelyworst case scenario. While we do not expect companiesto hold capital at 99.8%, we believe that it is essential forcompanies to perform severe stress tests to quantifypotential losses to the enterprise under such a draconianscenario. A company “safe” at the 99th percentile couldlose significant money at the 99.8th percentile. Whilethis measuring stick may at first seem extreme, butMoody’s history shows that highly rated companies areexpected to have extremely low default rates. For exam-ple, history shows that the five-year cumulative defaultrate for senior unsecured debt rated by Moody’s at theAa1 rating level is only 23 b.p. which is equivalent to the99.8th percentile.22

STRESS TESTINGMoody’s emphasizes that it believes that companies should adequately stress test their guarantees. Oneway to accomplish this is through stochastic testing. Through this approach worst case scenarios can bedeveloped for further analysis. However, companies should remain cognizant that this approach remainssensitive to the previously discussed subjective inputs. In addition, stochastic scenarios will not fully cap-ture all potential risks since no model can exactly predict the future.

Simple deterministic scenarios do not capture a wide range of potential scenarios; however, a deter-ministic approach remains a valuable tool in understanding the sensitivity of a company’s exposure tochanges in differing input variables.

Moody’s also believes that a well-managed insurer will set appropriate threshold limits on the amountof this risk that they are willing to absorb. For example, the insurer may decide to limit its risk to a speci-fied amount of capital in a defined worst case scenario. This threshold would then be used to set limits onkey variables such as new business production, retention, or product design. However, we are not aware ofthis line of reasoning being used by insurance industry in actual practice. In fact, it is almost unheard offor an insurer to publicly disclose the amount and nature of the equity related risk they are assuming inthese products.

The Scenarios: The Good, The Bad And The UglyFor illustrative purposes, we have classified scenarios for annuity secondary guarantees into three broadcategories: the good, the bad, and the ugly. In Appendices C, D and E we display our analysis for a hypo-thetical block of variable annuity contracts with GMDB, GMIB, and GMAB guarantees, respectively. Weagain note that the actual product risk to a particular company is highly dependent on the factors that wehave previously discussed.

21. The “appropriate” level of capital depends on a number of factors, including the risk profile of the product and the risk tolerance of the company.

22. See Moody’s Special Comment, Historical Default Rates of Corporate Bond Issuers, 1920-1999, pg. 27, January 2000.

Present Value of Cash Flows(Hypothetical Risk Profile)

5 15 25 35 45 55 65 75 85 95 -200-175-150-125-100

-75-50-25

02550

Percentile

THE GOODIn theory, most of the unhedged annuity guarantees on the market should produce favorable returns forthe insurance company the majority of the time. If everything proceeds according to expectations, all theparties involved will win. The contract holder will be able to sleep comfortably at night knowing that theyare participating in the equity markets, but have limited their downside risk. The insurance company hasdifferentiated its variable annuity from mutual funds and at the same time improved its returns on a lowmargin product.

As shown in Appendix A, in the good scenario, the sample block of variable annuities with an enhancedGMDB exposure earns a 26% after tax return on equity (ROE). GMAB and GMIB type guarantees expireout-of-the-money as long as there is modest growth in account values over the applicable contract dura-tion. The insurance company prospers by collecting fees, net of any hedging or reinsurance costs.

THE BADAppendix A also illustrates another less favorable scenario. In this scenario, a rapid market decline leavesthe insurer with a significant net amount at risk on its block of variable annuity business since the guaran-teed account value is greater than the current account value. The negative impact on earnings of thisexposure is compounded by declining asset-based M&E and investment management fees, calculated as apercentage of current account value. In conjunction with a 1.2% mortality rate23, the company realizes anegative 26% after-tax return on equity on this product.

In our example, the insurer experiences a negative cash flow of 32 b.p. of its initial account value inthe first year of our example.24 This may seem small, but a company with $10 billion of outstandingenhanced variable annuities, this represents an annual $32 million cash drain. A prolonged marketdecline combined with poor mortality could make this “bad” situation turn “ugly,” severely eroding aninsurer’s surplus over time.

