Chapter 3 — Marketplace & Regulation

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. Today’s annuity companies have 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 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 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 nearly constant warfare. A form of annuity called a tontine emerged — 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 both security and 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, provide stipends to the royal family, and reward the loyal. Fans of Charles Dickens and Jane Austen will know that in the 1700s and 1800s, annuities were fashionable in European high society — prized for their ability to shelter annuitants from the “fall from grace” that afflicted investors in other markets.

The annuity market grew slowly in the United States. Until the turn of the 20th century, annuities were mainly purchased by lawyers or executors of estates who needed to provide income to a beneficiary as described in a last will and testament — few people saw the need for structured annuity contracts when they could rely on extended family support.

This began to change 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 between 1866 and 1920). During the Depression, investors sought more reliable investments, looking to insurance companies as a haven of stability. Today, annuities represent roughly 30% of premium dollars collected by insurance companies.

Annuities have existed for centuries, long before the advent of modern-day annuity companies. 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 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 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, transferring future appreciation out of her eventual estate and lowering the family’s estate tax liability.

If structured properly, the mother receives a lifetime income treated as part tax-free return of principal (using the exclusion ratio concept) — and the arrangement also delays recognition of any capital gain from the sale until the annuity payments are received. The mother, of course, runs the risk that her children will not pay the promised payments for whatever reason (business failure, personal animosities, etc.).

Commercial annuities, on the other hand, are contracts issued by companies in the business of writing annuities — in most cases, these companies are also life insurance companies. 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 become near certainties — allowing insurance companies to turn what would be a risky proposition for any individual into a fairly safe and profitable one for the group. The rest of this course concentrates on commercial annuity contracts.

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, considering factors such as company earnings, capital adequacy, operating leverage, liquidity, investment performance, reinsurance programs, and management ability, integrity, and experience.

An annuity company’s rating measures the financial strength of the company — and should be used when analyzing fixed (including indexed) annuity contracts backed by the company’s general assets. Ratings do not apply to separate accounts 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.

Most annuity companies will refer to their ratings in marketing literature and post their rating on their website. As you would expect, prices for contracts issued by more highly-rated companies will generally be higher than prices for lower-rated companies. Advisors should limit their recommendations to higher-rated carriers, even if this means recommending that a client pay a slightly higher price or accept a slightly lower return. A weak annuity company represents potential for financial loss to its contractholders — failure could mean both loss of investment and loss of future income. It is important to check the financial security of a company prior to purchase and then periodically monitor the company’s condition going forward.

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 life; group annuity contracts, by contrast, are one contract covering a number of individuals. Most of this course focuses on individual annuity contracts, but a brief discussion of group contracts is in order.

Insurance companies started marketing group insurance policies — life, medical expense, and disability — to corporations shortly after World War I. In the early 1920s, Metropolitan Life extended the group concept to the corporate pension market. Up until that time, corporations that offered employees a pension benefit would finance retiree benefits on a pay-as-you-go system out of current earnings (not unlike the current Social Security system). Metropolitan began managing corporate pension programs, collecting contributions while workers were employed and paying out benefits upon retirement. 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, and 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.” In 1974, Congress enacted ERISA (Employee Retirement Income Security Act) in 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. As businesses that had traditionally offered annuity purchase plans (e.g., manufacturing and heavy industries using organized labor) began to shrink, and as more workers became employed in the service sector and non-unionized industries, defined benefit plans were steadily replaced with defined contribution plans — reducing the market for group annuities.

Defined contribution plans (centralized “money purchase” plans or individualized 401(k) plans) focus more on accumulation of retirement savings, although they have distribution features as well. Future growth in the group annuity marketplace 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.

At one time, life insurance products (including annuities) were sold primarily through the insurer’s “captive” sales force. Today, that is no longer the case. Over the past couple of decades, changes in the marketing and distribution of individual life and annuity products have had a strong impact on industry growth and profitability. New distribution channels include banks, broker-dealers, wirehouses, the Internet, and fee-for-service financial planning. This expansion is partly the result of non-insurance companies diversifying their product mix, and partly the result of mergers and consolidations within the financial services sector. These expanded channels increase the opportunity for insurers to access new customers, but have also resulted in increased costs due to more intense regulatory scrutiny and new compliance requirements.

