Betting on the spreads has become a big business for the gambling industry. Virtually any newspaper shows a long list of point spreads in all of the major sports for all of the favorite teams.
Spreads of a different sort also drive the annuity industry.
In these difficult economic times, the one bright spot for the insurance industry is the sales of fixed annuities. FA sales are driven mainly by the current favorable interest-rate-spread environment.
So, when discussing annuities, it helps to analyze a number of interest rate spreads.
The most important spread is the difference between corporate bonds and U.S. Treasuries. Because almost all insurers invest assets in corporate bonds, the net investment earned rate for a company–and hence, the credited interest rate on annuities–is highly dependent on the corporate bond rate. On the other hand, bank certificates of deposits more closely follow the U.S. Treasury rate.
Therefore, in addition to the favorable tax treatment for annuities, FAs compare favorably to bank CDs when the spread between corporate bonds and U.S. Treasuries widens.
The chart shows the spread in the last 10 years between a Moody’s corporate AAA bond rate and the Treasury constant one-year maturity rate. Note that the spread at the end of 2008 is much wider than the last 3 years and is very similar to the spread from 2001 to 2004.
The corporate-bond spread is not the entire difference between fixed annuity credited rates and CD rates. Insurance companies have what is often termed an interest-rate spread to cover expenses, benefit costs, and targeted profit margins. These spreads do not generally vary over time, but do vary from company to company, depending on the cost structure of the insurer and the product design. Most of the time, these interest rate spreads are 100 to 200 basis points, which reduces some of the spread difference between FAs and CDs.
Removing 100 basis points from the corporate spread shown in the chart would suggest that CDs had credited rates similar to fixed annuities from 2005 through 2007.
Other factors do impact each of these spreads, e.g., steepness of the yield curve, but the corporate spread is an important indicator of the competitive position of FAs.