For years, critics have charged that the guaranteed features offered in many variable annuities are marketing gimmicks that cost insurers little. But with the current bear market about 18 months old, the perspective on the potential cost of these benefits is changing dramatically.

The benefits coverage greatly enhances the allure of variable annuities from a sales perspective. Variable Annuity Research and Data Services (VARDS) reports that the number of variable annuities offering improved benefits increased 112% from 1995 through 2000. Meanwhile, Moody's Investors Service estimates that guaranteed minimum income benefits (GMIBs), guaranteed minimum accumulation benefits (GMABs) and enhanced earnings benefits (EEBs) account for about 10% of all VA sales.

Risk-averse investors are attracted to products with enhanced death-benefit guarantees, but some observers are concerned that insurance companies may be exposing themselves to greater risks. In a prolonged bear market, they may have to pay more in death-benefit claims than they expected. Or they may have to dip into their own reserves more than anticipated to cover living benefits.

Scott Robinson, a Moody's analyst, says the service isn't downgrading any insurance companies due to their risk-based capital or reserves they have set aside for aggressive death- and living-benefit guarantees. But the credit-ratings service is watching insurers that derive the bulk of their business from variable annuity sales.

"For now, there appears to be adequate reserving," says Robinson, "But reserving is very unclear. The response has been to unbundle some of these features. This should help spread the risk if they price the options adequately."

Timothy Pfeifer, consulting actuary and principal with MillimanUSA in Chicago, says pricing is more of an issue with GMABs, GMIBs and EEBs. "The guaranteed death benefit is less of an issue because the policyholder has to die for the cost to come into play," Pfeifer says. "Living benefits are optional and exercisable at the discretion of the policyholder. The more these benefits come into play, the more the pricing is challenging."

More aggressive issuers could experience problems if the stock market continues to perform poorly for an extended time period, Pfeifer argues. "Insurance companies decide to price benefits based on a variety of equity performance scenarios," Pfeifer says. "They use the 85th and 90th percentiles as worst-case scenarios. Pricing is not a problem. More aggressive companies are pricing on the 60th percentile of the scenarios. But in a catastrophe, the cost they charge for the benefits would be inadequate."

Pfeifer also says how much they are putting into reserves and risk-based capital for living benefits is a gray area. There are no regulatory guidelines on what the level of risk-based capital for living benefits should be.

A National Association of Insurance Commissioners (NAIC) task force has been working on regulatory guidelines for more than a year, a NAIC spokesperson says. Concerned about the potential financial solvency of insurance companies that offer living benefits, the organization expects to have model regulations published in late 2002. "Companies have been increasing their reserves, but that is a stopgap approach," Pfeifer says.

Norse Blazzard, partner with Blazzard, Grodd & Hasenauer in Westport, Conn., maintains many insurance companies could run into major financial problems if there is a prolonged, 1970s-style bear market. And if an insurance company went bankrupt, policyholders would not receive their death- or living-benefit coverage. State guarantee associations, which insure policyholders, do not cover variable insurance products.

"Sixty percent of the premiums from most insurance companies come from variable annuities," says Blazzard, who formerly was chairman of the National Association of Variable Annuities (NAVA). "Some have even more. Insurers could have severe problems. If it [a poorly performing stock market] were long enough, there could be bankruptcies on a case-by-case basis."

A Moody's October 2000 report, "Bells and Whistles: Credit Implications of the New Variable Annuities," argues insurance companies may not be pricing their options adequately. "The regulators have not kept pace with the guaranteed living-benefit marketplace," the report says. "Consequently, actuaries were forced to rely on professional judgment in setting appropriate reserves and capital levels without explicit regulatory guidance. The insurance industry has had limited experience in setting and implementing reserves for products containing equity-based guarantees. Furthermore, limited data on policyholder behavior makes it difficult for actuaries to develop methodologies for price and evaluate these products."

