Risk Professional - December 2009

American International Group is the most obvious case in point. Its structured investments suffered spectacular losses, and the U.S. government injected over $180 billion to keep its systemic risk from spiraling out of control. Comprehensive ERM was lacking, to say the least: In a March 2008 letter, the U.S. Office of Thrift Supervision warned that AIG Financial Products had to rein in its risk, but even as that unit began to limit its subprime mortgage exposure, the AIG Investments and United Guarantee Corp. units were doing the opposite.

Among those in the variable annuity (VA) business, MetLife, Axa Equitable and Fidelity Investments Life Insurance Co., as well as TIAA-CREF, which sat out the rider frenzy, came out better than Manulife Financial Corp. and the Hartford Financial Services Group. Subprime mortgages cause the asset side of balance sheets to suffer, while liabilities from guaranteed VAs have sharply increased due to lower interest rates and greater equity volatility.

Ramy Tadros, partner and head of the North American insurance practice of consulting firm Oliver Wyman Group,

GMLB comes in three variations: guaranteed minimum income, accumulation and withdrawal benefits. The last two of those are marked to market, while GMDBs and most guaranteed minimum income benefits (GMIB) are not. The reason, according to most interpretations of the Financial Accounting Standards Board guidelines, is that withdrawal and accumulation benefits represent an equity-linked option. GMDBs are not considered embedded derivatives because the policyholder has to die for the disbursement of funds.

As New York-based Prudential Financial disclosed in its 2008 annual statement, “We have deemed the risks associated with the guaranteed minimum income benefits suitable to retain.” The same went for GMDBs. Manulife also had a relatively lax approach.

On June 12, Fitch Ratings downgraded Manulife’s issuer default rating from AA- to A+ and put it on a negative ratings watch, citing the potential for higher-than-expected losses in its credit portfolio and the possible need to shore up capital to support the “large, unhedged variable annuity business” if equity markets declined further.

You can’t squeeze blood out of a turnip. Variable annuities

points to hedging missteps as a major cause of pain. “ Insurance companies wrote put options that were unhedged or hedged only to accounting rules,” he says. “But you could be well hedged from an accounting perspective and still get seriously hurt from a regulatory capital perspective, where the hedge objectives are different.”

Capital Considerations

That points up the new focus on regulatory risks. “Prior to the crisis, a lot of the emphasis was on setting up hedging programs to manage volatility in our income statements” under generally accepted accounting principles (GAAP), notes Rallis. “Now, the emphasis has begun to shift towards managing statutory capital” – which has been built into Rallis’ hedging program at MetLife since 2005.

Part of the trouble that insurers got into has to do with accounting rules. Under Financial Accounting Standards 133 and 157, hedge accounting rules vary for the different types of VA guarantees. The two types of guarantees, or riders, offered with an annuity are guaranteed minimum death benefit (GMDB) and guaranteed minimum life benefit (GMLB).

Now firms are taking a closer look at the metric of eco- nomic capital, or simply assets minus liabilities at cur- rent values, and product design. Economic capital differs from calculations of statutory capital and GAAP return on equity in that it does not make forward-looking assumptions about the future market performance. It also assumes a firm hedges all of its equity and interest rate exposures. At the same time, the National Association of Insurance Commissioners, which represents U.S. state regulators, has its own guidelines for reserves.

ING’s Potjes explains the complications when the codes aren’t harmonized: “We see that local statutory rules are different from the accounting rules, which are not the same as the economic principles that determine the value of annuities. One of the challenges of risk officers is to balance and apply these all at the same time and to highlight which one is the most stringent for the business at a certain time. But whether you are insolvent under International Financial Reporting Standards or under local GAAP, you are still insolvent.”