Rife insurance

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The annuities and structured products industries are locked in a bizarre embrace. While the two are actually very separate in terms of providers, there are strong similarities that bind them, and some brokers and advisers sell both products. The basic idea behind the investments is that they offer some guarantees with additional upside potential. However, the trillion-dollar annuities industry is well established, encompassing fixed, variable and indexed annuities, the latter being like a hybrid of each type and most similar to a structured product, with returns typically dependent upon the performance of an equity index (see box).

Indexed annuities alone represent a $123 billion industry, according to the US Securities and Exchange Commission (SEC). This easily surpasses volumes in the nascent structured products market, which was estimated to have finished in the region of $100 billion for 2008 (Structured Products, January 2009). This is unsurprising given the size of the annuities industry as a whole and the relatively more comfortable environment in which they operate compared to structured products - there are no limited offering periods, glossy marketing material abounds thanks to the enormous volumes, and vendors were controlled by individual state regulation rather than centrally.

But Rule 151a, introduced in late December 2008 by the SEC, has the potential to toughen the annuity landscape considerably. Indexed annuities are not regulated as securities, even though they can look and feel like securities products, because they are insurance contracts. The sale of insurance is not supervised centrally by the SEC. So the stricter conditions brought to bear on the sale of structured products, which are indisputably securities, did not apply.

High-profile unfavourable media coverage alerted the SEC to protect senior investors from what the regulator's former chairman, Christopher Cox, called "abusive sales practices by unscrupulous marketers" in June last year. The eventual result was Rule 151a, which gives the SEC the authority to regulate certain annuity products issued from January 12, namely those that rely on indexes or securities to calculate payouts after specific periods, or where the insurer is 'more likely than not' to end up paying the investor more than the amount guaranteed under the contract. Advisers now wishing to sell indexed annuities will have to be representatives of SEC-registered broker dealers, rather than independent insurance agents which are individually state-licensed.

On the face of it, this seems like the news the US structured products market has been waiting for. Market participants were anticipating as recently as six months ago (Structured Products, July/August 2008), that if structured products and annuities faced the same regulatory constraints, "structured products would just crush annuities," as one broker-dealer insisted. Training advisers to sell annuities and get sales documentation approved by the relevant authorities costs time and resources, which are already squeezed by current market conditions.

However, despite structured products industry participants' enthusiasm for the rules, the flipside is that it could have a positive effect on the indexed annuity space. Coverage of abusive sales practices had scared many investors away from the investments, but now they are more tightly controlled, they may be tempted back.

"Classifying indexed annuities as securities will almost surely lead to improvements in terms of reduced complexity, better marketing, transparency and ultimately, increased acceptance by financial advisers who have traditionally shunned the product," says David Macchia, Boston-based chief executive of Wealth 2K and founder of the Retirement Income Industry Association (RIIA). "All of this augurs well for sales of indexed annuities over the long term," says Macchia.

Perceived security

An important distinction that Macchia also highlights is that amid fears over counterparty risk, the protection offered by an insurer may prove to be more convincing than that sold by investment banks. "What level of faith will people have in structured products' warranties versus the insurance companies' explicit guarantees?" asks Macchia.

The insurance industry's relative security could prove to be a serious blow. Aside from AIG's troubles, insurance companies have largely avoided the worst results of the financial meltdown, unlike the very public disappearances or mergers of US investment banks, says Bill Payne, president of Tri-Star Financial in Houston, Texas, which has sold both annuities and structured products. In Texas, for example, an insurance guarantee system is in place that obliges all insurance companies in the jurisdiction to cover each individual up to $100,000 per contract if one insurance company becomes insolvent.

"Indexed annuities are going to have the upper hand at this point in time from a marketing standpoint," says Payne. "The new rule will affect at most 2-10% at most of the annuities industry - most were prepared for it and had already obtained their licence." Insurance contracts have also been unaffected by plummeting rates. With six-year Treasuries offering a tiny 0.29%, structurers have very little room to create attractive terms. "You've lost 400 basis points of spread in one year across two, five and 10-year Treasuries. You've lost the ability to create a product," says Payne, who remains enthusiastic about using structured products when the market begins to recover.

However, the recent meltdown has pushed advisers to consider new solutions for retirees, says Macchia, who believes this is good news for both industries. Even if the new annuity rules do not provide the boost that the structured products industry might have hoped for, 76 million baby boomers are set to retire in the near future, which leaves trillions of dollars available for capture, according to statistics provided by RIIA in 2005. Provided confidence returns and rates rebound eventually, there is still potential for both industries to thrive.

Indexed annuities: pluses and pitfalls

An annuity is a contract between an investor and an insurance company. The insurance company agrees to make a series of payments to the investor after they have paid a lump sum or their own series of payments. The basic guarantee is normally for 90% of principal plus 3% interest. With equity-indexed annuities, the sum of money ultimately returned to the investor is, as with structured products, calculated according to the performance of a specific index, usually based on equity, using one of a variety of indexing methods.

The ratchet mechanism simply takes the positive performance of the index from beginning to end and locks in gains each year. The high watermark mechanism looks at the value of the index on fixed dates throughout the investment, usually annual anniversaries, and picks the highest value compared to its level at outset. However, no interest is credited until the end of the term, so if the investment is surrendered early then investors may receive no interest at all. Lastly, point-to-point systems compare the index between two fixed points, such as the beginning and end of the investment. If stock market falls hit the index at the investment's maturity, then the investor could see all earlier gains wiped out, and the same caveats apply with the early exits. One of the main pitfalls is that these mechanisms are often combined with other investment features that can make them considerably less attractive.

Participation rates in index gains are frequently set at around 80%, which mitigates index increases. Instead of, or even alongside, these rates, some insurance companies take a margin of index gains, which may be around 3.5%, and use caps that limit the maximum amount of interest that can be received. Annuities are also designed not to be exited early, and are subject to surrender charges if investors decide that they need their money back of up to 10-15%, as well as tax penalties. The upshot of these various conditions and caveats is that investors can end up with less than they initially invested. Both the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (Finra) issued investor alerts last year to warn of the investment's complexities.

Source: SEC and Finra Investor Alerts, 2008.

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