Extended Forecast: Falling P rates
Equity index annuity participation rates have dropped this
year. Some annuities with point-to-point or high point
structures have decreased rates over 40% in the last sixty
days. Annual reset methodologies have fared better, but
most of the companies are planning rate cuts in the next month.
Why is this happening?
Falling bond yields and
rising option prices are lowering participation rates
Two of the primary factors in setting index annuity
participation rates are bond yields and option prices.
Bonds, or similarly investments, are used to provide the
minimum guaranteed return that make an index annuity a fixed
annuity.
If an index annuity has a minimum guarantee of 3% interest
compounded on 90% of the premium, the annuity needs to provide
$1.10 for every dollar of premium at the end of seven years.
If bonds are yielding 6% then the insurance company would need
to invest 73 cents of the dollar to provide this minimum
guarantee.
Long term interest rates are down roughly 1% since the
first of the year. That 6% yield would now be 5%.
If the insurer can only earn 5% on the bonds they would need
to invest 79 cents to protect the minimum guarantee.
This reduces the amount available to buy options by 6 cents.
Six cents may not sound like much. However, if the
typical insurer needs to set aside a dime for overhead and
expenses, leaving 90 cents to buy options and bonds, lower
yields mean that instead of having 17 cents available to buy
options we no have only 121 cents. If a "full"
option costs 17 cents, we would only be able to purchase 65%
of that option. Falling bond yields leave less money on
the table to buy options.
The other factor is that option prices are rising.
For some index structures the cost of options has more than
doubled in the last few months.
The seller of an index option has special risks that the
seller of a normal stock option doesn't have. If you own
a stock you could sell and option giving a buyer the right to
buy the stock at a certain price. This is known as
writing a covered call. If the price of the stock rises
above the option price, the option buyer could exercise the
option and buy the stock. The option seller can meet
their obligation by deliver the stock.
Which an index option you can't deliver an underlying asset
if the option is exercised. Index options are settled in
cash. The writer of an index option can offset some of
the risk by holding a diversified portfolio of stocks that are
similar to the option sold, or buy options on those stocks,
but eh writer bears the risk that the value of their stocks
won't increase as much as the Index.
The more volatile the market, the greater the risk that the
underlying stock hedge, will not keep pace whit the index, and
volatility continues to increase because of uncertainty in the
global markets. When Index option writers are unsure of
future market movements they demand a higher premium on the
index option they are selling, or they withdraw to the
sideline and wait, which creates additional upward pressure on
those writers willing to sell.
Index annuity
participation rates will move lower in the
fourth quarter
Long term options pose the greatest uncertainty and their
prices have risen sharply. Index annuities that
guarantee their participation rate for the term of the
surrender period are the most vulnerable. Annuities that
may reset participation rates each year are under less
pressure. But, participation rates for all annuities are
affected and will move lower.
When will option prices fall? When the marked feels
it has a better sense of where the marked is going. My
guess is that the fourth quarter of the year will be rocker
than the third as troubles in the global economy further
impact our domestic one.
Intro to EIAs
S&P 500 Index
Benefits of the S&P
Advantage 500 Prospects
Gain without Pain
Extended Forecast
Sample Calculation
Selling Points
Best & Worst
Annuity Performance
Why EIAs are Popular
Source: Index Compendium, Vol 2, Number 10.
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