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August 24, 2009 at 08:00 PM
Banks are marketing a new type product, the indexed certificate of deposit, and this is making insurance professionals wonder how their own indexed product, the fixed indexed annuity, stacks up.
Indexed CDs link their potential credited interest to the performance of an external market index such as the S&P 500. (This distinguishes them from traditional CDs, which provide a guaranteed stated interest rate each year.)
The value proposition is, indexed CDs offer the potential to exceed traditional fixed interest rates without exposing principal to market risk. In addition, if the market index does not create any interest credits, the indexed CD guarantees that depositors will get their money back as long as they hold the CD to the end of the selected term.
But FIAs also derive interest credits from the performance of an external market index. So, how do the two products compare and contrast? Here is an assessment:
What is the same?
Interest crediting method: Both products provide that, if the index rises during the measured period, the owner receives an interest credit. If the index remains level or drops during the measured period, the consumer receives no interest credits. As a result, it is possible to receive a zero earned interest in any given period.
The indexing has market appeal because it offers consumers the potential to earn more than traditional fixed interest rates without the need to take on market risk.
However, banks and insurers take different approaches on this.
Purchasers of indexed CDs agree to keep their money on deposit during the agreed upon term. The bank then lends this money to borrowers and begins earning interest on the loan.
In a traditional CD, the bank keeps a portion of this loan portfolio yield and credits the CD with a lower fixed interest rate. But with the indexed CD, the bank instead uses the interest it would have otherwise credited to the CD to purchase a call option on the chosen market index.
Note: If the market index rises, the call option becomes more valuable, allowing more interest to be credited to the product. Alternatively, if the market index falls, the call option will expire as worthless, so no interest is credited for that period.
With FIAs, however, insurance companies do not manage a commercial loan portfolio. Instead, they aggregate all policyholder premiums in their general account; they guarantee the principal and provide a statutory minimum guarantee. The minimum guarantee assures that the owner will receive more back than the original principal if the owner holds the annuity to the end of the contract. This happens regardless of the performance of the chosen index.
Within the insurance company general account, the insurer manages the assets by investing in a conservative portfolio of highly rated government bonds and investment grade corporate bonds. This generates a yield. The insurance company keeps some of this yield to pay for administrative costs and allow for a profit.
In a traditional fixed annuity, the company pays the consumer the difference expressed as a stated interest rate. In an FIA, however, the insurance company uses the interest it would have otherwise credited to the policyholder to purchase a call option–for the same reason the bank purchases call options, cited above.
If the index rises, the FIA owner receives an interest credit. If the index falls, the FIA owner receives no interest credit for that period but does keep any past interest credits as well as the principal guarantee.
Although FIAs offer many more styles of crediting methods than indexed CDs, consumers will likely view the way interest is earned in both as basically the same.
