Insurers in for More Misery

Melissa Gannon
November 6, 2008

Insurance companies that have sold billions of dollars worth of annuities that make guaranteed payments when stock indices like S&P 500 fall, could weigh on several companies that offer the products.

Equity index annuities (EIAs), also known as fixed index annuities, pay holders a percentage based on the performance of a market index, such as the S&P 500. As the S&P goes up or down, so does the amount of interest the insurer pays the annuity holder. However, EIAs also offer a minimum guaranteed interest rate, generally about 3% (the "fixed" component). Companies do employ hedging strategies targeted to time the annual index credits paid out to annuity holders which should offset some losses, but the amount of the offset is dependent upon the success of those strategies.

With the S&P 500 down 33% since the beginning of 2008 and the bottom unknown, the effectiveness of those hedges will be a key factor in the insurers' success.

Aviva (AIVAF:NYSE), the largest issuer of this type of annuity with $2.8 billion in sales, according to the Advantage Index Sales & Market Report published by, is the first to report third-quarter results. While the U.K.-based company did not break out equity index annuities, it reported flat capital reserves of 11.5 billion euros, thanks to offsets to the decline in the equities markets through the strengthening U.S. dollar and other factors. The company will not report its bottom line until the end of the year.

American Equity Investment Life Holding Co. (AEL:NYSE), the third-largest player with $1.1 billion in fixed index annuities sales during the first half of the year, reports third-quarter results after Wednesday's close. The insurer lost $231 million on its call options, intended to hedge interest payouts, during the six months ending June 30.

In its second-quarter Securities and Exchange Commission filing, American Equity also reported $42 million paid out primarily on contracts with fixed rate options and minimum guaranteed interest, which was five times the $7.8 million it paid out based on appreciation of underlying indices. In 2007, however, the $40 million interest credited for fixed rate options and minimum guarantees was only one third the $128 million paid out based on index appreciation.

Allianz Life (AZ:NYSE), the second-ranked seller of equity index annuities, in the first half of the year with $2.1 billion, reports results Nov. 10. It did not report details on its equity index annuity business in the second quarter.

Rounding out the top five fixed index annuity companies are Midland National Life and Old Mutual, neither of which are publicly traded.

Allianz and Aviva did not return calls. It is clear, however, that equity index annuities are another likely stumbling block for insurers already taking a bath from the variable annuity business. Insurers like The Hartford Financial Services Group (HIG:NYSE) reported steep losses tied to their variable annuities business in the third quarter and AIG (AIG:NYSE) is expected to do the same when it reports results on Nov. 10. What are Equity Index Annuities?

Buyers of equity index annuities typically pay a lump sum premium up front. The average lump sum amount in the second quarter was $52,460, according to Then the insurance company agrees to pay the annuity holder an amount based on the performance of a stated market index such as the S&P 500 or an aggregate Treasury index. If the return of that stated market index goes below a certain percentage, then the insurer pays a guaranteed minimum.

This simple concept then gets much more complicated. First, there is what is known as a participation rate. This essentially determines how much of the gain is credited to the annuity value. If the participation rate is 80%, then 80% of the index return is credited.

Instead of a participation rate, some companies use a spread that is subtracted from the index gain before it is credited to the annuity. For example, if the index gains 10% and the spread is 3%, the annuity is credited with 7%.

Yet a third way to determine the amount of the index credited to the annuity is via an interest rate cap. This simply means that the insurer puts an upper limit on the percentage it will credit to the annuity, regardless of how much the market index returns.

To further complicate things, there are typically three ways the insurer determines the percentage change in the market index. The first way is an annual reset whereby the change is calculated by comparing the index at the beginning of the year with the value at the end of the year. The second method is called the "high water mark," which is to take the value of the index at particular points in time during the contract period and compare the highest point it to the level at the beginning of the contract term. The third method is called "point-to-point," which is simply to compare the index at two points in time.

Some insurers also average index levels daily or monthly. What is clear, though, is that the method of interest crediting can have a dramatic effect on the performance of the annuity.

The Financial Industry Regulatory Authority does an excellent job of explaining the complexity of equity index securities on its Web site.

EIAs typically have very high fees if an annuity holder wants to withdraw his money early. These are known as surrender charges. This charge is the highest during the very early years and generally declines on a sliding scale until it goes to zero in what could be as much as 10 or 15 years. In its second-quarter report, American Equity reported that its average surrender charge collected was 15.3%.

The guaranteed payment form an insurer is only as good as the strength of the company paying it. If that insurer becomes insolvent and is taken over by regulators, all bets are off. So it's important to know how financially sound a company is before you purchase an EIA or any other retirement product. Ratings issues financial strength ratings on each of the nation's 8,600 banks and savings and loans which are available at no charge on the Banks & Thrifts Screener. In addition, the Financial Strength Ratings for 4,000 life, health, annuity, and property/casualty insurers are available on the Insurers & HMOs Screener.

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