Fixed Indexed Products

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Fixed Indexed Products

• Overview of Products and Practices
• NAIC Educational Seminar
• March 4, 2006
• Noel Abkemeier, F.S.A. Jack Marrion
• Milliman, Inc. Advantage Compendium, Ltd.

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Discussion Topics

• Quantitative market overview
• Product characteristics/design
• Financial aspects for insurers
• Regulatory requirements
• The Securities World and Fixed Indexed Products
  
• Views of other entities
• The sales process
• Question and Answer session

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Index Annuity Mantras

• An Index Annuity is a fixed annuity with a
  nontraditional method of crediting interest.
• All Index Annuity benefit formulae are created
  equal.
• The highest returning design for a purchaser will
  be known only in arrears.
• An Index Annuity is not a VA with Living Benefits
  (VAGLB).

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Source Advantage Compendium
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Source Advantage Compendium
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Source Advantage Compendium
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Index Annuity Sales By Distribution - 2005
Source Advantage Compendium
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Source Advantage Compendium
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Source Advantage Compendium
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How Does An FIA Work?

• Interest linked to change in index
• Minimum crediting guarantee, commonly 0 annually
• Minimum benefit guarantee, e.g., minimum cap or
  participation rate
• Cumulative minimum guarantee, related to SNFLIDA
• Over long term, it credits interest competitive
  to other fixed annuities (historically somewhat
  higher)

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Fixed Rate Annuity
Minimum Interest
Additional Interest
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Index-Link
Index Annuity
Minimum Interest
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Major FIA Crediting Methods Annual Reset
measures index movement over a period of 1 or 2
years before calculating interest, often
capped Monthly Cap Annual Reset type that sums
monthly gains in index up to a cap and deducts
losses without a cap for 1, 2 or 3 years. Term
End Point measures index movement over a period
longer than 2 years before calculating interest
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Product Interest Crediting 92 Credit
Index-Linked Interest Each Year 2 Credit
Interest Every Two Years 6 Credit Interest At
End Of Periods 5 Years Or Longer
Source Advantage Compendium
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Benefit Variables

• Typically 1 moving part
• Other variables set at issue
• Participation rate
• Crediting cap (annual or monthly)
• Averaging
• Other - Yield Spread / All or nothing
• Market value adjustment

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Flexibility in Allocations

• Choice among a few index allocations
• Fixed-rate accounts also common
• Reallocation possible at end of crediting term,
  usually annually
• But 95 goes into SP 500 and anecdotal evidence
  is money stays put

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Index Annuity Crediting Can Be Very
Simple Interest All of Index Gain lt
8 Or Interest 6 If Index Gain is gt 0 And You
Can Never Lose Credited Interest Even If The
Index Drops
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Source Advantage Compendium, AnnuitySpecs
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Source Advantage Compendium, AnnuitySpecs
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Average Total Returns 5 Year Periods
CD Index Annuities 9/98 9/03 23.0 36.7 9/99
9/04 25.1 22.8 9/00 9/05 14.0 24.0
Source Advantage Compendium, Federal Reserve
Board
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Financial Aspects for Insurers

• Investment strategies to support indexed benefits
• Insurers risk profile
• Financial results

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Investments for Indexed Products

• Primary investment is fixed-yield instruments
  (96 in most cases)
• The balance is a call option hedge
• 3-4 for annual ratchet products
• 15-20 for multi-year guaranteed products

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What Does the Hedge Do?

• Relieves the insurer of risk by matching the
  liability that the insurer has for crediting
  index-based interest
• Creates the same risk profile for the insurer as
  with fixed-rate annuities

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Interest Crediting and Hedges

• In most cases, the insurer purchases call option
  hedges with a cost equivalent to the interest
  that otherwise could have been credited.
• This available amount is the hedge budget.
• The index-based benefit is whatever can be
  afforded within the hedge budget, e.g., cap,
  participation rate, spread fee, etc.

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Range of Affordable Benefits

• Average value of index-based benefits is similar
  to the fixed interest that could have been
  credited with the underlying fixed-yield assets.
• High participation rates are partially caused by
  lack of dividends in the underlying index.
• Benefit design features can allow higher
  participation rates, e.g., monthly averaging,
  spread fee, cap.

