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December 19, 2023 at 07:21 PM
What You Need to Know
- Rates are up.
- The regulations are strong.
- If rates fall, that could also be good.
It is my obligation as a financial professional to offer clients the financial product and plan that best suits their unique situation.
In many instances that plan can include a fixed indexed annuity (FIA), and it’s important that all financial professionals know something about them.
Whether it is as a bond alternative, or a safe haven for an IRA, FIAs have grown in popularity.
They are a fantastic tool for those who seek protection of principle, upside gain potential, and the ability to generate guaranteed lifetime income.
So, why is now the best time to purchase an FIA?
To answer that, we need to understand a bit more about how FIAs are constructed.
What’s in an FIA?
The indexed part of fixed indexed annuities is referring to market indexes that represent the performance of the stock market.
To be clear, FIAs are not direct investments in the stock market.
No, insurance companies primarily purchase a derivative investment, known as a call option, tracking a certain index.
If the index goes up, the option is executed at the strike price and any gains from the option are credited to the FIA.
If the index goes down, the option is worthless, but the FIAs principle stays intact.
That said, where do insurance companies get the money to purchase these call options for their FIA products?
Risk Management
We must remember that FIAs protect the client’s principal.
An insurance company creates a hedging plan to manage its risk associated with an FIA.
An insurance company allocates client funds primarily into low-risk investments (this speaks to the safety and security of entrusting your money with an insurance company).
These low-risk investments generally provide a return, and that return provides the budget for the call options to be purchased.
These low-risk investments, such as U.S. Treasury bonds, are not only desired, but in many states required.
It’s the responsibility of the National Association of Insurance Commissioners to develop model rules and regulations for the industry, which generally must be approved by state legislatures.
The NAIC strengthened solvency regulation in the 1980s, through an accreditation program that requires state insurance departments to meet certain standards.
The accreditation program also established minimum capital requirements for insurers.
Monitoring of the financial health of insurance companies is also accomplished through detailed annual financial statements that insurers are required to file, as well as periodic examinations of insurers.
It’s a function of safety.
State regulators do not want to replicate what happened to one provider in the early 1980s, when insurance company investments were not regulated as closely.
As a result, certain companies poured more and more of their clients’ money into riskier investments in an attempt to gain a competitive edge.
When the market turned, these investments proved cancerous, and the company was sent into receivership because it was unable to keep up with its financial obligations.
Strict regulations at the state level help keep the reputation of annuities and client trust intact.
It’s a good thing.
So, if an insurance company’s budget for purchasing call options is largely limited to whatever its return on low-risk investments is, then the payout of such low-risk investments is critically linked to how an FIA will perform.
The Bond Market
Let’s dissect the U.S. Treasury bonds a bit more and start by comparing the U.S. Treasury yield curve from Sept.18, 2020, and Oct. 31, 2023. The yield is substantially higher now than it was just three years ago in 2020.
Focus on the 10-year Treasury bond. Why the 10-year?
When insurance companies contract a new annuity, they attempt to line up the investments with the surrender period as best as possible.
This helps ensure that they can offer the same participation rate, cap or spread that they offered when the contract was issued for the duration of the surrender period.
Contrary to some conspiracies I’ve heard, an insurance company does not want or intend to “bait and switch” participation rates for their clientele.
Although they reserve the right to change participation rates, caps and spreads each year, it’s something they’re desperate to avoid.
That’s why they look to get a guaranteed yield when they issue an annuity for the duration of the annuity’s surrender period, which is commonly 10 years.
Now, compare what a 10-year Treasury bond paid in 2020 at 0.70% and what it pays in 2023 at 4.88%.
