With margins razor thin and interest rate risk unsettling, insurers are creating annuities linked to equity indices. And yes, that means selling structured derivatives to retail.

By Miriam Bensman

Call it one of life's coincidences, proof that great minds think alike, or a sign that an idea's time had come. In May 1993, Paul LeFevre, senior vice president and chief financial officer of Boston-based Keyport Life Insurance Co., was visited by officers of Genesis Development Co., a financial product design firm. Genesis was pitching a new idea and wanted LeFevre to sign a confidentiality agreement.

"I'm not signing any agreement until I make sure it's not the same idea," LeFevre replied. He revealed that Keyport was developing a single-premium defined annuity that is indexed to the S&P 500, but protects the holder from losing its principal. "Their mouths dropped open," LeFevre recalls. "That was the idea Genesis had come to sell."

Keyport and Genesis weren't the only ones thinking along the same track. Unbeknownst to both of them, UK insurers such as Financial Assurance, GA Life and AIG Life had been offering similar products for more than three years. Indeed, in 1994 equity-indexed products comprised an estimated one quarter of the £8.9 billion of single-premium life contracts sold in the United Kingdom.

The new product is spreading quickly across the Atlantic. Last year, Keyport Life Insurance Co. and Lincoln Benefit Life Co. rolled out the first equity-indexed annuities in the United States. Other offerings (EIAs) are being planned by CNA Insurance Co., Community National Assurance, John Alden Life, Unity Mutual Life, and others. Equity-indexed annuities, in fact, are becoming one of the hottest new products in the insurance business. Insurance actuaries and brokers had to hunt for seats at a Global Business Research conference on the subject in New York in December.

Big Hopes

For insurers, EIAs represent a promising alternative to margins in traditional annuity products, which are one-third of what they were ten years ago and half of what they were five years ago, according to John Stracka, executive vice president at Financial Distributors Inc.

Insurers are also seeking to avoid the risk inherent in traditional, fixed-rate annuities. "The problem with fixed-rate annuities is the insurance company bears all the risk," says Robert Rich, chief actuary and chief financial officer for Lincoln Benefit Life, a wholly owned subsidiary of Allstate Life. When interest rates spiked in the 1980s, for example, customers cashed in old policies earning 3 to 4 percent to invest in CDs or new annuities that paid 12 percent. "Insurers with 25- to 30-year bonds in their portfolio were hammered, just like thrifts," he says.

Since then, of course, insurers have developed much stronger risk controls, but with the typical single-premium defined annuity, it's impossible to eliminate all risk. That's because state nonforfeiture laws require insurers to allow policy holders to back out of the contract with a 5 to 10 percent surrender charge that only covers the cost of the sale.

Insurers are also hoping EIAs will help them regain assets lost to the mutual fund industry. Between 1980 and 1990 mutual fund assets grew by 600 percent, while insurance company assets grew by just 223 percent. "The insurance industry has been asleep, letting customers move assets to other sectors," says Ray Mathews, president of FDI Financial. "This is its wake-up call."

Different Strokes

For derivatives dealers and money managers, EIAs represent a whole new market to serve. Insurers have taken a variety of approaches to hedging their exposure on these new products. For the most part, UK and European insurers buy perfect hedges to eliminate all market (but not credit) risk, reports Steven Meeks, executive director in the global equity derivatives team at Union Bank of Switzerland. By contrast, many US insurers manage the hedges themselves, merely buying the pieces from dealers.

Intermediaries are also getting into the act. BEA Associates is now marketing its ability to manage hedges for insurers banned by Texas state law from trading directly in OTC options. "Others may give us part of their EIA portfolio to hedge so they can learn what the broker-dealers are doing," says BEA senior vice president Vincent Bailey. "If we manage the options for them, they preserve some hedge risk, but get to learn how it works and how market changes impact participation rates and other factors in the formula. They can start doing it themselves a few years later."

But managing the options in-house or through a fiduciary intermediary like BEA is not for everybody. Although it can increase potential profit by a full 1 percentage point-from 4 or 5 percent to 5 or 6 percent-it inevitably leaves insurers with some residual risk. "This is a dangerous product to do out of your back pocket," Keyport's LeFevre warns. "You need to have the modeling in place and the systems for senior management. If you do it in-house, it requires having someone on board who understands what the risks are and how to manage them."

