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August 05, 2007 at 04:00 PM
Problems occur if brokers unwittingly create unrealistic expectations in the minds of deferred annuity clients.
An example would be unintentionally giving just enough information to allow the client to draw conclusions about future product performance–conclusions that aren’t realistic because they are based on an incomplete understanding of the facts.
Index annuities provide a great example. Let’s start with a quick poll question:
Will a renewal index rate cap on an annual, point-to-point index annuity likely go up when the index has been gaining over the last few months?
If you answered no, you’d be correct. The fact that the index went up during the contract year (and is higher now than it was on the prior policy anniversary) is not relevant to setting the renewal rate cap.
In a sales situation, however, problems can occur if the broker creates an expectation in the client that the renewal rate cap is directly linked to the index performance. This is an unrealistic expectation. It’s quite possible the renewal rate cap will go down even when the index is going up. On the flip side, the client may be happy to know the same holds true when the index is going down–it’s quite possible in that scenario that the renewal rate cap could go up.
To keep client expectations reasonable at renewal time, it’s important to know how the renewal index rate cap is set each year. The reality is that renewal rate caps on annual, point-to-point index annuities are set basically the same way initial rate caps are set. For example, in today’s low interest rate environment, an insurer would invest about 96% of the original deposit in bonds and mortgages. The blended return on those investments is what supports the minimum guarantee on the annuity. With the minimum guarantee secured, the remaining 4% is used to purchase 1-year options that allow the company to credit excess interest to the account if the index goes up in value during the index term.
Because the only amount that can be spent to purchase the option is 4% of original premium, the price of the options determines how high the rate cap can be set. At the end of the investment year, the options expire, or are cashed in if they are “in the money,” and new options are purchased to hedge the index movement for the upcoming index term.
Since the cost to purchase options changes on a daily basis, the client should expect renewal rate caps to change, to some degree, every year.
Option costs that support index growth annuities are determined in large part by the volatility (up and down movement) of the index used in the contract (the most common index is the S&P 500). So, the fact that the index is up over a certain period is not a primary factor in determining the option cost; volatility is the key.
