After a couple of difficult years, Transamerica Life Canada has reversed the downward momentum in its financial ratings.

Both New-Jersey based A.M. Best Co. and Standard & Poor’s Financial Services LLC have raised their financial ratings on the Toronto-based insurance firm, which is ultimately owned by AEGON NV of the Netherlands.

A.M. Best has boosted Trans-america’s ratings to BBB+ and affirmed a “positive outlook” for the firm. S&P similarly has raised its rating on the insurer to BBB+ with a “stable outlook.”

In describing the rating decisions, the rating agencies have made similar arguments, mostly leaning on the fact that Transamerica’s massive liability in segregated funds had come due with the company’s balance sheet intact.

Doug Brooks, CEO of Trans-america, says he’s pleased with the ratings changes and notes that about $1.25 billion in seg fund policies were paid to clients in the first half of 2010 — with roughly $300 million to come.

In describing Transamerica’s three-year-long process to develop a better “enterprise risk management” framework, Brooks says: “One of the things we’ve done over the past number of years is to develop that framework, to make sure that it’s comprehensive and that we understand the risks that we deliberately set and are willing to take.”

ERM, which refers to the way in which an insurance-product manufacturer looks after the potential pressures on its balance sheet, includes the more predictable variables, such as policyholder mortality, but also equities market risks and liabilities.

A major part of the heightened ERM for the firm has involved structuring a hedging program that matches 95% of the firm’s equities market exposure in its new seg fund program, according to S&P.

Brooks describes the hedging program as mostly an elaborate, timed put option on its equities exposure. The biggest challenge has involved matching the timing of the puts with the equities, he says. He notes that the process had taken considerable analytical time and that finding the hedging products at good prices was difficult due to the size of the Canadian market for derivatives.
@page_break@The successful hedging program is another major reason both rating agencies have cited for the rise in their ratings on Transamerica. The program also applies to older policies — the ones that had caused the company’s ratings to slide in 2008, when S&P had downgraded them to BBB from A- with negative momentum.

Those policies were among the first generations of the seg funds sold about 10 years ago, at the height of the dot-com boom. The policies came with 100% guarantees and aggressive “step-up” features, says Brooks, that essentially allowed policyholders to reset the value of their guarantees every time the market hit a new high.

As a proxy for the market environment in those days, consider the Nasdaq composite index, which was trading above 5000 as late as March 2000. Within a year, the index had lost about 64% of its value, trading slightly above 1800. It has traded sideways ever since; last month, the index was hovering at around 2200.

But Transamerica had remained on the hook for policies owned by clients who could have reset their guarantees around that high-water mark. Many policyholders had done so at the behest of their sophisticated advisors, according to Transamerica’s previous CEO, Paul Reaburn.

By 2008, the liability related to these policies was obvious and, in the meantime, Transamerica’s revenue was not blowing out the lights.

AEGON then injected capital into its Canadian unit to cover both internal reserve needs and the potential that the firm would run afoul of the Office of the Superintendent of Financial Institutions’ minimum continuing capital and surplus requirements.

Brooks explains that troublesome, step-up policies had been discontinued long ago — another fact both ratings agencies have cited for Transamerica’s higher ratings — and that most of the firm’s newer seg funds’ liabilities are dispersed across a much longer time period.

He adds that the new seg funds are slightly more expensive — to account for the hedging program — but they also limit policyholders’ exposure to equities markets, which limits Transamerica’s risk.

Transamerica also has terminated its term-to-100 product and capped its LCOI (level cost of insurance) universal life product. The company won’t issue certain policies with a face value of more than $500,000 anymore. In both cases, says Brooks, today’s economic environment doesn’t make those policies profitable, given the risks involved in selling them.

IE