For most of the last decade, variable annuities have been one of the most popular investment products offered by insurance firms. The attraction of tax-deferred growth and a broad range of guarantees and investment choices made VAs one of the fastest growing products in the insurance industry. But the financial markets crisis, which saw virtually every asset class post massive declines in the U.S. and globally, has dampened the enthusiasm for VAs. And recently, investors have shied away in favor of fixed annuities.
However, rather than undermining the value of the product due to the recent bear market, VAs have proven their valuable benefits to investors for their unique and significant for investors in or near retirement. As the markets return to normalcy, the appetite for VAs is poised for a comeback which will perhaps outshine the growth of the past decade.
The reason for this optimistic outlook: Many investors continue to face volatile financial markets, dwindling pensions and a money-strapped Social Security system that may be incapable . Given the challenges in retirement funding within today's risk-averse investment climate, the VA, coupled with an appropriately diversified portfolio, can serve as an important retirement-income solution.
Insurers learn new lessons
But the most recent past hasn't been kind to VAs and the insurance firms that provide them. The collapse in capital markets resulting from global deleveraging was a perfect storm for insurers. With management fees, insurance guarantee costs and profits highly dependent on market values, the broad drop in equities and decline in interest rates were damaging.
In addition, the crisis also exposed weaknesses in hedging strategies insurers employed to offset the cost of policy guarantees that in some cases were unable to keep pace with the rising values of these guarantees.
Furthermore, the pricing formulas for VAs' long-dated guarantees assumptions on projections of future volatility became quickly outdated during the recent market dislocation. Consequently, due to the high and constantly rising costs, as well as the complexity of the liabilities, many insurers were not hedging to offset the value of the guarantees, so significant increases in their liability values were reflected in their balance sheets, putting pressure on GAAP earnings. 
Statutory capital and reserve requirements for insurers also played a role. In 2005, a statutory regulation called C-3 Phase II, which mandates that VA insurers maintain enough capital to accommodate the worst-case scenarios derived from Monte Carlo simulations, modified the process insurers use for quantifying the risk embedded in VA guarantees, such as equity, interest rate, basis, pricing, policyholder and longevity risks. As 2008 drew to a close and companies completed their calculations of capital and reserve requirements, they found the strength of their capital position substantially eroded.
