What Determines Pars, Caps, Etc.?

[jmarkk1]

What factors contribute to lower and higher caps?
Is it the market?
Inflation?


How does a company set these "limits?"

 

[JFBAgent]

THe insurance company invests in long term treasuries or other bonds. Then they keep a spread just like in an old-fashioned plain fixed annuity. The remainder of the interest is used to purchase an option on an index for a period of time. If movement in index is positive at the end of term, then option is called and the insurance company adds interest to the FIA contract.

With long term bond rates so low and the VIX so wild, the caps and par rates are low right now. These are the main 2 components that determine caps/par rates/etc.

 

[jmarkk1]

THe insurance company invests in long term treasuries or other bonds. Then they keep a spread just like in an old-fashioned plain fixed annuity. The remainder of the interest is used to purchase an option on an index for a period of time. If movement in index is positive at the end of term, then option is called and the insurance company adds interest to the FIA contract.

With long term bond rates so low and the VIX so wild, the caps and par rates are low right now. These are the main 2 components that determine caps/par rates/etc.

When looking back at "renewal rates" is 10 yrs. sufficient data?
(2002-2012)

It's true that all I'm seeing right now are low caps, etc., which may give client a bleak picture about going into contract with initially low caps. They may wonder..."2% per year is nothing"
But if I can give them a company's track record, it may help them see that there is strong possibiliy of "ups" from where they are at right now...which seems to be the bottom.

 

[iceco1d]

What factors contribute to lower and higher caps?
Is it the market?
Inflation?


How does a company set these "limits?"

When a client purchases a FIA contract, here is what the insurance company does with the funds:

Assume $100K deposit on a 6 year contract with a 1% GMIR, paying the agent a 5% commission.

The insurance company is going to take the MAJORITY of the $100K premium, and invest it in their general account (which is comprised of almost entirely investment grade bonds with a suitable duration to meet their expected liabilities). Lets assume for now the insurance company has a average return on their general account of 3.5% (this is going to vary by company).

So back to our example, on this contract the insurer needs to place about $82,000 of the premium into their general account at 3.5%, to be able to give this client their guaranteed minimum rate of 1% per year by the end of the surrender period (i.e. $82K @ 3.5% for 6 years approximately equals $106K). This is what GUARANTEES the client their money back, plus some interest.

The insurer, in this case, also needs to pay $5,000 to the writing agent. And let's say they would like to make 6% on this contract (1% per year for the contract), so take another $6,000 out for insurer profit. And let's assume another $500 for other costs (like sending statements, training agents on products, sales literature associated with the contract, etc.).

So with $93,500 accounted for, we have just one last task - credit indexed interest. So with the remaining $6,500, the insurer will purchase call options on an index. Length of the option, and on what index, depends on what crediting methods the client selects, but lets just do a simple example.

Note: A call option gives the OWNER of the option the RIGHT to purchase something at a particular price, anytime before the expiration date of the option (American style options...European style options can only be excercised at expiration). Index call options are settled in cash, rather than in securities.

Suppose the client wants all of their indexed interest based on the S&P 500. The insurer buys index call options on the S&P. Suppose this happens today with the S&P at 1405. One year from now, one of 3 things can happen...

1: S&P goes UP. If the S&P closes at say, 1500, the insurer will have a hefty profit on their option and will exercise it, and use those profits to give the client their indexed interest.

2: S&P stays the SAME. If this happens, the option will expire worthless, and the client will get zero indexed interest.

3: S&P goes DOWN. Again, if this happens, the option will expire worthless, and the client will get zero indexed interest.

Keep in mind, in reality the insurer would not put all $6,500 towards options in year 1, because if scenario 1 or 2 occur, the insurer wouldn't have any funds available in future years to buy options (as all $6,500 would be worth zero). So they will purchase varying amounts of options, of varying expiration dates, depending on the length of the contract, and the type of crediting method(s) selected.

Note: You can use the Black & Scholes options model (using Delta, Vega, Theta, Rho, and Gamma) to see how options prices will change as the underlying value of the index would change (Delta), changes in interest rates (Gamma), etc. This is a whole other discussion, but thought I would mention in case you care to dig into it deeper. Back to our example...

