By definition, insurance is a way of transferring risks associated with certain unforeseen events from an individual or corporation to an insurance company (in exchange for a premium). Not surprisingly, insurance companies have worked hard over the years to establish a reputation for stability and dependability. Recent events have begun to call into question this reputation. Several insurance firms – including the Hartford, Lincoln, Principal and Prudential– have drawn unwelcome scrutiny regarding their ability to pay claims. Policyholders are now sharing some of the recent fears of shareholders.

Certainly, the current financial crisis has been tough on the entire financial services industry. While a broad range of complex financial products have come under scrutiny (credit-default swaps, RMBS, complicated derivative contracts, etc.), personal insurance contracts have avoided the spotlight – until now.

Variable annuities in particular are bringing to light the difficulties now faced by insurance companies. The October 13th edition of the Wall Street Journal featured an article showing that this year’s broad decline in equity markets has made variable annuity products a drag on profitability (“Variable-Annuity Business Is Adding to Life Insurers’ Woes”). Within days, Goldman Sachs downgraded several high-profile insurance companies whose financial strength has been tested by plummeting market conditions.

Variable annuities offer a number of guaranteed riders and benefits aimed at mitigating losses within an account, or guaranteeing a set level of income for the future. Though costly, these added provisions are supposed to take some uncertainty out of possible future income needs. Unfortunately, given the recent market downturn, these promises no longer appear realistic.

With that in mind, insurance firms are beginning to modify riders and benefits to reflect deteriorating asset values. For example, AXA Equitable eliminated a popular GMIB in an effort to manage the firm’s risk exposure. Another high-profile insurance company, Mass Mutual, has temporarily suspended a guaranteed rider called the Income Plus 6. We’d wager these won’t be the last firms to take these kinds of steps to shore up their bottom line in the coming months, especially given the stark alternative. 

For consumers, this brings to mind the old adage – don’t put all your eggs in one basket. Diversification is an essential component of any sound financial plan, but nowadays diversification doesn’t just apply to asset allocation. It also means spreading retirement moneys across several well-capitalized financial institutions.

For the insurance industry, we see a long, hard road ahead. Events like the near collapse of AIG and the negative press surrounding variable annuities have compromised the industry’s reputation. Those firms that survive this downturn will have their work cut out for them. It’s no easy task regaining consumer confidence.