Poor investment performance over an extended time period is required for a GMAB or GMIB benefitto offer value to the contract holder. While a historical analysis of modern U.S. equity markets would indi-cate that this is unlikely, history over a historically short interval may not be an accurate measure of futuremarket performance. While in modern times U.S. equity market corrections have been relatively mild andshort lived, the risk of a major market correction has not become nil. In fact, some investment professionalswould argue that equity markets’ recent favorable performance has become a risk factor in itself.

The consequences of inadequate risk management in such a scenario could be severe, especially for acompany without conservative capital and reserves.

The distinction between “bad” and “ugly” scenarios depends heavily on the length and severity of themarket decline as well as the nature of the product guarantees.

THE UGLY: THE IMPROBABLE BECOMES REALITYThe thought of a prolonged equity market downturn in combination with low interest rates sends shiversup a pricing actuary’s spine. These circumstances are exactly what has occurred in Japan in recent times.Under these circumstances, the GMIB, GMDB and GMAB benefits all become in the money at a cost tothe insurer.

The GMDB “ugly” scenario illustrated in Appendix C is essentially a continuation of the “bad” sce-nario without a subsequent market recovery. The compounding nature of a GMDB guarantee creates sig-nificant exposure when markets stay flat for a prolonged period. For example, take a 6% annual roll-updeath benefit, which is equivalent to an 8% guaranteed investment return after expenses. If the marketstays flat for ten years, the net amount at risk on a ten-year old enhanced GMDB annuity is approximatelyequal to the account value. If there is no ceiling on the guaranteed account value, the net amount at riskwill continue to grow at a compound rate of 8% a year unless the market improves.

For GMIBs, the severity of the situation is highly dependent on current interest rates. As illustrated inAppendix D, the net amount at risk is decreased if the guaranteed annuitization factor is greater than the

23. For illustration purposes. The actual expected mortality is highly dependent on the gender and age profile of the block of business.24. Actual cash flow is dependent on the age of the business, experience and product design. For cash flow purposes, we ignore funds

in the separate account, as they are not available to the insurer.

Moody’s Special Comment 15

current annuitization factor.25 In simple terms, higher current interest rates and lower life expectanciesthan the conservative ones incorporated into the guaranteed factor will offset poor equity performance.Consider the case of a company with a concentrated block of business as the result of a step-up guaran-tee26. In the ugly scenario of an immediate equity market decline of 20% followed by a flat market overthe next nine years, with contractually guaranteed interest rates of 3% and current pricing interest rates of3%, the insurance company’s economic loss at time ten (excluding accumulated profits) is over 150% ofthe account value.27

Election rates are not an unknown variable for GMABs since contract holders always automaticallycollect the positive value of any benefit earned. In the case of an immediate market decline of 30% fol-lowed by a flat market until maturity, the insurer in Appendix E realizes an economic loss of 114% of theaccount value (excluding accumulated profits) at time ten.

Some products have an enhanced GMDB in addition to either a GMAB or GMIB. While no individualcontract holder can get both benefits, the claim frequency of both benefits are correlated since both are in-the-money when the market drops. Thus, such products could greatly enhance the risk profile of an insurer.

ConclusionThe industry’s shift from offering protection to accumulation products continues to reshape its overallasset mix and risk profile. Moody’s believes that with the competition for assets increasing, insurers willincreasingly be exposed to and retain more equity-related risk. With the majority of the equity guaranteessold to date having been issued during a bull market, most have only contributed to insurer’s profits andsurplus, and have encouraged insurers to offer more enhanced guarantees to deliver more tangible andtransparent value to customers. Regulators are lagging the industry’s move to equity guarantees, leavingmuch of the risk management to individual companies.

Unfortunately, the nature of these products and guarantees are such that they can potentially all beexercised at roughly the same time due to difficult equity market conditions. While the risk can be miti-gated through product design and limiting business concentration, traditional reliance on diversificationcannot be relied upon. Moody’s will continue monitoring developments in this rapidly evolving market.We will focus our efforts on quantifying insurers’ exposure to downturns in this market and how it wouldimpact their financial strength.

25. Specifically, the net amount at risk at election date is equal to: MAX{[((current annuity factor/guaranteed annuity factor)*(guaranteed account value)) minus current account value],0}.