Here are profiles of three insurance companies and how they plan to hedge risks associated with EIAs.

Lincoln Benefit: Rolling Annual Options

Lincoln Benefit has chosen to offer a seven-year equity indexed annuity that gives customers 85 percent participation in the price return of the S&P 500, subject to a cap of 14 percent in the first year. Both the participation rate and cap can be reset annually. The company sold about $100 million of the contracts between its April launch and year-end, and expects to sell about $200 million this year. "We went to an annual-not full-term-rate guarantee since it's more like a standard single-premium defined annuity," explains Lincoln's Rich. "There was lots of resistance to it, but it's less risky for us, requires lower reserves and allows us to offer a higher participation rate."

The company is hedging the annuities itself by buying one-year OTC call spreads and rolling them upon expiration. The equity participation reset in later years, if any, will be based on the cost of rolling the hedge. One can, of course, look at it the other way: the participation reset protects Lincoln from rollover risk. Each call spread includes a 3 percent out-of-the-money long call and a 14 percent OTM short call that hedges the cap.

"We expect the cap to stay at 14 percent during the life of the contract," Rich adds, although in subsequent years, new contracts might offer caps ranging between 10 and 20 percent. The purpose of the cap is to increase the index participation rate. Without the cap, the participation rate would be cut to 60 percent.

Lincoln's goal is to keep the cost of the options down to 5 percent of the contract amount. (In January it was less than 4 percent). The rest will go into a corporate bond and mortgage portfolio with a seven-year average life that hedges the annuity's guarantee of 10.6 percent return of principal if held to maturity. CNA assesses a flat surrender charge of 8 percent. Holders who surrender early get back the 90 percent of premium plus 3 percent annual interest cash value required by law, whichever is higher.

CNA Insurance Co.: Buying Strings of Options

CNA plans to offer a contract that would allow investors three investment options: participate in the annual returns in the S&P 500 for five years, or receive a five-year interest-rate guarantee, or both. That's similar to split products offered in the variable-rate annuity market.

What they won't get is an annual reset of terms. "We hear from customers all the time that annual resets are based on a "trust me" mechanism they don't like," explains Ed Turner, chief actuary at CNA. Customers will thus get a full guarantee of the terms, as long as they hold the annuity to maturity.

The fixed-rate alternative, which will have an interest rate declared at issue and guaranteed for the full five-year term, will be hedged with a portfolio of zero coupon and current coupon corporate bonds.

The payout and hedging on the equity alternative is more complex. In the first year, investors will receive credit for the participation rate multiplied by the difference between the average level of the S&P 500 during the final 90 days of the contract year and the S&P's level on the issue date in the first year. In subsequent years they will receive credit for the difference between that year's 90-day final average to the 90-day final average of the preceding year. The point of the final-period averaging is to reduce customers' timing risk-and make the option less expensive for CNA. "It's a win-win situation," says Turner. To hedge its equity exposure, CNA plans to buy, at least initially, a series of five one-year calls and sell a series of five one-year OTC calls up front, thus eliminating roll risk.

Investors who stay in for the full term are promised an annual return no lower than zero percent and no greater than 12 percent. "Given the fixed dollars we're spending on the options, we could have a higher participation rate and a lower cap, or vice versa," explains Turner. Higher participations are easier to sell. History has shown, he adds, that in almost all years, customers would do better with a 75 percent participation rate and 12 percent cap than a 60­65 percent participation rate and 14 percent cap. But investors who surrender early get no such guarantee.

To hedge the interest-rate risk from early surrenders, CNA is taking an unusual tack: it is registering the contracts with the SEC, so it will make a market value adjustment on early surrender. If the SEC approves, CNA would charge early surrender customers a fee that is a function of interest rates and roughly emulates the loss on the underlying bonds. The company would also like to pass along the risk that it will lose money on the equity options if customers get out early, Turner says, but it hasn't yet figured out how to do so.

