Marketplace & Regulation3

In 1759, Pennsylvania chartered the "Corporation for the Relief of Poor and Distressed Presbyterian Ministers and Distressed Widows and Children of Ministers" to provide periodic payments to retired ministers and their survivors.  From that humble beginning, the market for annuities in the United States has evolved into a dynamic marketplace collecting contributions totaling over $230 billion in 2007.  Today's annuity companies have also evolved.  Aside from having less-distressing sounding names than their colonial forbearer, the annuity industry has created a variety of products to meet the needs of a diverse clientele ranging from private individuals to Fortune 500 companies.  Annuities, which once represented a small percentage of the insurance industry's business, now represent a major source of its revenues.

 

Annuities, in one form or another, have been around for over two thousand years. In Roman times, speculators sold financial instruments called annua, or annual stipends. In return for a lump sum payment, these contracts promised to pay the buyers a fixed yearly payment for life, or sometimes for a specified period of term. The Roman Domitius Ulpianus was one of the first annuity dealers and is credited with creating the first life expectancy table.

 

During the Middle Ages, lifetime annuities purchased with a single premium became a popular method of funding the nearly constant war that characterized the period. There are records of a form of annuity called a tontine. This was an annuity pool in which participants purchased a share and, in turn, received a life annuity. As participants died off, each survivor received a larger payment, until finally, the last survivor received the remaining principal. Part annuity, part lottery, the tontine offered not only security but also a chance to win a handsome jackpot.

 

During the 18th century, many European governments sold annuities that provided the security of a lifetime income guaranteed by the state. In England, Parliament enacted hundreds of laws providing for the sale of annuities to fund wars, to provide a stipend to the royal family, and to reward those loyal to it. Fans of Charles Dickens and Jane Austen will know that in the 1700s and 1800s, annuities were all the rage in European high society. Annuities owed this popularity among the upper class to the fact that they could shelter annuitants from the "fall from grace" that occurred with investors in other markets.

 

The annuity market grew very slowly in the United States. Annuities were mainly purchased to provide income in situations where no other means of providing support were available. Few people saw the need for structured annuity contracts to guarantee themselves an income if they could rely on support from their extended families. Annuities were mostly purchased by lawyers or executors of estates who needed to provide income to a beneficiary as described in a last will and testament.

 

This all began to change at the turn of the 20th century, as multi-generational households became less common. The Great Depression was especially significant in the history of annuities. Until then, annuities represented a miniscule share of the total insurance market (only 1.5% of life insurance premiums collected in the US between 1866 and 1920). During the Great Depression, investors sought out more reliable investments in order to safeguard themselves from financial ruin. With the economy less stable than it had ever been, many individuals looked to insurance companies as a haven of stability in what seemed a sea of anything but.  Today, annuities represent roughly 30% of premium dollars collected by insurance companies. 

 

 

Private vs. Commercial Annuities

 

Annuities have existed for centuries, long before the advent of modern-day annuity companies.  Jane Austen's character Mrs. Dashwood, whom we met in the introduction, was referring to a private annuity contract between her husband and his half-sisters.  Private annuities continue to exist today -- in fact any kind of installment sale can be viewed as creating an annuity (a stream of payments).   Unlike standard installment sales, private annuities require the buyer to continue payments for the seller's lifetime. 

 

The tax code acknowledges the sale of property or business interests in exchange for private annuities, and these tax provisions can afford substantial estate and income tax planning advantages.  What sets a private annuity apart in the tax code is that the party agreeing to make the annuity payments in the future cannot be in the business of writing annuities.  In many cases, private annuities are contracts between family members.  A mother might sell her share of the family business to her children in return for a lifetime of income payments.  It provides a way for the family to transfer ownership in the business to the next generation and lock in the price of that asset at today's value.  This transfers future appreciation from the mother's eventual estate to the children and lowers the family's estate tax liability.      If structured properly, the mother receives a lifetime income, which is treated as partial tax-free return of principal (using the exclusion ratio concept) and it also delays recognition of any capital gain from the sale until the annuity payments are paid.  The mother, of course, runs the risk that her children will not pay the promised payments for whatever reason (business failure, personal animosities, etc.).  As Mrs. Dashwood would say, "Annuities are a serious business..."

 

Commercial annuities, on the other hand, are contracts issued by companies in the business of writing annuities -- in most cases, annuity companies are also life insurance companies.   Companies in the business of writing commercial annuity contracts do so to make a profit.  They rely on the Law of Large Numbers and their expertise in calculating mortality (or survivorship) factors.  The Law of Large Numbers states that given enough exposures, mathematical probabilities can become absolute certainties.  Toss a coin once and it is impossible to predict whether it will land heads or tails.  Toss it a hundred times, and chances are good that it will come up heads roughly 50 times (and tails 50 times).  Toss the coin a million times, and it is very certain that the split will be exactly 50%-50%.  Insurance companies use this law to accurately predict the mortality and survivor experience of large numbers of people and be able to turn a risky proposition into a fairly safe and profitable one. 

 

The rest of this course will concentrate on commercial annuity contracts.