26. We note that in Canada, contract holders have not made efficient use of their “reset” option, which is analogous to the step-up feature. However, we believe that it would be ill advised for insurance companies to count on continued contract holder inefficiency.

27. For illustration purposes, we assume a 100% election rate. In reality it would most likely be below this level; however, it is important to note that the election rate is likely to increase as the value of the benefit increases.

16 Moody’s Special Comment

Appendix A: Glossary“Cliff” Risk Profile: An option type profit-loss profile where the insurer realizes a steady, limited upside

profit in the majority of scenarios; however, under certain limited circumstances that are increasinglyunlikely, losses increase rapidly. While the expected gain to the insurer may be positive, potential lossesare much greater than potential gains.

“Greater-of ratchet or roll-up”: A death benefit that is the greater of the ratchet or roll-up benefits.

Look Back Put Option: A put option in which the strike price is dependent on the maximum underlyingasset value during the lifetime of the option.

Path Dependent Option: The ultimate value of the option is dependent on the movement of the underly-ing asset values during the life of the option.

Ratchet: A death benefit that it is reset at the greater of the prior or current underlying asset value at agiven frequency such as annually.

Roll-up: A death benefit of the premiums paid less any previously made withdrawals compounded at aspecified annual return.

Secondary Guarantee: An annuity secondary guarantee is a product feature other than the core annuiti-zation guarantee required to qualify the product as an annuity.

Step-Up Guarantee: In the case of a GMIB, the base on which the guarantee is based is increased toreflect increases in the account value. In most cases, the contract holder has approximately one monthafter the contract anniversary to “step-up” the base, which is to reset the premium base to the newaccount value. Upon election, the waiting period, or the time until the policyholder can exercise his or heran option, is restarted.

Moody’s Special Comment 17

Appendix B

DETERMINANTS OF ANNUITY SECONDARY GUARANTY RISK PROFILEGMDB: Level of floor guarantees, mortality rates, type of investment funds offered and their returnperformance, contract investment fund allocations and transfers, lapses, treatment of net amount at riskwith dollar-for-dollar partial withdrawals28, and age and sex distribution of contract holders.

GMIB: Guaranteed minimum investment return and annuitization rates, waiting period to annuitize,type of investment funds offered and their return performance, contract investment fund allocationsand transfers, correlation between bond and equity markets, lapse rates, mortality rates, limitations onannuitization, and annuitization election rates.

GMAB: Guarantee minimum investment return, lapse rates, mortality rates, type of investment fundsoffered and their return performance, contract investment fund allocations, and contract duration.

28. Companies not decreasing net amount at risk by the amount of the partial withdrawals face anti-selection. For example, with a GMDB, if the contract owner withdraws $1,000 of the account value, the net amount at risk should decline.

18 Moody’s Special Comment

Appendix CGuaranteed Minimum Death Benefit Illustration

The UglyThe Good The Bad Year 1 Year 2 Year 3

Initial Market Rise of: (first six months) 5.0% 20.0% 20.0% 0.0% 0.0%Followed by Market Rise of: (next six months) 5.0% -40.0% -40.0% 0.0% 0.0%Mortality Rate 1.00% 1.20% 1.20% 1.00% 1.00%Lapse rate 0.0% 0.0% 0.0% 5.0% 5.0%Time Horizon (years) 1.0 1.0 1.0 2.0 3.0

Beginning Account Value 1,000,000 1,000,000 1,000,000 711,360 669,034 Ending Account Value 1,102,500 720,000 720,000 675,792 635,582 GMDB Guarantee 1,102,500 1,200,000 1,200,000 1,126,320 1,059,304 Net Amount at Risk (EOY) 0 480,000 480,000 450,528 423,722 Initial Capital (adj. for lapses & mortality) 8,000 8,000 8,000 7,904 7,434 Pre-Tax ROA (bp) 30 30 30 30 30 Tax Rate 35% 35% 35% 35% 35%

Annual Earnings (excluding GMDB) 3,154 2,580 2,580 2,081 1,957 GMDB Benefits 0 5,760 5,760 4,505 4,237 Earnings after GMDB 3,154 (3,180) (3,180) (2,425) (2,280)