So you can see, EVERYTHING in the FIA contract is guaranteed. The $82K @ 3.5% assures the client their GMSV at the end of the 6 years. The agent commission and insurer profit are built in. And you can see what generates indexed interest.

So we can now back into your answer, and say that the OVERWHELMING factor in determining caps, spreads, participation rates, etc. is INTEREST RATES.

Consider this: If the insurer was getting 5.5% in their general account, they would only need to put $73,000 in there to get the $106,000 GMSV after 6 years. Do you think they would increase agent commissions because of interest rates? Unlikely (and if so, it would be minimal). Will they just line their coffers with the extra $9,000? Maybe a little bit. But remember, a FIA needs to be competitive with other fixed products or else people won't buy them. So the insurer would take all of that extra $9K and buy more call options (well, they may put a little bit of it in the general account and offer a higher GMIR, like 2%, but I doubt it at this point).

So back to our example...if companies can offer 3.5% 1 year point-to-point caps with $6,500 to buy call options with, how high could caps go with $15,500? Probably 9% - 12%. So that is the BIGGEST factor in determining caps.

A much smaller piece is going to be how the options perform (which would be based on the stock market they are derived from). If the insurer made a HUGE profit, they would likely plow at least some of that profit back to policyholders in the form of higher caps for future years, in order to keep clients happy (i.e. if the market goes up 89%, and clients only get 3.5%, there WILL be money in motion, and most insurers would recognize that). Profit potential in call options is INFINTE, but the magnitude of the market movement required to significantly change FIA caps on existing contracts is highly unlikely.
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THe insurance company invests in long term treasuries or other bonds. Then they keep a spread just like in an old-fashioned plain fixed annuity. The remainder of the interest is used to purchase an option on an index for a period of time. If movement in index is positive at the end of term, then option is called and the insurance company adds interest to the FIA contract.

With long term bond rates so low and the VIX so wild, the caps and par rates are low right now. These are the main 2 components that determine caps/par rates/etc.

Two things to note:

#1: The insurer is long the call options, it cannot be "called." The insurer can choose to exercise their option. Whoever is short that contract can have the option "called." Probably semantics, but technically a drastic difference.

#2: The VIX is actually near 5 year lows right now. Low implied volatility actually makes options LESS expensive, which would mean HIGHER caps (insurer can buy more option contracts given the same amount of money). This point about the VIX though, really drives home how little "the market" matters when it comes to setting cap rates, and how overwhelming of a factor interest rates are. Volatility is super low right now, and caps are still near rock bottom (due to interest rates).

 

[jmarkk1]

When a client purchases a FIA contract, here is what the insurance company does with the funds:

Assume $100K deposit on a 6 year contract with a 1% GMIR, paying the agent a 5% commission.

The insurance company is going to take the MAJORITY of the $100K premium, and invest it in their general account (which is comprised of almost entirely investment grade bonds with a suitable duration to meet their expected liabilities). Lets assume for now the insurance company has a average return on their general account of 3.5% (this is going to vary by company).

So back to our example, on this contract the insurer needs to place about $82,000 of the premium into their general account at 3.5%, to be able to give this client their guaranteed minimum rate of 1% per year by the end of the surrender period (i.e. $82K @ 3.5% for 6 years approximately equals $106K). This is what GUARANTEES the client their money back, plus some interest.

The insurer, in this case, also needs to pay $5,000 to the writing agent. And let's say they would like to make 6% on this contract (1% per year for the contract), so take another $6,000 out for insurer profit. And let's assume another $500 for other costs (like sending statements, training agents on products, sales literature associated with the contract, etc.).

So with $93,500 accounted for, we have just one last task - credit indexed interest. So with the remaining $6,500, the insurer will purchase call options on an index. Length of the option, and on what index, depends on what crediting methods the client selects, but lets just do a simple example.

Note: A call option gives the OWNER of the option the RIGHT to purchase something at a particular price, anytime before the expiration date of the option (American style options...European style options can only be excercised at expiration). Index call options are settled in cash, rather than in securities.

