Morningstar Rating for Variable Products (VA, VL, and VUL)

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1 Morningstar Rating for Variable Products (VA, VL, and VUL) Morningstar Methodology Paper 31 May Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. Reproduction or transcription by any means, in whole or in part, without the prior written consent of Morningstar, Inc., is prohibited.

The information in this document is the property of Morningstar, Inc.

2 Contents Characteristics of Underlying Funds 3 Ratings for Underlying Funds 4 Characteristics of Subaccounts 5 Ratings for Retail VA and VL/VUL Subaccounts 6 Ratings for Group VA and VL/VUL Subaccounts 7 in whole or part, without the prior written consent of Morningstar, Inc., is prohibited. 2

Subaccounts 6 Ratings for Group VA and VL/VUL Subaccounts 7 in whole or

3 Underlying Funds Characteristics of Underlying Funds Morningstar tracks the underlying funds that are used in variable annuity and variable life products. There are about 4,200 such funds. Some of these funds are clones of open-end mutual funds, while others are offered exclusively through variable products. The primary consumers of this information are insurance companies evaluating funds for use in new products, seeking to replace poorly performing funds, and monitoring and benchmarking the performance of existing subaccounts Open-end funds that can be used in variable annuity subaccounts are designated as available to insurance products in Morningstar s database. Ratings for Underlying Funds Underlying Funds are rated using an overlay of the open end mutual fund rating bell curve. If we rated underlying funds separately we would be assigning two star ratings to essentially one security. This could create the potential for investment companies to use a star rating in the wrong context, which may be a liability for Morningstar and investment companies. Start with monthly total returns based on NAV. Insurance/subaccount fees are not included here Underlying funds don't have loads, so we do not adjust for loads. Rankings for Underlying Funds All rankings associated with the star rating (MRAR, Morningstar return) are an overlay to OE breakpoints. For all other rankings VA underlying funds are ranked against other VA underlying funds and as an overlay to OE breakpoints. in whole or part, without the prior written consent of Morningstar, Inc., is prohibited. 3

The primary consumers of this information are insurance companies evaluating funds for use in new products, seeking to replace poorly performing funds, and monitoring and benchmarking the performance

4 Subaccounts Characteristics of Subaccounts There are about 75,000 VA subaccounts and 27,000 VL/VUL subaccounts. Investors can buy variable annuities (VA) or they can buy variable life (VL) or variable universal life (VUL). Variable annuities provide tax deferred accumulation, an income stream while the investor is alive (annuitization), and various death and living benefit guarantees. VL and VUL products are primarily purchased to provide a death benefit, for example to bequeath assets to heirs or for estate planning or business continuity planning. The policy is the legal structure that wraps the assets of multiple subaccounts. The separate account is the legal structure that holds the assets of the subaccounts, so called because it keeps said assets separate from the asset in the general account of the insurer, which are subject to creditor claims in the event of bankruptcy. Many fees are charged at the policy level and may or may not be asset based. Issuing companies receive credit ratings from rating agencies such as AM Best that provide an indication of the ability of the company to pay on future claims. Morningstar does not rate VA or VL/VUL policies, only the subaccounts and underlying funds. The AUV is the accumulated unit value, or price, for the subaccount. It is calculated by insurance companies and it is based on the NAV of the underlying fund less certain insurance expenses (administrative fees, distribution fees, and Mortality & Expense (M&E) risk charges). M&E is not deducted from the NAV for VL/VUL subaccounts as it is generally not an asset based charge, rather it is charged against the face (insurance) amount of the policy. in whole or part, without the prior written consent of Morningstar, Inc., is prohibited. 4

Variable annuities provide tax deferred accumulation, an income stream while the investor is alive (annuitization), and various death and living benefit guarantees.

5 Subaccounts (continued) Ratings for Retail VA and VL/VUL Subaccounts Retail VA subaccounts (subaccount offered in variable products that are available to individual investors) are rated against other VA subaccounts within a single Morningstar Category. Retail VL/VUL subaccounts are rated against other VL/VUL subaccounts within a single Morningstar Category. VA subaccount ratings are not adjusted for loads. Loads in the VA world include contract charges, surrender charges, and front- and back-load charges. We don t adjust for loads because they are not structured in a consistent manner and it is hard to apply these fairly across all subaccounts. (Standardized returns, however, do take these loads into account as mandated by the SEC.) Returns are adjusted for the excess over the T-Bill return to calculate Morningstar Risk-Adjusted Return (same as OE methodology). The rating bell curve is drawn based on the number of distinct values for Morningstar Risk-Adjusted Return. There are subaccounts that use the same underlying fund and charge the same fees. This means they have the same AUV string and the same MRAR. (Sometimes, one subaccount is closed to new investors.) We want to make sure all subaccounts with the same MRAR get the same rating (not cut into two groups if they are straddling a breakpoint). Ratings are assigned to subaccounts for the three-year, five-year, and ten-year periods. Then a weighted average is calculated for the overall rating. Unlike OE, for VA we include extended performance ratings as if they were real when averaging the time-period ratings to get the overall rating. Rankings for Retail VA and VL/VUL Subaccounts For all rankings Retail VA and VL/VUL Subaccounts are ranked against other Retail VA and VL/VUL Subaccounts. in whole or part, without the prior written consent of Morningstar, Inc., is prohibited. 5

VA subaccount ratings are not adjusted for loads. Loads in the VA world include contract charges, surrender charges, and front- and back-load charges.

6 Subaccounts (continued) Ratings for Group VA and VL/VUL Subaccounts Group VA and VL/VUL subaccounts (subaccount offered in variable products that are available to individual investors) are rated using an overlay of the open end mutual fund rating bell curve. Group variable subaccounts are solely available through employer sponsored plans, do not provide additional tax deferral (tax deferral is already provided in the plan), and investment in the product is driven by its use in the employer plan rather than for certain features and benefits. We have therefore determined that, on balance, the most appropriate methodology is to rate these subaccounts against the open end universe as open end funds are commonly used in group plans whereas the use of a retail variable annuity product in a group plan is comparatively rare. Rankings for Group VA and VL/VUL Subaccounts All rankings associated with the star rating (MRAR, Morningstar return) are an overlay to OE breakpoints. For all other rankings Group VA and VL/VUL Subaccounts are ranked against other Group VA and VL/VUL Subaccounts and as an overlay to OE breakpoints. in whole or part, without the prior written consent of Morningstar, Inc., is prohibited. 6

Group variable subaccounts are solely available through employer sponsored plans, do not provide additional tax deferral (tax deferral is already provided in the plan), and investment in the product

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