Careful Banks Can Avoid Problems with Annuities

When insurer Baldwin-United Corp. hit the skids in 1983, holders of $3.7 billion in annuities issued by the company's subsidiaries felt a sharp pain in the pocketbook.

Instead of being paid interest rates as high as 15.5%, as promised, investors learned they would get 3.6% to 9%.

Last June, when First Executive Corp. filed for Chapter 11, experts projected holders of policies issued by the company's Executive Life unit might get less than 75 cents on the dollar. But that was only if the troubled company were allowed to continue operating.

Despite these scare stories, demand for annuities remains strong. As a result, many banks are forging ahead with plans to offer the products, traditionally sold by insurance companies.

Establishing tougher product-screening and due-diligence standards is a way to avoid costly stumbles.

One point is clear: There's a solid market for annuities. A recent survey in the Newsletter of the Bank Insurance Industry said bank sales of annuities in 1987 totaled $4 billion. Last year, these sales had more than doubled, to $9 billion. And by 1995, sales are forecast to jump to $40 billion.

Another survey, by Affiliated Financial Services, a third-party provider of annuity and other nontraditional products, corroborated that projection. The survey said 25% of banks and thrifts now offer annuities but added that, by the year 2000, those that "are likely to provide" annuities may reach 55% of the total.

Moreover, annuities give bank customers a range of benefits. These include:

* Some of the advantages of an Individual Retirement Account - albeit without tax-deductibility - without limitations on deposit amount.

* Choice for consumers from among annuities whose underlying investments emphasize stocks, money market funds, or bonds.

* Fixed or variable interest rates. * Tax-free compounding of dividends, interest, and capital gains.

* Tax payments due only when investors make withdrawals.

Benefits to Banks

But banks also can benefit. Consider:

* Fee income can be hefty, and expenses are minimal. A typical $500 million bank can expect to book $1 million in fees per year with a reasonably well-oiled marketing program.

* Such fees can help build capital and improve capital-to-asset ratios.

* Converting maturing certificates of deposit to annuities takes liabilities off the balance sheet and, thus, can further improve regulatory ratios.

* Annuities offer a large saving over CDs in terms of operational expenses.

* Offering annuities helps maintain customer relationships and creates new ones. The AFS survey respondents who now offer annuities ranked "retaining existing customers" as the No. 1 reason to do so, closely followed by "attracting new customers" and "profitability," which tied for second.

Reasons for Problems

When annuities encounter problems, meanwhile, some common reasons usually explain them. Among them are:

* Looser standards.

Bankers normally subject commercial borrowers to exacting credit standards and asset-liability review. Yet when it comes to choosing an annuity to offer their customers, they inexplicably fail to apply the same precautions.

Due Diligence

Instead, they blithely accept recommendations of insurance company annuity product providers without so much as either a cursory review of investment portfolios underlying the annuities or of the insurer's capital adequacy.

With America's patchwork system of insurance industry regulation, in which different standards apply from state to state - and with some states auditing insurance companies as infrequently as every three years - it is a must that bankers do their own due diligence before beginning an annuity program.

* Overleveraging and failure to apply risk-based standards of capitalization.

In January 1989, the Federal Reserve and the Office of the Comptroller of the Currency issued risk-based capital guidelines for commercial banks. Last year, the National Association of Insurance Commissioners established a committee to look into similar guidelines for both property-casualty and life insurance companies.

Risk-based capital analysis recognizes that an important distinction often exists between accounting capital and real capital needed to absorb risks. NAIC's efforts are laudable but lack the force of law.

Behind the Numbers

Without any uniformity of regulation, banks themselves must look not just at the numbers but also at what the numbers represent - just as they would on a loan application from a commercial borrower.

* Capitalization based on "surplus relief reinsurance."

This is a kind of industry alchemy that often masks major capital deficiencies. Equitable Life Assurance Society of the U.S. increased its capital by $600 million, more than one-third, by employing surplus relief reinsurance, according to a June 7 report in The Wall Street Journal.

The same article reported that the insurance units of First Executive Corp. also relied on this technique. Reinsurance permits one insurance company to take on the risks of another in order to share in the profits. Surplus relief reinsurance also adds to the insurer's capital by enabling the insurer to decrease its liabilities. This often permits insurers to raise capital without lessening risk.

* Heavy dependence on junk bond portfolios. Such portfolios may promise - but fail to deliver - high returns to the annuity holder and higher sales volume and commissions to banks serving as brokers.

* Lax regulation by state regulatory agencies. Agencies in only a few states, including Iowa, impose tough standards.

The solution? Banks must take it upon themselves to confirm independently an annuity's soundness. And that means going beyond just looking at the annuity's evaluation by the major rating agencies, including A.M. Best, Standard & Poor's, Moody's, or Duff & Phelps.

While valuable, such sources are not omniscient. For one thing, ratings can be misleading. Consider:

Some consumers bought Executive Life products partly because the company was rated A-plus by A.M. Best until January 1990. The same consumers were surprised when this supposedly top-rated company was taken over by regulators only 15 months later.

In addition, ratings codes vary substantially from one agency to another.

Confusing Comparisons

For instance, A.M. Best's highest rating is A-plus, followed by Contingent A-plus, then A, then Contingent A. Standard & Poor's and Duff & Phelps are in synch with top ratings of AAA, AA-plus, AA, and A.

But then there's Moody's. Its top ratings sound like something from a chemistry lesson: Aaa, Aa1, Aa2, and Aa3.

The result could be vast confusion, noted journalist Jane Bryant Quinn in an April column. For example, Ms. Quinn cited Bankers Security Life Insurance Society in New York, given a rating of A-plus by Standard & Poor's. At A.M. Best, that rating would signify a top-drawer company. But at S&P, A-plus is the fifth rank down.

The upshot: Bankers involved in due-diligence investigations should look at two or more rating services.

Qualified Solvency Ratings

Meanwhile, yet another method of rating an insurance company, the "qualified solvency" rating, was introduced by S&P this spring. It is derived exclusively from the financial statements that companies give state regulators.

Here's how it works:

The three ratings - BBBq, BBq, and Bq - denote, respectively, above average security, average security, and below average security. The spring 1991 issue of S&P's "Insurer Solvency Review" gave qualified solvency ratings to 893 companies.

One hundred and forty-eight were rated BBBq, 427 BBq, and 318 Bq. Unlike S&P's long established claims-paying-ability ratings (AAA, AA-plus, etc.), the qualified solvency ratings are not done or published at the request of insurance companies.

Improvements Needed

With the exception of A.M. Best, which charges a relatively modest fee of $500 per year to insurers, the agencies charge a substantial fee to insurers who request a rating.

In summary, more improvements are needed in the effort to shore up standards and public confidence in annuities. Particularly helpful would be more frequent exams, tightened capital standards, less reliance on surplus-relief reinsurance, and the introduction of risk-based capital standards.

In the meantime, however, bankers should not shy away from annuity products. The vast majority of annuities can be sold with confidence. Careful analysis can help to ensure that yours are among them.

Mr. Graham is president of Affiliated Financial Services, Denver.

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