Fitch Develops Capital Requirements Model for Variable Annuities

4 August 2005

Fitch Ratings has developed a stochastic model to analyze capital requirements for U.S. variable annuities (VAs). The model will be used in the process of evaluating the capital adequacy of life insurance companies that sell VA products.

As such, a Criteria Report on this topic has been released, 'Increasing Capital Requirements for Variable Annuities,' and now available on the Fitch Ratings web site, www.fitchratings.com.

The Fitch VA capital requirements model utilizes several thousand economic scenarios to depict potential loss distributions based on the specific features and risks associated with these products. The model estimates the gross capital requirements can range from 1% of account value for conservative products, such as guaranteed minimum death benefits, to 8% for risky products, such as guaranteed minimum income benefits.

Calculating for aggregation, reserves, reinsurance, hedging, and covariance, the net capital charge is typically expected to fall in the 0.5%-2.0% range, Fitch believes. Given over $1 trillion of variable annuity assets under management, this equates to a $5 billion-$20 billion net capital requirements.

'Although these results appear dramatic, they should not be surprising to those leading variable annuity writers who are following NAIC developments and have been conducting internal stochastic modeling of their variable annuity business,' said Jeff Mohrenweiser, Senior Director, Fitch and co-author of Fitch's criteria report.

U.S. insurance regulators are in the process of approving new minimum capital requirements for VA products using an approach similar to Fitch's model. Fitch expects this enactment by the NAIC for year-end 2005, so called 'C3-Phase II,' to produce similar results as those highlighted above. This proposed revision to statutory risk-based capital is a shift toward a principle-based model utilizing insurer-developed stochastic models. Consequently, leading insurers are implementing hedging strategies or product changes that are intended to limit these risks and the corresponding capital requirements.

Among other topics contained in the report, Fitch discusses the following:

-- The market background of variable annuities;

-- Fitch's opinion on the market;

-- Why Fitch is implementing a stochastic model;

-- What are the results of the model;

-- What are the key risk drivers and how much hedging credit Fitch will give to insurers.

Fitch does not expect information garnered from its new variable annuity capital model to immediately result in rating changes of any insurers in the VA market. Fitch is taking a prospective view and monitoring insurers as they implement various risk mitigation strategies in reaction to unfolding regulatory requirements. In addition, the market has weeded out many overly aggressive insurers and practices.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.