Friday, August 10, 2012

Models Run Amok

Random Glenings will be on vacation next week.  My next post will be Monday, August 20.

Low interest rates are frustrating many investors.  However, for life insurance companies that offered above-market guaranteed annuity rates, today's credit markets are threatening their very existence.

Hartford Financial, for example, was one of the most aggressive companies in recent years in their offerings of variable annuities.  Now, despite recent stock market gains, the company is finding itself unable to earn the returns necessary to pay out benefits.

So Hartford - along with several other insurance companies - are now returning to their policy holders and offering to redeem the policies at a premium in order to reduce their liabilities. Here's what Bloomberg wrote today:

Life insurers are paying the price for guarantees made to clients before 2008, when stock markets were in the midst of a five-year rally and the yield on the 10-year Treasury was more than 4 percent... 

Industrywide variable annuity sales were $159 billion last year. The figure had spiked to $184 billion in 2007 as insurers competed to win more business, in some cases guaranteeing annual returns of about 7 percent to long-term savers who were willing to accept limits on access to their funds, said Alan Devlin, an analyst at Atlantic Equities LLP. 

Hartford was among the most vulnerable insurers on the guarantees because the company didn’t hedge risks as much as MetLife Inc. (MET) and Prudential Financial Inc. (PRU), the largest U.S. life insurers, Devlin said by phone from London

Liabilities on the contracts swelled in the financial crisis, helping drive Hartford to a U.S. bailout and fueling a 60 percent plunge in the Standard and Poor’s 500 Life & Health Insurance Index in the 12 months ended May 3, 2009.

I mention this today not to second-guess any business decisions that Hartford made - their plunging stock price is reminder enough - but rather to point out that even the most sophisticated financial modeling can go awry.

Hartford offered its high rate products not because of carelessness, but rather because its internal modeling indicated that past returns would be a good predictor of future results.

No one would have ever believed 5 years ago that global interest rates would plunge to today's historic lows, or that the stock market would have earned very little over the last 5 years as well. But that's what has happened.

In short, another reminder that historic returns are no guarantee of future results.