Market research by LIMRA indicates that consumers tend to segment their financial activities into two broad groups — insurance and financial planning. Because consumers typically view annuities as investment products, they are often more willing to consider traditional investment distribution channels (banks, stockbrokers, financial planners) as acceptable sources for purchasing annuities. But when it comes to life insurance, consumers continue to gravitate toward traditional insurance professionals. Today, stockbrokers and banks write approximately 40% of total individual annuity new business, while less than 10% of new individual life premium is written through these channels.

The shift to third-party distribution was seen as a way to meet customers’ calls for more independent sales representatives, as well as a way for companies to shift away the fixed costs of a captive sales force. There have been unintended consequences, however. Insurance products, including annuities, have come to be viewed as interchangeable “commodities,” leading to greater price competition. Companies also found themselves competing for limited “shelf space” as independent agents were given a wider variety of branded products to offer their clients. Both of these trends have placed greater pressure on company profitability.

In addition, unaffiliated agents with access to products of several different carriers can quickly discern and exploit any pricing or design mistakes to the detriment of insurers. Because these producers no longer have a strong affiliation with a single carrier, they are more likely to recommend replacement of existing contracts when new products come to market. This can upset the “persistency” assumptions insurers make when pricing their products (persistency is the average length of time a contract stays in force). Insurers amortize their contract acquisition costs over a long period — any increase in policy surrenders has a negative impact on company profits.

The distribution chain has become longer and subject to forces outside the control of the underwriting carriers. This has put old regulatory assumptions under pressure: Who is responsible for supervising the agents? Who is responsible for determining whether a recommended product is suitable for a particular client? Increased price competition and a wider range of alternatives would seem to benefit the annuity-buying public. But the downside is that the new sales force may not be as knowledgeable about the products they are selling, or may be more concerned with the short-term gain afforded by generous commissions than with long-term client satisfaction.

Liquidating marketable securities such as stocks, bonds, or mutual funds is relatively easy and incurs few transaction costs. That has not been the case with annuity contracts. Deferred annuities allow for partial withdrawals or surrender, but in the early years of the contract there may be steep surrender fees. And once the contract is annuitized, those limited options are usually not available (a few contracts do offer “commutation” provisions to allow for surrender after annuitization).

In some cases, beneficiaries inherit annuities that met the initial contractholder’s needs but do not fit the beneficiary’s financial plan. Other contractholders may face an urgent need for cash due to financial emergencies, while others may simply find that their financial plan has changed: investment strategies, estate planning or wealth transfer needs have shifted. Some annuity holders may simply have buyer’s remorse and wish to undo a mistaken purchase.

A nascent secondary market for annuities is emerging, giving investors the opportunity to sell what was once unsalable and possibly cash in their policies for more than they could receive from the annuity company upon surrender. According to a survey of existing annuity contractholders by the American Council of Life Insurers (ACLI), 27% of respondents are concerned that they may be unable to sell their annuity if they want the money for something else.

A number of companies that previously filled a niche in turning structured settlements (usually judgments in court cases paid over time) into lump-sum payouts have expanded their services to include standard annuity contracts. According to the National Association of Insurance and Financial Advisors, however, “it’s a complicated, unregulated new field” with many variables making calculations “extremely complex and not transparent to the consumer.” This market is currently unregulated — company representatives need not be licensed, and the purchasing companies do not fall under state insurance regulations or other government oversight.

What Can (and Cannot) Be Sold

• Annuities tucked away in tax-qualified retirement accounts are ineligible — the IRS will not allow ownership to be transferred
• Deferred annuities still in the accumulation phase can be sold in this marketplace
• Annuities in their payout period can also be sold — but only those with a guaranteed payout period (such as period certain contracts) or other minimum guaranteed values
• Straight life immediate annuities cannot be sold, as the future payments are based on an unpredictable life expectancy — the purchasers in this market do not deal with enough contracts to rely on the Law of Large Numbers

Annuity companies and regulators tend to take a dim view of secondary market transactions (partly stemming from shady transactions in the viatical/life settlement market). But the availability of a method to cash out annuity payments for a lump sum might overcome many contractholders’ hesitancy to purchase or annuitize a contract in the first place — so in the long run, this secondary market may actually serve the industry’s purposes. With over a trillion dollars currently locked in annuity contracts, a secondary market could add needed liquidity and flexibility.