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Portfolio > Mutual Funds > Bond Funds

What determines renewal rates?

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Regulatory financial requirements mean most of the money in a carrier’s investment portfolio is in bonds with very little stuck in stocks, real estate or other investments. But a carrier can alter the quality and average maturity of its bond portfolio to lean toward higher yield or lower risk.

Lower risk, higher rated bonds tend to have lower yields than riskier bonds because there is less risk of default. A carrier can play it safe and put most of the money in high-grade bonds and accept a lower yield, or it can attempt to increase the yield by including more high-yield bonds and hope that through good management and a bit of luck the extra yield it receives won’t be taken away by bonds going bad.

Continuing on bonds, typically the longer the maturity of the bond, the greater the respective yield (although inverted yield curves occasionally happen wherein short interest rates are higher than long ones). If one bond portfolio has an average maturity of 12 years and another one has a 20-year life, the 20-year pool should provide higher yields than the shorter one. However, the longer average maturity means the yields will be more affected by interest rate swings.

Index annuities have a different set of factors that will affect their renewal rates. The typical carrier buys options to provide the index-linked interest potential. If exchange-listed options (existing options traded on stock exchanges) can be used, the costs may be lower than if synthetic options are created by the option seller and bought by the carrier. Lower option costs mean more options may be purchased for each dollar of premium, which translates into higher caps or participation rates.

In addition, big option buyers get quantity pricing breaks. A carrier buying $25 million of options usually gets a better price than another buying $1 million of options, which means the big buyer gets more options for each dollar spent, and this can translate into higher caps or rates.

Finally, a carrier can forgo buying options at all by using a process called dynamic hedging, which attempts to mimic the option’s behavior by building a small portfolio of other equity instruments – this gives the potential for higher returns, but the risk also is higher than simply buying the options outright.

But whether the bonds are “AAA” or “BB” and their maturity is 10 years or 25 years, or whether the index link is produced by exchange-traded options, over-the-counter options, or dynamic hedging, it is the carrier that sets the renewal rate. Carriers make pricing assumptions on policy expenses that may be more conservative or less conservative, and these assumptions affect how much money is available for renewal rates. One carrier may require it earns a 14 percent return on its equity, while another is happy earning a 12 percent return (and less money taken by the carrier leaves more money for the annuity owner).

And renewal rates are set by people, which means their decisions may have emotional factors at play that are not backed by economic factors. All of these different factors determine annuity renewal rates.


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