Part of the problem, Moody's contends, is that many companies price and allocate capital to stochastic results at the 95th and 98th percentile. But Moody's does not believe this is "an adequate degree of conservatism." The reason: Moody's historical default rate for Aa3-rate issuers is 41 basis points, which is equivalent to the 99.6th percentile standard.

The margin between safety and risk is thinner than many assume. A company safe at the 99th percentile could lose significant money at the 99.8th percentile. "We don't think they have to price the policies based on the 99th percentile, but they should be aware of the catastrophe if there were a severe decline in the market beyond the 95th percentile," says Robinson, co-author of the report.

So how bad could it get? The report says a poor-performing stock market could cost insurers millions of dollars. The analysis found that an aggressive roll-up death-benefit guarantee could be costly in a flat market. If variable annuities had a 6% annual roll-up with no cap on the guaranteed account value, the net amount at risk would grow at an 8% annual compound rate until the equity market improved.

Regarding living benefits, the report shows that a rapid market decline leaves the insurer with a significant net amount at risk on its block of variable annuity business since the guaranteed account value then would exceed the current account value. The negative impact of the exposure is compounded by declining asset-based mortality, expense charges and investment management fees. Based on a 1.2% mortality rate, the insurance company would realize a -26% after-tax return on equity on this product.

An insurance company would experience a negative cash flow of 32 basis points on its initial account value in the first year of the contract. Put another way, a company with $10 billion of outstanding enhanced benefits would experience a $32 million cash drain. "A prolonged market decline combined with poor mortality could make this bad situation turn ugly, severely eroding an insurer's surplus over time," Robinson says.

The risks of equity losses caused reinsurance companies to back off from covering enhanced death and living benefits in 1998. Both Cigna and Swiss Reinsurance got out of the business. Today, only AXA Reinsurance and offshore firms such as ACE Tempest Reinsurance and Annuity Life Reinsurance cover death and living benefits-and at high prices.

Timothy Ruark, president of Ruark Insurance Advisors in Simsbury, Conn., says reinsurance companies backed off in 1998 after analyzing the ramifications of a bear market. He maintains that if a bear market in stocks lasted two years or more, reinsurance companies would lose money covering products that guarantee the contract holders' principal will increase at a 5% or 6% annual rate.

Insurers that cover immediate annuity guaranteed, minimum income benefits also would be at risk. In an environment with low interest rates and volatile stock prices, the reinsurer may not be able to invest the death-benefit fees at a high enough return to cover claims. "The one-year ratchets are not affected," Ruark says. "But the 6% roll-ups and guaranteed minimum income benefit offered by some companies during annuitization are affected."

Denny Carr, executive vice president and chief actuary with Integrity Life Insurance Co. in Louisville, Ky., says insurance companies began to unbundle their variable annuities after reinsurance companies would not renew their contracts for guaranteed minimum death benefits. By offering a variety of death benefits and living benefits at different costs, the insurance companies can spread their risks and charge a fair premium for each type of coverage.

Carr believes insurers now are more adequately pricing and reserving for their variable-annuity liabilities. But there is always uncertainty, particularly with these types of coverage. In the future, he says, some reinsurance companies may offer catastrophe insurance for new variable-annuity benefits. This would help mitigate the costs in volatile markets, but generally would increase the cost of benefits.

"There is always the potential that you are not charging enough," Carr says. But he adds that on average, about 1% of annuitants die annually. Because not all of those people have elaborate death- or living-benefit guarantees, the risk to the insurance companies is mitigated. Plus, over the long term, insurance companies are building up their reserves for the benefits.

Nationwide Financial in Columbus, Ohio, was the first to unbundle its popular Best of America variable annuity, opting to self-insure its enhanced benefits because reinsurance was too costly. Eric Henderson, a Nationwide variable-annuity product officer, says reinsuring enhanced benefits would have cost the company 25 basis points, while self-insurance runs about 15 basis points.