The market-value strategy, while a regulatory burden, protects the firm entirely from the interest rate risk on surrenders that haunts annuity providers; it also offers more advertising flexibility. Turner says interest-rate losses from early surrenders on fixed-income annuities can be as much as 15 percent, and the rate from EIAs could perhaps be even greater. "Depending on the options strategy, the annuity providers could get beat up both ways," Turner says. "If they bought five years of options up front and rates rose while the stock market fell, they could take a loss on the bonds and the options."

Even with the market value adjustment, CNA may be exposed to some significant cash flow problems associated with early withdrawals. "We have to estimate the cash flow needs from early surrenders, policy holder deaths, and exercise of a free 10 percent annual withdrawal option," explains Turner. "We haven't figured out how to immunize ourselves from that risk yet."

Keyport Life: Avoiding Liquidity Risk

Keyport Life offers two index products. One is a simple one-year contract with a 100 percent principal guarantee that pays 70 percent of the S&P 500 at year-end, subject to a 15 percent cap. The contract is simple to hedge, of course: Keyport just buys at-the-money European S&P 500 calls, and bonds.

The other product is a five-year uncapped contract that offers 85 percent participation in the index's return at contract termination, or at the highest anniversary level, whichever is greater. "Our market research indicated that people were afraid the market might crash on the day five years ahead when the layout was determined," says Jeffrey Lobo, an equity derivatives trader at CS Financial Products. Adds Lobo, who was hired by Keyport in November 1994 to run the hedges and build the necessary systems for this product, "we applied the high-water mark to remove the timing risk."

Although the simplest way to hedge high-water mark products is to buy five-year discrete look-back options from a derivatives dealer, Keyport didn't want to go that route. "There's a cost issue, although people are really hungry now on the Street so the costs aren't too high," notes Lobo. The bigger issue was the difficulty in predicting what policy holders will do. In an extreme bear market they might decide to surrender the policies. If Keyport had to unwind a discrete look-back option early, it might get a bad price. As a result, the company chose to hedge its exposure using relatively liquid, plain vanilla OTC European calls subject to competitive pricing from many dealers.

Keyport could also have chosen to manage the equity exposure itself with a listed call option. Since the guarantee on the policy is 104.33 percent and the participation rate is 85 percent, the market would have to go up about 5.1 percent the first year before the returns would exceed the company's guarantee to investors. Subsequent market rises could be hedged by buying more call options. Keyport decided against that strategy, Lobo explains, because the cost of the options would jump if implied volatility jumped, and Keyport's contract doesn't include a participation reset that allows it to lay off its rollover risk.

Instead, Keyport buys a portfolio of calls with maturities ranging from one to five years, and on each anniversary date, any calls left with time to maturity are rolled up to a new strike, if necessary. "By owning the longer-term options," says Lobo, "the amount that has to be repurchased in any year is just a fraction of the hedge," which reduces Keyport's roll-over risks. "We had a choice between roll risk and liquidity risk, and chose to take some roll risk."

What are equity-indexed annuities?

Equity-indexed annuities are a form of tax-advantaged retirement savings. Similar to an IRA or KEOGH plan, they do not carry a limit on annual contributions. In the United States, savers put up a lump sum for a stated period; taxes on any gains are deferred as long as the annuity is rolled over, and a tax penalty is assessed if the money is withdrawn before age 591/2.

Fixed-rate annuities, which dominate the market, typically promise a credited rate of say, seven percent for the first year, and reset the credited rate in later years to reflect the returns on the insurer's bond portfolio. State insurance regulators require that they guarantee principal plus a minimum annual credited return, usually three percent, even to customers who get out early. Federal law, meanwhile, requires those that expose the holder to full downside market risk be classified as securities funds and registered with the Securities and Exchange Commission. Thus, most variable-rate annuities-essentially equity mutual funds in tax-advantaged drag-are SEC-registered.

Equity-indexed annuities are a middle step, offering conservative savers the market's upward return, without risk of principal loss. "Equity-indexed annuities bridge the gap between fixed and variable-rate buyers-and we want to catch the jumpers," says Lincoln Benefit's Rich.

Like a convertible bond, they are conceptually made up of a zero coupon bond plus an equity index option, and perhaps a cap. An investor's participation in any upside can vary from 60 percent to 200 percent, depending on interest rates, equity market volatility, the level of the guaranteed return, and whether the participation formula is based on a European, Asian or look-back option, a single five-year option or a string of one-year options.