  

 

 

Ratings

 

A commercial annuity is only as secure as the insurance company issuing it. One simple way to analyze a company's strength is to review its rating. Six major credit agencies determine insurers’ financial strength and viability to meet claims obligations. They are A.M. Best Co.; Duff & Phelps Inc.; Fitch, Inc.; Moody’s Investors Services; Standard & Poor’s Corp.; and Weiss Ratings, Inc. These companies consider factors such a company earnings, capital adequacy, operating leverage, liquidity, investment performance, reinsurance programs, and management ability, integrity and experience. (Note: A high financial rating is not the same as a high consumer satisfaction rating, or vice versa.)

 

An annuity company's rating measures the financial strength of the company as such, they should be used when analyzing fixed (including indexed) annuity contracts that are backed by the company's general assets.  Ratings do not apply to separate accounts (investment portfolios) held within a variable annuity.  Clients should not rely on these ratings to determine the quality of investments within a variable annuity's separate accounts, but ratings can be helpful in gauging the company's ability to back up a variable annuity's guaranteed values, such as the minimum death benefit.

 

For details on each rating agency's methodology and rating systems, please refer to the agency's website.

 

Most annuity companies will refer to their ratings in their marketing literature and post their rating on their website. 

 

As you would expect, prices for contracts issued by more highly-rated companies will be higher than prices for lower-rated companies.  Advisors should limit their recommendations to higher-rated carriers, even at this means recommending that a client pay a slightly higher price or accept a slightly lower return.  A weak annuity company represents a potential for financial loss to its contractholders, as well as a number of headaches and hassles. Failure could mean both loss of investment and loss of future income. Therefore, it is important to check the financial security offered by a company prior to purchasing an annuity and then periodically monitor the company's condition going forward.

 

Note: as we learned in the subprime mortgage market, rating organizations may be susceptible to influence.  Insurers pay the ratings agencies for their rating, so there is an inherent conflict in the relationship.  Ratings agencies typically rely on data from the past, and will not devote a lot of their analysis to projections of future trends.  Thankfully there are a number of agencies, and viewed collectively, their ratings can provide useful insight into the company's financial strength.

 

 

 

Individual and Group Contracts

 

As is the case with life insurance, annuity contracts can be broken into two basic categories: individual and group.  Individual annuity contracts relate to an individual lives; group annuity contracts, by contrast, are one contract covering number of individuals.   Most of this course will focus on individual annuity contracts, but a brief discussion of group annuity contracts is in order.   

 

Insurance companies started to market group insurance policies life, medical expense and disability to corporations shortly after World War I.  In the early 1920's, Metropolitan Life extended the group concept of annuities to the corporate pension market.  Up until that time, corporations that offered employees a pension benefit (usually only to executives) would finance retiree benefits on a pay-as-you-go system out of current earnings (not unlike the current Social Security system).  In 1921, Metropolitan started to manage corporate pension programs, collecting contributions while the workers were employed and paying out benefits upon their retirement.  Eventually, the company introduced its own retirement plan program and began actively marketing group annuities.  These early group annuity contracts called for employer and employee contributions during the working years, with a provision for the employee, at age 65, to take a lump sum or lifetime annuity payments.  Unfortunately, the Great Depression hit before this market could fully develop.  Promises of a minimal retirement benefit under the new Social Security System (enacted in 1935) also slowed development of the private-sector group annuity market.  After World War II, the market for group annuities grew rapidly, pushed in part by collective bargaining agreements negotiated with organized labor.  In 1941, only about a quarter of a million workers were covered by group contracts; twenty years later, that had grown to almost four million, and to 38 million by 1988 its high water mark.

 

Pension plans funded with a group annuity contract were called "annuity purchase plans", for obvious reasons.  In 1974, Congress enacted ERISA (Employee Retirement Income Security Act) as a response to the bankruptcy of Studebaker in 1964, and the resulting problems it caused for its employees and retirees.  This federal law codified pension regulations and created the two major classes of retirement plans we know today: defined benefit plans and defined contribution plans.  The rules on defined benefit plans (the old annuity purchase plans) were tightened.  At the same time, businesses that had traditionally offered annuity purchase plans (e.g., manufacturing and other heavy industries that used organized labor) began to shrink, while increasing numbers of workers became employed in the service sector and non-unionized industries.  As a result of these changes, defined benefit plans were steadily replaced with defined contribution plans -- and this reduced the market for group annuities.   Defined contribution plans (centralized, "money purchase" plans or individualized 401k plans) focus more on accumulation of retirement savings, although they do have distribution features as well.  Future growth in the group annuity marketplace today will focus on serving the distribution needs of defined contribution plans.

 

Generally speaking, group annuities (at least to large corporations) are placed through large insurance brokerage firms.  Perhaps as the marketplace changes, and the Boomer generation reaches retirement age, there will be more opportunities for individual agents to capture some of the market for group annuities.  

 

 

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A.M. Best

ambest.com

Standard & Poor’s

standardandpoors.com

Moody’s

moodys.com

Fitch

fitchratings.com

Duff & Phelps

duffandphelps.com

Weiss Ratings

weissratings.com