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Hedging Approaches

• Buy over-the-counter (OTC) tailor-made options
  from dealers that match the indexed benefit risk
• Buy OTC options from dealers that cover an
  aggregated indexed benefit risk
• Purchase exchange-traded options for approximate
  hedging
• Use dynamic hedging that is similar to the
  process for guarantees on variable annuities

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What Are the Risks in the FIA Market?

• Product Management design evolution
• Living within hedge budgets
• Hedge ineffectiveness
• Market Conduct/Regulatory Risk
• Earnings Risk GAAP volatility and statutory
  similar to declared-rate fixed annuities

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Insurer Risk Profile

• All fixed indexed products can be managed in a
  fashion similar to fixed interest products.
• Insurer annually manages the hedge budget in
  the same way that credited interest is managed on
  fixed interest products.
• A properly hedged program presents little
  additional risk to that of a fixed interest
  product.
• Current products priced to traditional IRR
  targets or other profit measures
• Reinsurance is seldom used

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Financial Results

• Statutory income should be similar to that on
  fixed-interest products if the hedging matches
  the liabilities.
• GAAP reporting under FAS 133 causes some earnings
  volatility, particularly for ratchet designs.
• Index benefits cover longer period than current
  (annual) hedge
• Sensitivity to changes in Treasury curve

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Regulatory Requirements

• Statutory reserving
• Nonforfeiture laws
• SEC stances

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Statutory Reserving

• FIA subject to Actuarial Guideline 35
• Application of CARVM principles
• Market value and book-value approaches available
• Results similar to fixed-interest annuities
• FIUL subject to Actuarial Guideline 36
• Application of CRVM principles
• Market value and book-value approaches available
• Results similar to fixed-interest universal life

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Annuity Nonforfeiture Law and FIAs

• Cumulative cash surrender value floor of 87½ of
  premiums accumulated at the minimum nonforfeiture
  interest rate
• Minimum nonforfeiture rate at 5-year CMT minus
  1.25 for fixed-interest annuities, but 2.25 for
  FIAs.
• Extra 1.00 for EIAs must be justified as less
  than the value of the indexed benefit.
• NY applies an annual crediting floor at the
  nonforfeiture interest rate and does not provide
  for the additional 1 FIA allowance.

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Nonforfeiture Laws and Design

• Cumulative minimum guarantee structured to
  satisfy annuity nonforfeiture law
• In NY, annual benefit must be at least as great
  as the nonforfeiture interest rate

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• Is an indexed annuity the same as a variable
  annuity with a living benefit?

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Index Annuity
Variable Annuity
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An index annuity is a savings instrument designed
to provide the potential for higher returns than
other savings instruments, while protecting
principal and credited interest. Variable
annuity principal protection features are
designed to lower the market risk of owning a
variable annuity. They are designed for two
different worlds.
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(No Transcript)
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• Is an FIA a Security?

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SEC Positions and Actions

• The indexed annuity product structure, in which
  the guarantees have satisfied the state
  nonforfeiture laws and regulations, has not been
  officially limited by the SEC.
• Concept Release in 1997 by the SEC led to no
  action.
• The SEC briefly checked the market through
  discussions with law firms in 2002, but again
  took no action.

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SEC Request in July 2005

• The SEC requested major FIA insurers to submit
  information regarding the following FIAs
• Any unregistered contracts where the payout at
  any point may be less than 90 of premiums paid
• The five unregistered FIA contracts with the
  greatest sales volume for the period January 1,
  2005, through June 30, 2005.

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SEC Request in July 2005

• With respect to each such contract, they
  requested the following
• A copy of the contract
• All written sales materials, including scripts
  prepared for oral presentations, whether for
  prospective contractowners, selling agents, or
  any other party
• Any written materials provided to contractowners
  or prospective contractowners, including any
  disclosure documents
• Identities of the 10 entities distributing the
  contract that had the greatest sales volume for
  the period January 1, 2005, through June 30, 2005
• The companys legal analysis as to why
  registration is not required.
• No response has been made by the SEC.

