By Mark R. Triplett

InsuranceNewsNet

Nov. 19, 2010 — Indexed annuities have been sold in the United States for more than 15 years. Sales of IAs have skyrocketed in the past decade, increasing parallel to their popularity. Two driving forces behind the success of IAs are consumers looking for an alternative to traditional savings vehicles and investments and financial professionals’ eagerness to satisfy their clients’ needs.

Whether you like them or not, IAs are undeniably a controversial, new-kid-on-the-block product line that demands attention. You may think you know how indexed annuities work, and probably have formed a strong opinion as to whether they are good or bad. Your opinion may be based on fact or perhaps on hearsay.

Nevertheless, as of the end of the second quarter 2010, 44 insurance carriers offered a total of 237 different index annuities. Making general assumption about this broad spectrum of offerings could mean bad news for your clients and your practice!

Not all indexed products are created equal. Although it is true that they all have the same components, the balancing act between the guarantees, expenses/profit and hedging budget will have a lasting impact on the client’s overall experience with the product. The integrity of the carrier’s management team and ownership may also contribute to a positive or negative experience.

Indexed annuity and indexed life insurers have to juggle three main components that all indexed products are designed around: guarantees, expenses/profit and the heavily promoted “upside potential without downside risk.” The ability to have a better-than-average opportunity to earn a better-than-average interest rate, while preserving all premiums paid and prior interest credited is what makes indexed products so attractive. However, overpromising on the opportunity or setting irrational expectations on the additional interest to be earned has given indexed products a black eye.

First of all, as an industry we should be promoting guarantees along with “SOME of the upside potential and none of the downside risk.” Too often we hear these products promoted as if they have unlimited potential for growth. In reality, indexed products provide an opportunity to earn additional interest, linked to an index, without placing any principal or credited interest at risk. However, the potential is limited because there are guarantees involved, and they are expensive to provide. This is especially true in today’s low-yielding bond environment.

In an indexed product, all of the client’s money is held in the general account of the insurance carrier. The insurer then allocates most of the money toward purchasing long-term, high-grade investments to back the guarantees of the contract. They keep a spread on these reliable investments in order to cover their operating expenses (including sales commissions paid to the agent) and to generate a profit.

Lastly, the money that is left over, typically fewer than five pennies on a dollar, are allocated to hedging the gain of a specific index. This is typically done through the purchase of a European Style option.

Because the options that the carrier purchases cost more than what they have left over to spend, they are limited to the percentage of the option that may be purchased and retained. As a result, the “upside potential” that may be available to the policy holder is limited. Caps, margins, participation rates or variations on crediting methods, such as monthly and daily average methods, may be implemented to reduce the cost of hedging the index gain.

All of the features of an individual IA may be considered one of three components: guarantees, expenses/profit and hedging budget. A premium bonus for example is a guarantee. An enhanced withdrawal privilege is a guarantee. Adding a guarantee will take away from the hedging budget and therefore reduce the crediting rates that will determine the customer’s opportunity for additional interest to be earned.

A product with an increased commission will result in a similar situation. However, a product with a lower commission or fewer peripheral guarantees provides for more money to be allotted for purchase a greater percentage of the hedge. This would result in more opportunity for additional interest to be earned by the client.

Ultimately, you want your clients to be successful so that they will give you repeat business and be open to sharing you with their friends, neighbors, family and so forth. Creating the right expectations and then delivering on them is a great starting point.

In order to set the right expectations, become knowledgeable about the general makeup of indexed products. Then apply this knowledge to the products that you offer to your customer, looking past the marketing gimmicks and seeing the products’ true colors. This will lead to a more selective approach in determining what you offer to your valued clients.

Mark R. Triplett is vice president of annuity distribution at AMZ Financial. Mark can be reached at Mark@amzwebcenter.com.

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