Tax Effect 1,104 (1,113) (1,113) (849) (798)After-Tax Earnings 2,050 (2,067) (2,067) (1,576) (1,482)

After-tax ROE (on adjusted initial capital) 26% -26% -26% -20% -20%

AssumptionsCapital requirements of 80 basis pointsGMDB is semi-annual ratchet100% equity exposureLapses immediately prior to EOYDeaths at EOYNotesAnother potentially “Ugly” scenario is a prolonged flat market after a market downturn for a roll-up GMDB guaranteeEither “Ugly” scenario would be compounded by increased mortalityThe capital supports the entire variable annuity product - not just the GMDB secondary guarantee

Moody’s Special Comment 19

Appendix DGuaranteed Minimum Income Benefit Illustration

GMIB ScenariosAssumptions (1) (2) (3)

1st year Account Return 5.00% -10.00% -20.00%Years 2-10 Account Return 5.00% 4.00% 0.00%Lapse Rate 5.00% 5.00% 5.00%Expenses (% account value) 2.00% 2.00% 2.00%Rollup Guarantee 6.00% 6.00% 6.00%Election rate for in the money options 100% 100% 100%Original Account Value 100,000 100,000 100,000Time Horizon (years) 10 10 10

Company Annuity Factors at Time 10Annuitization interest rates (Year 10) 5% 4% 3%Annuity factor (Year 10) 12.1 13.2 14.5

At End of Year 10Guaranteed Account Value 112,868 112,868 112,868 Ending Account value 84,700 66,282 40,987 Net Amount at Risk (at year 10) 28,168 46,586 71,881

GMIB Sensitivity Analysis Realized value of policyholder option less ending account value

Guaranteed annuity a 0 22,931 57,013 Guaranteed annuity b 1,737 28,013 62,595

Guaranteed annuity c 10,804 37,904 73,460 Guaranteed annuity d 21,168 49,211 85,881

as a % of Ending Account Value

0% 35% 139%2% 42% 153%

13% 57% 179%25% 74% 210%

1) Net amount at risk increases as interest rates at time ten decline (across)2) Net amount at risk increases as annuity guarantee increases (down)

Notes:Mortality: (note that this was selected for illustration purposes only)Guaranteed: GAM 94 male w/ 6 year setback and ten-year certain periodCurrent: GAM 94 male w/ 3 year setback with ten-year certain periodThe 5% lapse rate is a conservative assumption

Ratio current annuity to guaranteed annuityint. rate Factor (1) (2) (3)

Contactually Guar. Annuity FactorsGuaranteed annuity a 2.50% 16.7 72% 79% 87%Guaranteed annuity b 3.00% 15.8 77% 84% 92%Guaranteed annuity c 4.00% 14.3 85% 92% 101%Guaranteed annuity d 5.00% 12.9 94% 102% 112%

Data table of current annuity factorsCurrent annuity a 2.50% 15.3Current annuity b 3.00% 14.5Current annuity c 4.00% 13.2Current annuity d 5.00% 12.1Current annuity e 6.00% 11.1

20 Moody’s Special Comment

Appendix EGuaranteed Minimum Accumulation Benefit Illustration

The Good The Bad The Ugly

Assumptions1st year Account Return 12.00% -20.00% -30.00%Years 2-10 Account Return 12.00% 4.00% 0.00%Combined Lapse and Mortality Rate 5.00% 5.00% 5.00%Time Horizon (years) 10 10 10Expenses (% account value) 2.50% 2.50% 2.50%GMAB Principal Guarantee 115.00% 115.00% 115.00%

Original Account Value 100,000 100,000 100,000

At End of Year 10Guaranteed Account Value 72,479 72,479 72,479 Ending Account value 156,190 55,848 33,873 Net Amount at Risk (at year 10) 0 16,631 38,605

Value of policyholder option (at year 10) 0 16,631 38,605 as a % of Ending Account Value 0.00% 29.78% 113.97%

Notes:The 5% lapse rate is a conservative assumption

Moody’s Special Comment 21

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