DEALTALK-Japan assets may impede ING's Asia sale

* 18 bln euro variable annuities business of particular concern

* Other insurers also suffered from Japan VA sales, stopped selling

* ING reviewed Japan VA assumptions, found no material change

* Majority of ING Re's business is ING Japan variable annuities

By Clare Baldwin and Taiga Uranaka

HONG KONG/TOKYO, Feb 16 (Reuters) - ING's Japan unit is proving to be a stumbling block in the auction of its Asia insurance business that is expected to fetch more than 6 billion euros, with sources saying the Dutch group may have no choice but to retain the Japan unit for now.

Japan is one of ING's two biggest Asian operations, so what becomes of it in the event of a sale is important. The concern has to do with the 18 billion euros worth of high-guarantee variable annuity policies the Japan operation has on the books.

"The problem with variable annuities in general is that you may look like you're profitable now but the markets move against you and you could start losing money," said Hong Kong-based Credit Suisse Asian insurance analyst Arjan van Veen.

The extent to which there may be problems with ING's variable annuity business in Japan is unclear. One senior Asia-based insurance executive said potential buyers right now are talking about the Japan variable annuity business as a toxic asset, and that if ING is consistent with other players in the market, that business is probably worse off than people think.

Two Asia-based investment bankers following the auction said that the Japan variable annuity business was their biggest concern. An insurance industry source countered by saying that ING hedged its variable annuities better than some of its competitors, though he did not have precise details on the status of how it was hedged in Japan.

The Dutch financial group announced last month that it was considering ways to dispose of its Asia insurance and investment management businesses separately from its European businesses, a move that would help it pay back the 2008 bailout it received from the Dutch government.

Reuters previously reported that investment banks have been hired to run the sale and that the auction will split ING's Asia investment management business into a separate sale.

ING is in the process of drawing up a more detailed accounting of its Asia businesses but that information has not yet circulated, sources with direct knowledge of the situation said. The sources mentioned in the story could not be named because the details of the auction are not public.

A spokeswoman for ING said the company is exploring options for all of its Asia operations, including Japan, but could not comment on the details of the process.

HEAVY DRAG ON EARNINGS

ING wrote its Japanese variable annuity policies -- which guarantee a minimum payout and then an additional payout based on investment returns -- between 1999 and 2009 when consumers were suffering from years of ultra-low interest rates amid the country's prolonged deflation.

The guarantees attracted customers. But they became a heavy drag on insurance companies that had aggressively sold such policies following the market plunge in the wake of the collapse of Lehman Brothers.

Other insurers selling similar policies, such as Hartford, Allianz and Prudential Plc subsidiary PCA Life, also suffered in the market turmoil and also stopped selling variable annuity policies in Japan.

It can be difficult to hedge some variable annuity obligations, and the cost of the hedging can become prohibitively expensive, Credit Suisse's van Veen said.

JPMorgan Cazenove in a report late last year said that while ING's Japanese variable annuity business is hedged against equity market and interest rate risk, it is not hedged against volatility and there is some currency risk.

The report went on to say that the reinsurance contract the Japan variable annuity business struck with ING Re was likely underpriced, and that the Japan operations are worth less than shareholders' equity.

The ING spokeswoman said the Japanese variable annuity business is hedged against equity market, interest rate and currency risk and partially hedged against volatility risk. She said the reinsurance contract was put in place at "arm's length".

The spokeswoman said the Japanese variable annuity business constitutes the majority of ING Re's business but declined to comment on valuation.

At the end of last year, ING valued its Asia Pacific insurance operations at 5.8 billion euros, with an additional 0.3 billion euros from the investment management business being attributed to Asia, an analyst presentation on ING's website () shows.

ING Re is part of ING's corporate line insurance. In the fourth quarter, the pre-tax underlying results from corporate line insurance widened to a loss of 98 million euros from 88 million euros a year earlier.

ING said lower interest rates on hybrids and debt helped to curb the losses. It also said it converted some hybrids to equity and moved some interest expenses owed to the Group out of corporate line insurance.

Part of how ING's Japan business will fare will be tied up in the outlook for the Japan market since high guarantees can be met with high investment returns. With unemployment around 5 percent, a shrinking population and stiff competition among insurers, however, it could be tough.

"Overall, the demand is shifting from death benefit coverage to pension, nursing care medical insurance. These areas have growth potential but competition is very fierce and pension products are not as profitable as death benefit coverage," said Ayako Nakajima, a director at ratings agency S&P in Tokyo.

U.S. CONCERNS

The question ING now faces is whether anyone will be interested in taking that risk. Right now, in the early stages of ING's Asia-Pacific trade-sale, there are expected to be bidders for the entire Asia package but in the end, the variable annuity policies could mean that Japan is sold separately or not at all.

One recent event that raised concern among potential Asia buyers is what happened with ING's U.S. variable annuity business.

ING also wrote variable annuity policies in the United States. Late last year Group CEO Jan Hommen described policyholder behavior as "very difficult to project" and said ING would be taking a charge in the fourth quarter because some of its assumptions about policyholder behavior were incorrect. ING also said it would be completing its annual review of actuarial assumptions for its Japanese variable annuity business.

Last week, ING announced a 1.1 billion euro charge for its U.S. variable annuity business. It said there were no material changes to the assumptions underlying the Japanese variable annuity business.