Ready For Some New Approaches To Indexing?
With all of the stir associated with the recent equity market volatility and the decline in interest rates, it may be easy to overlook the fact that sales of indexed products, particularly equity indexed annuities, have increased strongly over the past few years.
This increase in sales has occurred in a financial environment that has not been particularly favorable for equity indexes. Specifically, low interest rates and high option volatility have increased the cost of hedging the equity linkages in the products and providing for the policy guarantees. Both factors place a drag on the products competitiveness.
The upswing in equity indexed sales suggests the products are benefiting from an economic environment that has placed high value on guarantees and recognizable equity indexes.
To date, indexed products have achieved success in a modest number (10 or so) of insurer portfolios. The indexed products of choice have been S&P 500-linked deferred annuities, or equity-indexed annuities. The chief competitors to EIAs are variable deferred annuities with living benefit guarantees, and fixed deferred annuities.
Does this mean the index product market is poised to leap to its next level of evolution, a level that may involve a broader range of insurance company participation? Very possibly. But what key drivers might be necessary for the products to achieve this new level?
First, indexed products must penetrate more product types than just deferred annuities. Although some indexed life insurance products exist, the market is quite thin.
Significant potential exists to design universal life and interest-sensitive whole life products with cash value returns and/or death benefits that are a function of an external index. Such products would offer a modest return guarantee, with the index return being added on top of the guarantee or compared to the guarantee. Secondary guarantee features could be added to the basic chassis to create a strong package.
In addition, indexing can be an ideal structure for immediate or payout annuities. Compelling cases can be made for indexing future benefits to one or more of a range of indexes, both interest and equity types, with a benefit floor. Indexed subaccounts (with underlying floor guarantees) could be appealing options in variable life and annuity contracts.
Second, more indices need to be available for incorporation into indexed products. In order for an index to be attractive for an indexed life insurance or annuity product, it needs to be broadly recognized, hedgeable, and historically trackable to distinct market characteristics.
Today, the available indices are limited to the S&P 500 and S&P 400, Treasury Index Rates, the Consumer Price Index, and, to a lesser degree, the Dow Jones Industrial Average, NASDAQ and Russell 2000. The S&P 500 dominates usage in indexed products.
The challenge for use of other indexes has been the ability to efficiently purchase (or purchase at all) hedging instruments. We believe the market would be receptive to indexes based on corporate bonds, real estate, precious metals, and defined industry sectors.
In particular, interest indexes could resonate well with customers and sales reps in todays environment, where interest rates are viewed as unusually low. It may be necessary for new asset types to be created to facilitate the hedging of indexed liabilities.
Third, the cost of providing the index linkage must be lowered to enable indexed products to be an even more compelling financial package.
For this to happen, life insurers must become more familiar with, and take greater ownership of, the hedging process. Blind acceptance of OTC market pricing without comparison to costs associated with hedging by replication or other innovative investment approaches may doom index products to mediocrity in returns over the long term.
Lastly, from a marketing viewpoint, indexed products must more boldly share the products success stories with the outside world.
Particularly with respect to equity indexed products, the performance of certain policies issued five years ago could be strong models for the philosophy of indexing. Real-life successes could powerfully deflect some of the criticism levied against the products by non-providers.
In light of the severe challenges faced by variable product providers and manufacturers of fixed interest products, indexed products may be a worthwhile product line to revisit. However, in order to achieve sales levels that warrant the investment of time and money into this product line, the indexed return market should be looked at with a fresh eye and a clean sheet of paper.
Timothy C. Pfeifer, FSA, MAAA, is a principal at Milliman USA, a Chicago actuarial consulting firm. His e-mail address is firstname.lastname@example.org.
Reproduced from National Underwriter Life & Health/Financial Services Edition, September 16, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.