How will the Next Derivative Train Wreck affect industry leaders

head small trasThere’s only one problem with those places that feature sand, surf, sun and surff this year . You come back burned, bushed and broker. So it has been with one of the greatest oxymoron’s of the last 30 years “implicit government guarantee” As the world’s largest pool of capital at $700 trillion and growing  has shown us,  Warren Buffet is probably right on target when he describes certain sectors of the derivatives  market as a crap shoot.  A derivative is a security “derived” from another security. We all remember Collateralized Debt Obligations or CDOs. In the meantime, the life  industry’s leading derivatives player and leading indexed annuity sales leader reported decent bottom line sales but drooping sales on all of its core annuity products including index annuities, indexed life and variable annuities. It’s industry leading indexed annuity  product also fell off the top of the pedestal as the leading product sold as it has added overhead and reduced it’s competitiveness as part of it’s strategy. Market share is declining as well and so are it’s distribution partners. Profits continue robust.

 

The Justice Department recently implicated S&P ratings agency for fraud accusing them of deliberately misapplying its rating criteria.  The problem with derivatives is similar to the same problem Michael Keaton ran into in the movie ‘Multiplicity”. In the film, Keaton tries to duplicate himself to make life less busy and complicated. He finds out though that no one can figure who the real Keaton is and who is a fraud. The other problem is that the more Keaton duplicates himself, the more confusing life gets and cloned Keaton’s become progressively dumber. Traders call this counter-party risk. The only problem is that life insurance companies which are large derivatives traders have to know who is holding the cards and what cards are being played. They rely upon the ratings agencies in a way reminiscent of 1989 when certain agencies rated Executive Life and Mutual Benefit AAA. The agencies knew that both companies were holding junk bonds but had no idea the extent of  mis-pricing  in these bonds and default rates. Both companies wound up being sold at substantial losses.

 

Now, with the disclosure by the Philadelphia Fed that 727 AAA CDOs issued between 1999-2007 will have to written down by 65% and FNMA and FMAC a wreck, investors may ask if sovereign national governments can default when will the shoe fall on life insurance carrier as the income rider roll-up battle goes on and interest rates remain near record level lows. Will it be a mutual company, which has largely ignored the indexed annuity market because of its margins, or a private equity manager running a life insurance company using too much leverage or too much sales sizzle? Maybe a stock company that fails to hedge properly its underlying risk. Have state regulators responded to glaring differences between cash surrender value income promises and implicit income rider benefit account values?.  Based on what has transpired in the Variable Annuity industry, there will be different faces in the hunt for indexed annuity share in the future as other carriers recognize the potential size of the industry or if one major carrier stumbles. The same applies for the marketing organizations that latch onto one or two carriers.

 

The Variable Annuity industry has changed dramatically in leadership over the last 20 years primarily because of aggressive pricing. During the much talked about early 80s annuity miscues, several carriers were caught in a liquidity trap locked into high interest rate liabilities when rates were plummeting. During the early 90s, the mistakes were in over investments in junk bonds or real estate. Both of these periods where a coupled of respected carriers stumbled were marked by investing mistakes. Recently, over the last 10 years pricing has been a problem. My guess this time is that a life carrier suffers massive  bond losses by trying to squeeze too much yield while interest rates move up 300-400 basis points from a run on the U.S. dollar similar to what we have seen on the Yen this past week or two. In the short run, it is great for bondholders to be forced into stocks by central banks around the world but life insurance company’s lifeline is bonds and that’s what scares many experts.

Mutual Benefit Life Insurance Company building...

Mutual Benefit Life Insurance Company building at 300 Broadway in 1915 (Photo credit: Wikipedia)

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