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Securities World andFixed-Indexed Products

• Customer perspective
• Insurer perspective
• Regulator perspective

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Customer Perspective on FIAs

• Current interest crediting guarantee
• Current interest floor guarantee
• Minimum interest crediting guarantee in later
  years
• Long-term interest floor guarantee
• Limited selection of interest crediting basis
• Limited reallocation flexibility
• No control of assets
• Purchased like other fixed annuities

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Insurer Perspective on FIAs

• FIA characteristics are similar to those for
  other fixed annuities
• Assets overwhelmingly in fixed-yield investments
• Asset-liability management (ALM)
• Risk profile of insurer
• Benefit guarantees and obligations of the insurer
• Method of managing interest crediting
• Profitability profile
• Capital structure (RBC)

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Regulator Perspective on FIAs

• State Insurance fixed annuity characteristics
  indicate insurance regulation as an unregistered
  product
• SEC linkage to equity indices requires
  consideration of whether the products should be
  registered
• NASD linkage to equity indices suggests that
  suitability and disclosure requirements should be
  comparable to those for registered securities

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• Index-Linked Savings Instruments
• Certificates of Deposit
• Series I Saving Bonds
• Fixed Indexed Annuities

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Source Advantage Compendium, Wall Street Journal
4 Oct 05
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• Smoke versus Fire
• Ive read NO lawsuits alleging economic loss due
  to the poor performance of an index annuity
• 2004 NAIC Closed Customer Complaints 24 Index
  Annuities, 181 Variable Annuities, 895 Fixed
  Annuities
• Less than 1 of index annuity producers reported
  securities registration was dropped to sell index
  annuities

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• Registered Reps ARE NOT allowing their licenses
  to lapse to sell indexed annuity products
• Our survey of 219 IA producers in the fourth
  quarter of 2004
• 11 had let their Series 6 or Series 7
  registration lapse BUT
• 5 said their carrier had pushed it on them, but
  they had never sold MFs or VAs and so couldnt
  see the reason to maintain license.
• 2 had let lapse because they had become RIAs
• 2 said they were simply going to sell index
  annuities instead
• 2 gave no reason.
• January 2006 Survey of 114 producers in our data
  base that said they had Series 6 or Series 7
  registration.
• 5 Said Theyd Given Up License Due To NASD 05-50

Source Advantage Compendium
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What are the sales method issues?

• Agent Training
• Sales Practices Suitability

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• Agent Training
• Range from none to comprehensive
• Often conducted by marketing organizations
• Heavy on sales training
• Some carriers require detailed training program
  documented training, training logs, require
  agent training for contracting
• A Series 6 is not helpful in index annuity
  training

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Dearborn 24th Edition Series 6 Study Guide Heres
Everything It Says About Indexes index A
comparison of current prices to some baseline,
such as prices on a particular date. Indexes are
frequently used in technical analysis. An index
funds performance tracks the underlying indexs
performance. Only says -annuities and bank CDs
are considered illiquid. 12 lines describing
the cycles that create bull and bear markets, 6
pages on suitability (but life insurance is not
mentioned). 9 suitability questions on practice
final 1 (but the suitable answers are always
securities) 6 suitability questions on practice
final 2 (but the suitable answers are always
securities)  Passing A Series 6 Does Not Qualify
You To Sell Annuities
Source Advantage Compendium
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• Index Annuity Training Topics
• What an Index Annuity is ( What it isnt)
• Basic interest crediting methods
• Differences between fixed and variable annuities
• Setting realistic consumer expectations
• Suitability Examples, Suitable Transfers
• Index Annuity suitability is the same as Fixed
  Annuity
• Suitability Fixed Annuities appeal to
  risk-averse consumers

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FIA Sales Practices

• Suitability practices same as for other fixed
  annuities
• Sales presentations similar to other fixed
  annuities
• Illustrations not used, although demonstrations
  of crediting may be

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Who Shouldnt Buy An FIA? Too Short A Time Frame
Going For Maximum Returns Must Be FDIC Insured
Portfolio Tinkerers (Fixed Annuities Are For The
Risk Averse)  
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• Equity-indexed annuities are only one example of
  a financial product that a firm might erroneously
  treat as a non-security... NASD considers all of
  these products to be securities, subject to firm
  supervision.
• - Vice Chairman Shapiro 25 May 2005
• NASD is not taking a position on whether a
  particular EIA is a security
• - NASD Notice to Members 05-50
• I think we need to start looking at fixed
  annuities
• Chairman Glauber 19 Sept 2005
• Despite what you may read in the press, our goal
  is not to extend our jurisdiction to insurance
  companies.
• - Chairman Glauber 23 Sept 2005

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• Questions and Answers