The humbling of the actuaries, part 357,121

Bloomberg has a nice article on one of my favourite pieces of actuarial insanity, guaranteed annuity contracts. The basic story is that life insurance companies wrote long-dated equity index and basket puts in size and didn't price them properly, because their actuaries didn't understand derivatives. With the recent market falls, they are beginning to see just quite how stupid an idea this was.

It’s ending in tears. In September, the insurance raters A.M. Best and Fitch moved the life-insurance industry into its negative-outlook column. In October, Moody’s, and Standard & Poor’s did the same. A.M. Best has downgraded 30 life and annuity companies so far this year.

Of course, because all of this is in an insurance wrapper, there is no requirement to mark to market, so investors cannot see the size of the problem.

In the meantime, the industry is proposing to handle its problems the good, old-fashioned, American way: by putting lipstick on its books.

As the value of GMWB [guaranteed minimum withdrawal benefit] annuities tumbles, the carriers are required to raise the reserves they hold against these products, as a way of assuring that consumers will be paid. Raising reserves, however, could starve their working capital at a time when they’re also writing down toxic mortgage assets. The companies say they’re already holding plenty of reserves, so they’re asking the states, which regulate the industry, to loosen the rules.

Astonishingly, some of the state regulators seem sympathetic:

The National Association of Insurance Commissioners will discuss the proposed changes this month. Iowa insurance Commissioner Susan Voss calls some of the reserves “redundant” and suggests that NAIC will go along.

Short now, short in size. It is a very cheap way to get protection on an extended period of low equity markets.