Transamerica Life Canada has received a tough education about the risks associated with providing segregated fund guarantees.

In March, Standard & Poors Corp. lowered the Toronto-based insurer’s financial strength rating to BBB from A-, the second downgrade in a year. And this was after Transamerica’s parent, Amsterdam-based AEGON NV, had stepped in to shore up Transamerica’s balance sheet with $422 million in capital to satisfy regulatory requirements and Transamerica’s own risk management.

A badly designed and mispriced seg fund product sold in the late 1990s has put strain on Transamerica’s balance sheet. Paul Raeburn, Transamerica’s president and CEO, admits the past four or five years have been a challenge for Transamerica.

“We stopped selling that product a long time ago,” says Raeburn, who joined the firm three years ago, well after the seg fund sales occurred. “And we’ve learned a lot from it.”

S&P underlines that Trans-america’s rating is still “investment-grade” and is confident that the firm has solved its capital reserve challenges. But advisors and policyholders alike should take note, considering the raft of new guaranteed-income products in the seg fund genre that have hit the market recently and the volume of sales they are racking up.

“The bottom line,” says Moshe Milevsky, finance professor at the Schulich School of Business at York University in Toronto, “is that companies who derive a substantial portion of their revenue from these [newer] ‘financial-type’ guarantees, as opposed to the traditional ‘insurance-type’ guarantees, will have to take a fresh look at whether traditional actuarial reserving techniques are enough to manage the risk.”

Transamerica’s trouble can be traced back to the heady days of the technology-inspired markets at the turn of the millennium. As a proxy for the market environment in those days, consider the Nasdaq composite index, on which many a dot-com company lived and died. The index was trading above 5000 points as late as March 2000. Within a year, the index had lost more than 64% of its value, trading slightly above 1800 points. It has traded sideways ever since; last month, the index was hovering around 2300 points.

Seg fund products offer several features, among them a principal guarantee that matures 10 years forward and a mortality guarantee for the original principal balance. Many products sold in the late 1990s offered various reset features that allowed policyholders to reset the guarantee amount, always extending the maturity date forward 10 years.

Any high-risk equity market fund heavily invested in the Nasdaq would have benefited from the high stock market valuations for a period of time. If an advisor and his clients played their cards right — and many of them did — the issuing company was, in effect, on the hook for the difference.

“The brokers are sophisticated,” admits Raeburn. “They did the right thing by their clients and they helped facilitate the resetting of a lot of the policies. So, we ended up with high guarantees. That combined with a fund that we didn’t monitor well enough.”

Many policies containing those seg products are now two to three years away from maturity and they’re coming due.

That scenario explains why Transamerica has periodically analysed its potential debt to policyholders, turning to AEGON on more than one occasion for cash to bolster its balance sheet for the coming payout.

In S&P’s March report, the rating agency makes a judgment about Transamerica’s decision-making, calling the quality of its enterprise risk management “weak.”

Not surprising, it’s a characterization with which Raeburn disagrees. He admits that Transamerica was lacking in some risk-management discipline at the time the seg fund product was being sold. But several layers of pricing and design review have been added to the company’s processes since then, including internal Canadian and U.S. oversight, plus reliance on AEGON’s expertise.

The risk to Transamerica from the block of seg fund business in question, says Raeburn, has been hedged to minimize downside risk.

Minimum continuing capital and surplus requirements, which insurers have to meet as part of federal solvency rules, have also been offset by some relief from the Office of the Superintendent of Financial Institutions in Ottawa.

“Things are probably 180 degrees different than what they were then,” says Raeburn. “We’re not expecting any change [in ratings] going forward.”

@page_break@There’s no arguing that those earlier decisions have hurt Transamerica’s earnings. But, he adds, “We have a very good starting point from here on in.”

Byren Innes, senior vice president and director with insurance consultancy NewLink Group Inc. in Toronto, says that it’s probably fair to say S&P’s ratings are somewhat backward-looking. The mistakes should have been reflected in Transamerica’s ratings years ago, in which case, the present ratings would have shown steady improvement.

Milevsky says, on the other hand, he is not surprised that Transamerica has encountered reserve problems, considering the liabilities that can be created by the product type: “You have a recipe for capital reserve problems.”

With typical universal life and annuity products, for example, risks are controllable and predictable by long-term mortality tables. As long as the insurer has sold enough policies, risk is diversified because people die at different times. But seg fund products each add the deep variability of market performance, and the risk for product manufacturers can be heightened by stronger sales.

“Selling more might actually harm your economic position,” Milevsky says. “After all, a bear market will impact each and every guarantee you have written at the exact same time.”

Milevsky has also pointed to so-called “moral risk” as a challenge for the insurance manufacturers, too. By this, he means that conservative investors feel free to tip the scales heavily toward risky equity exposure because they know they can count on the guarantee. It’s ultimately risk for which the manufacturer has to account.

“This is something product manufacturers should worry about from Day 1, when they issue the policy,” Milevsky says.

Transamerica is among several firms, including Kingston, Ont.-based Empire Life Co. and Montreal-based Standard Life Canada, the subsidiary of Britain-based Standard Life PLC, that have publicly announced that they are in the midst of product design and pricing for their GMWB products.

Raeburn, who isn’t prepared to give details on a product announcement as yet, acknowledges Milevsky’s point. But, he says, AEGON — and the industry in general — has learned from the U.S. experience, in which insurers have trumped each other with versions of the product that promise ever-increasing guarantees.

“If you compare AEGON’s U.S. product to earlier versions, it’s less risky,” he says. “There are some longevity risks. But you can handle those if you price it right, and analyse [the design].”

The S&P report notes that when firms are under capital pressure, they are often motivated to rationalize resources by off-loading business units.

On that point, Raeburn refuses to comment about the status of AEGON Dealer Services Inc. The mutual fund dealer has been shopped around the financial services industry to several suitors recently.

It is one of several brands operating under Transamerica’s National Financial Corp. subsidiary, including fund dealer Money Concepts Canada and managing general agent National Financial Insurance Agency Inc.

Raeburn did confirm, however, the departure of two members of Transamerica’s finance department: Paulette Kennedy, chief financial officer; and Richard Hepburn, vice president of finance.

Their departures are unrelated to the company’s reserve challenges, he says.

Diane Meiners, vice president of operational risk with AEGON USA, stepped in in January to manage financial functions on an interim basis. IE