Why are indexed life caps so much higher than indexed annuities?
By Sheryl J. Moore
Moore Market Intelligence
On annuities, insurance companies only have one way to make a profit — through a spread. On life insurance products, insurance companies have several ways that they can make a profit.
The number one question asked since historical-low interest rates have depressed indexed annuity caps is, “Why are the caps on indexed life insurance products so much higher than those on indexed annuities?”
Good question. Simple answer. Let us explore how insurance companies are able to make a profit on each of these products.
On annuities, insurance companies only have one way to make a profit — through a spread.
Let me explain. When an annuity purchaser makes a premium payment into a fixed annuity, the insurance company turns around and uses that premium to purchase bonds. Generally, the bonds are high quality and they mature at the same time the surrender charges expire on the purchaser’s annuity (i.e., I buy a 10-year surrender charge annuity and the insurance company then purchases 10-year Grade A bonds to cover my annuity’s guarantees).
This provides a relatively safe investment vehicle for the insurer to make enough interest off of in order to earn their spread/profit. So, just for simplicity’s sake, let’s make the assumption that the bonds are paying 4 percent interest and the insurance company is crediting 3 percent interest on its fixed annuities. This means that the difference of 1 percent is what the insurance company is using to cover its expenses and anything that is left is its spread/profit.
That’s simple enough. Now, let’s move over and apply this to indexed annuities: Instead of putting 100 percent of the purchaser’s premium payment in bonds, with an indexed annuity, the insurance company puts about 97 percent of the premium payment in bonds. (Some companies might use 96 percent, 98 percent, etc. of the premium payment; you get the idea.)
The bond covers the indexed annuity’s annual 0 percent floor, which protects the annuity purchaser from market losses. It also covers the minimum guaranteed surrender value, providing a return of premium plus interest to the beneficiaries in the event of death, in addition to providing the same benefit to the purchaser if the indexed crediting does not perform.
Now, let’s get to the other 3 percent of the purchaser’s premium payment. This portion of the purchaser’s premium payment is used to purchase options. These options provide the index-linked interest on indexed annuity contracts.
Today, we might take that 3 cents of our $1 to the options-seller and ask that he sell us an option for on the S&P 500, using an annual point-to-point crediting method with a cap being used to limit the indexed interest. The option-seller might tell us that our 3 cents will buy our customers a cap of 3.30 percent today. Not so hot. Then again, the S&P 500 is relatively low right now. If the market suddenly rebounded, and the S&P 500 returned to 1500 next month, that option-seller will likely offer a much higher cap for my 3 cents. (After all, if the S&P 500 is already at 1500, what is the likelihood that the index will increase tremendously over a one-year period?)
Now that you understand how insurance companies make a profit on annuities, let’s take a look at how they do the same on life insurance products. On life insurance products, insurance companies have several ways that they can make a profit:
- Cost of insurance charges
- Premium loads
- Policy fees
- Per 1,000 charges
- Percent of fund charges
- Surrender charges
- A spread (just like in our annuity example, above)
What’s more, indexed life annual point-to-point caps currently range from 4 percent – 17 percent, whereas indexed annuity annual point-to-point caps range from 1 percent – 7.55 percent. Now doesn’t that motivate those you who have never explored indexed life to get off the fence and ask about it?
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