All-ETF VA gives a hedge edge, Moody's says

Western & Southern Financial Group Inc.'s decision to base its variable annuity investment options on exchange-traded funds is a positive for the insurer, allowing it to better manage market risk tied to the products, according to Moody's Investors Service. Western & Southern's Varoom product, a variable annuity exclusively for rollovers, gives investors access to 18 fixed-income and equity ETFs from The Vanguard Group Inc. and iShares, plus a handful of international and alternative funds, such as the iShares S&P/Citigroup International Treasury Bond Fund. Traditional selling points for variable annuities have been the guaranteed living benefits and the wide selection of actively managed funds. However, insurers that sell these products have had to put hedges in place — either by purchasing short futures positions or buying put options on a basket of equity indexes, for example — to contend with volatile equity markets. Such an approach can make the guaranteed benefits more costly. Varoom is less complicated for Western & Southern to hedge because the ETF investment options are index-based, much like the hedges themselves. That reduces the likelihood of a mismatch between the hedge program and the performance of the funds, according to Weigang Bo, an associate analyst at Moody's who issued a report on the new product last week. The ratings agency viewed the insurer's improved ability to hedge as a credit positive. Some insurers suffered when their hedging programs failed to protect their actively managed funds from the market tumult in 2008 through early 2009. Lincoln National Corp., for instance, lost $336 million in the third quarter in 2008 due to VA hedging “breakage.” Hartford Financial Services Inc. had a VA hedging loss of $384 million during the fourth quarter of 2008. An ETF-focused variable annuity, however, contains hedging risks. For instance, a carrier could still face differences between the ETF's market price and its underlying net asset value, which tracks the index more closely. The differences between the market price and the NAV can become more pronounced during market volatility — even more so when using exotic ETFs, such as leveraged or inverse strategies. As a result, it is highly unlikely that insurers will spice up their ETF-based variable annuities with commodities-based funds and other more complex ETF offerings. [More: The complexity of ETF options] “The more exotic ETFs would defeat the purpose of easy hedging and wouldn't be terribly suitable for VA products; they introduce a lot of volatility,” said Joel Levine, a senior vice president at Moody's. E-mail Darla Mercado at [email protected].