Today, Best of America's Future Annuity product comes with a choice of three death benefits. The standard death benefit is built into the cost of the product. For 15 basis points, policyholders get the greatest value, based on a one-year step-up. The other enhanced death benefit pays the greater of one year's appreciation or 5% annual compound return. It costs another 20 basis points.

Last year, Nationwide added a GMIB that costs between 30 and 45 basis points. And in June, it added an EEB that equals 40% of the adjusted contract earnings, with no cap. The cost of this benefit is 40 basis points.

Henderson says the insurer has had to pay out few death-benefit claims this year. Nationwide paid out 3,160 claims, out of 900,000 contracts. "Investors now have a choice of benefits," says Henderson. "Multiline products give you a lot of diversification against risk."

American Skandia of Shelton, Conn., now offers 10 variable annuity products, although three of them are available only in New York. All but one product comes with standard death-benefit guarantees. The large number of products enable the insurer to avoid adverse selection because advisors can put people of different ages into the appropriate product. In addition, the diversification of the clients' mutual funds reduces investment risk.

Jacob Herschler, vice president of marketing, says two of American Skandia's most popular products are the ASApex, which comes with a four-year, back-end surrender charge. The ASL variable annuity has no surrender charge. Both products come with standard death-benefit guarantees and a 125 basis-point mortality and expense charge.

For an additional 35 basis points, policyholders can get an EEB with any of the products. They also can get a 5% guaranteed minimum death benefit for 30 basis points. There is also a guaranteed return for the first seven years of the policy. That option costs 25 basis points.

Herschler says American Skandia is self-insuring these guarantees. But he declined to comment on how much the company is reserving or has paid on claims during the past 18 months. "We are a public company, and I can't get into that," says Herschler. "We are meeting regulatory standards."

The Touchstone Family of Funds and Variable Annuities in Cincinnati recently introduced Touchstone Choices. The basic product comes with a standard death-benefit guarantee with a mortality and expense charge of 85 basis points, a 15 basis-point administrative fee and an annual $30 charge that translates into a 30 basis-point fee on a $10,000 investment.

The variable annuity comes with value-added options, including a choice of between 1% and 5% bonuses on first-year contributions during the first seven years of the contract. The charge is 15 basis points for every 1%.

The product's enhanced death benefits range from 15 basis points for the greater of the standard death benefit or the highest anniversary value to the greater of the standard death benefit to the highest anniversary value to the 5 percent roll up. This benefit costs 35 basis points.

Jill McGruder, Touchstone's president and CEO, says the company is self-insuring its variable annuity, which is underwritten by Integrity Life. About 2 to 8 basis points are reserved to cover the standard death benefits, while 100% of the cost of the enhanced benefits are reserved to cover claims.

McGruder says Touchstone, on average, pays out about 2% of assets in death-benefit claims, which is about the industry average. Over the past seven months, McGruder says, Touchstone paid out $40 million in death-benefit claims on both its fixed and variable annuities with total assets of $2 billion. "Reinsurance has been a big issue," says McGruder. "But you don't have to go to reinsurance if you unbundle. People will buy only what they need."

Metropolitan Life, however, is using reinsurance for its three new unbundled products, which are sold in different markets. The company has products for both financial advisors and broker-dealers, as well products for MetLife and New England Financial agents.

The financial planning and broker-dealer product is loaded with enhanced options. Policyholders have a choice of standard, annual step up or 5% roll-up with no-cap death-benefit guarantees. In addition, there are GMAB, GMIB, EEB and bonus premiums that can be added to the annuity. A policyholder who chooses all the enhancements would spend around 100 basis points for them, in addition to the mortality and expense charge.

Barbara Hume, a vice president at MetLife, says the company is reinsuring part of the risk. The cost of the enhancements covers the cost of the reinsurance. "We have the reserves and surplus and have low surrenders," she says. "We have $40 billion in assets and have not had a problem getting reinsurance."

She wouldn't comment on how much MetLife paid out in claims on its $40 billion in variable annuity assets, except to say "it is a small amount, and there has been no increase in death-benefit claims."