Two weeks ago we visited the question of moral hazard as it pertains to state guaranty associations (SGAs). We considered the advisability of buying (or recommending) fixed deferred annuities with superior yields from life insurers with inferior strength ratings and/or short track records.

One adviser had asked me: Why shouldn’t my client do that, given the safety net provided to annuity owners by SGAs and assuming that the premium was within the state’s coverage limit?

Several good reasons exist to avoid that, RIJ has been advised:

• Insolvencies can take years to resolve. Your clients may not get their money back quickly. Attorneys, accountants, and actuaries may struggle over who gets paid how much out of the carrier’s remaining assets. If the owners of the insurer oppose the declaration of insolvency, the contract owners may not recover their savings for years. Clients can’t necessarily afford to wait that long.
• In the case of single-premium immediate annuities in the payout stage, the calculation of covered benefits requires estimating a present value of future benefits. That depends on the age(s) of the contract owner(s).
• Other factors contribute to delays. SGAs have no pre-funded reimbursement funds. Insolvent carriers will likely have sold contracts or policies in many states, then the state leading the insolvency has to ask for proportionate amounts of money from surviving insurance carriers in each of those states.
• Once a carrier is in liquidation, contracts or policies earn a maximum interest rate based on an aggregate rate established by a ratings agency. That’s usually less than competing carriers pay on similar contracts. Thus, if an annuity matures during liquidation, it will [could?] rollover into a sub-optimal rate. At least some states can choose to lower the contractual rate on an annuity contract in liquidation if they consider it unreasonable. Carriers can’t offer unreasonable rates to preempt a state’s reduction.
• Annuity contract owners may not get all their premium back. The principal [current account value] for deferred fixed-rate or fixed indexed annuities in the accumulation stage are covered by the guaranty associations up to about $250,000 per contract ($500,000 if jointly owned). The exact amount varies from state to state.  For SPIAs it is the present value of $250,000. For amounts over the limit, the contract owner becomes a creditor of the insolvent company.
• The assets of variable annuities reside in separate accounts, beyond the reach of creditors. But SGA protection of the values of income riders (“living benefits,” or “guaranteed minimum withdrawal benefits”) on variable or fixed-indexed annuities is still unclear.

While the account value of a variable annuity is in a separate account, the guarantees on living benefits are backed by the carrier’s general account. No insurer that sold these products has become insolvent yet. So processes and outcomes haven’t been established.
(Given how heavily the costs of maintaining large blocks of VA/GMWB business weighed on many carriers after 2008, that’s remarkable.)

Bottom line: Why lose sleep for, say, half a percentage-point more yield? Over five years (1,825 nights), a $100,000 contract at 5.5% gains $30,696 while a 5% contract gains $27,628. You’re gaining less than $2 per night. Why disturb any sleep to “save” $600/year?

“You can roll the dice and bottom-feed for the best rate,” one knowledgeable SGA observer told RIJ, “but the odds of things turning out badly are likely not worth the extra interest.”

The buyer of a fixed deferred annuity that offers a higher yield (or a high crediting formula) is, in effect, buying a cheaper product. If people were about to spend six figures on a luxury car, would they, as a rule, choose the one that’s a few thousand dollars cheaper?

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