In an ironic twist for insurance companies globally, the very product upon which they were building their futures is tying up their capital and potentially hampering growth.

Segregated funds, including those with payout options (called variable annuities in the U.S. and Britain and guaranteed minimum withdrawal benefit products in Canada), are hampering insurers everywhere, including Toronto-based Sun Life Financial Inc. and Manulife Financial Corp. , Canada’s two largest insurers.

The nub of the problem is that through these products, insurers have promised a huge sum of future income to policyholders. But the value of the assets that partly guarantees that income has dropped precipitously along with the equities markets.

Unprecedented volatility and falling equities markets are forcing insurers to account for this massive liability in two ways. First, their internal actuarial modelling is demonstrating that to be safe, they need to make reserves so they will be able to pay policyholders according to the contracts.

“What happens is, when insurers sell products with guarantees, they have to take money out of their capital and put it into reserves,” explains Moshe Milevsky, a professor of finance at York University’s Schulich School of Business in Toronto. “The value of some guarantees is so high, and the cash value that has been set aside is so much, that this is a big hit. You’re seeing insurers move hundreds of millions of dollars.”

Second, regulators insist that insurers keep excess capital on hand in the event of bankruptcy. Insurers have sought regulatory relief so they can reduce the additional capital reserves required to keep the liabilities/capital ratio at a level that regulators consider safe should the insurer fail.

But the more insurers have to set aside capital to satisfy their own actuarial and regulatory requirements, the more it hurts earnings, affects share prices and ties their hands as they consider growth opportunities, including acquisitions of companies that are often in much worse shape.

“The reserve requirements on these products are eating away at insurers’ capital levels,” says Wes Swanson, an actuary and research associate with TD Newcrestin Toronto.

Insurers globally will be feeling the pain, although the problem is exacerbated in Canada by fantastic sales results. Manulife, in particular, is hobbled in a cruel twist that turns on its sales success in the GMWB product category. It sells segregated funds in the U.S. and in Japan with liabilities ranging from seven to 30 years, and this past summer it passed the $6-billion sales mark for its IncomePlus GIF in Canada. With such sales performance and strong assets, analysts have talked about Manulife being the most likely suitor for New York-based American International Group Inc. But those plans are on hold.

“When this product was launched two years ago, there was no value in it,” explains Milevski, describing Manulife’s IncomePlus GIF. “Now, there’s $6 billion or $7 billion, and nobody would have dreamt that we’re going to see a 40% to 50% drop in equities markets over this period of time. It’s hard to predict.”

Manulife, which reports its results on Nov. 6, is not alone. Sun Life has moved to shore up its seg fund and guarantee reserves by $134 million. It posted a $396-million loss for the quarter ended Sept. 30.

Old Mutual PLC, a London, England-based insurer that does most of its business in South Africa, saw its stock price plummet after analysts wondered if the firm would need to raise additional capital to meet regulatory rules, the precise reason that Manulife’s share price rocked up and down at the end of October.

The Netherlands’ government has propped up both ING Groep NV and Aegon NV, the latter the parent of Transamerica Life Canada, after both firms posted large quarterly losses.

Aviva PLC, Britain’s biggest insurer by assets, said at the end of October that its reserves were sufficient but it is monitoring them.

Back in Canada, the Office of the Superintendent of Financial Institutions gave domestic insurers some of the relief they had been looking for when it dropped its forward-looking capital requirements. In particular, OSFI dropped the amount of capital required to meet liabilities looking ahead more than five years to 90% of conditional tail expectation (CTE), down from 95%.

That latter percentage reflects modelling for worst-case scenario, explains TD Newcrest’s Swanson: “For Manulife, we estimate that this represents about a $1.5 billion to $2 billion in excess capital that it doesn’t have to hold. In other words, it’s adding up to $2 billion in its excess capital position.”

@page_break@Equities analysts, Swanson included, have tended to side with the insurers when making their arguments to the regulators. In Manulife’s teleconference to analysts that detailed its argument, the insurer broke down the earnings potential of its $72-billion book of seg fund business globally to $4.8 billion in future earnings as of Sept. 30; with the capital requirements set by the regulator, it was set to lose almost $6 billion.

“The lifecos had argued that it made no sense that they had to set aside capital at a certain level when the ultimate benefits aren’t paid for 30 years,” says Swanson. “Equity markets will bounce back. What sense does it make to have to reserve at current levels if we’re don’t pay for 30 years?”

OSFI’s assets/liabilities requirement, part of its continuous monitoring of the insurers’ minimum continuing capital and surplus ratio (MCCSR), is broken down into three buckets of longevity. The regulator increased the capital amount looking ahead one year, maintained levels for the two- to five-year requirement, and decreased the requirement for liabilities in excess of five years.

The MCCSR — which includes operational, credit and morbidity risks — speaks to the amount of excess capital the insurers have to keep in their coffers to pay off all their liabilities in the event that they fail. OSFI looks for insurers to maintain a capital ratio of at least 150% before it would intervene.

Regulatory requirements aside, insurers globally may have to keep increasing internal reserves to meet their future liabilities. That’s especially the case for the newer guaranteed products, including GMWBs, deposited in the past 18 months. They have lost 20% of their value in the critical first two years of growth. The portfolios have a long way to go to recover their initial capital levels — and the insurers are on the hook for all of it.

“There’s no doubt that the situation has worsened,” says Alan Ryder, CEO of Toronto-based Aurigen Re, and some reserve has to be posted behind that liability.”

The alternative to increasing reserves is to take hedge market positions either internally or through reinsurance that can mitigate the risk to the assets, says Ryder: “You can’t hedge perfectly. But you can buy a series of financial instruments that are directionally correct.” He includes put options or derivatives instruments.

Sun Life has hedged some of its portfolio, although not perfectly, as evidenced by its writedown. Many U.S.-based insurers take hedging positions, says Swanson, and Transmerica Life similarly moved to hedge its equities exposure for its guarantees after its financial rating was downgraded.

Milevsky, who wrote several years ago that guaranteed products could pose a threat to insurers, takes no pride in his prescience. While many have focused on the cost of the products, he had wondered if they weren’t cheaply priced, considering the risks insurers were assuming.

“All the focus was on fees and features, when the elephant in the room was credit risk: who’s going to be around to pay all of [the guarantees]?” he says. “It wasn’t a prediction or a forecast; I just found it puzzling. Now it looks as though the puzzle has come true.” IE