Suppose the client wants all of their indexed interest based on the S&P 500. The insurer buys index call options on the S&P. Suppose this happens today with the S&P at 1405. One year from now, one of 3 things can happen...

1: S&P goes UP. If the S&P closes at say, 1500, the insurer will have a hefty profit on their option and will exercise it, and use those profits to give the client their indexed interest.

2: S&P stays the SAME. If this happens, the option will expire worthless, and the client will get zero indexed interest.

3: S&P goes DOWN. Again, if this happens, the option will expire worthless, and the client will get zero indexed interest.

Keep in mind, in reality the insurer would not put all $6,500 towards options in year 1, because if scenario 1 or 2 occur, the insurer wouldn't have any funds available in future years to buy options (as all $6,500 would be worth zero). So they will purchase varying amounts of options, of varying expiration dates, depending on the length of the contract, and the type of crediting method(s) selected.

Note: You can use the Black & Scholes options model (using Delta, Vega, Theta, Rho, and Gamma) to see how options prices will change as the underlying value of the index would change (Delta), changes in interest rates (Gamma), etc. This is a whole other discussion, but thought I would mention in case you care to dig into it deeper. Back to our example...

So you can see, EVERYTHING in the FIA contract is guaranteed. The $82K @ 3.5% assures the client their GMSV at the end of the 6 years. The agent commission and insurer profit are built in. And you can see what generates indexed interest.

So we can now back into your answer, and say that the OVERWHELMING factor in determining caps, spreads, participation rates, etc. is INTEREST RATES.

Consider this: If the insurer was getting 5.5% in their general account, they would only need to put $73,000 in there to get the $106,000 GMSV after 6 years. Do you think they would increase agent commissions because of interest rates? Unlikely (and if so, it would be minimal). Will they just line their coffers with the extra $9,000? Maybe a little bit. But remember, a FIA needs to be competitive with other fixed products or else people won't buy them. So the insurer would take all of that extra $9K and buy more call options (well, they may put a little bit of it in the general account and offer a higher GMIR, like 2%, but I doubt it at this point).

So back to our example...if companies can offer 3.5% 1 year point-to-point caps with $6,500 to buy call options with, how high could caps go with $15,500? Probably 9% - 12%. So that is the BIGGEST factor in determining caps.

A much smaller piece is going to be how the options perform (which would be based on the stock market they are derived from). If the insurer made a HUGE profit, they would likely plow at least some of that profit back to policyholders in the form of higher caps for future years, in order to keep clients happy (i.e. if the market goes up 89%, and clients only get 3.5%, there WILL be money in motion, and most insurers would recognize that). Profit potential in call options is INFINTE, but the magnitude of the market movement required to significantly change FIA caps on existing contracts is highly unlikely.
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Two things to note:

#1: The insurer is long the call options, it cannot be "called." The insurer can choose to exercise their option. Whoever is short that contract can have the option "called." Probably semantics, but technically a drastic difference.

#2: The VIX is actually near 5 year lows right now. Low implied volatility actually makes options LESS expensive, which would mean HIGHER caps (insurer can buy more option contracts given the same amount of money). This point about the VIX though, really drives home how little "the market" matters when it comes to setting cap rates, and how overwhelming of a factor interest rates are. Volatility is super low right now, and caps are still near rock bottom (due to interest rates).

Thanks for the information!

 

[JFBAgent]

Two things to note:

#1: The insurer is long the call options, it cannot be "called." The insurer can choose to exercise their option. Whoever is short that contract can have the option "called." Probably semantics, but technically a drastic difference.

#2: The VIX is actually near 5 year lows right now. Low implied volatility actually makes options LESS expensive, which would mean HIGHER caps (insurer can buy more option contracts given the same amount of money). This point about the VIX though, really drives home how little "the market" matters when it comes to setting cap rates, and how overwhelming of a factor interest rates are. Volatility is super low right now, and caps are still near rock bottom (due to interest rates).

Ah...semantics...the wealthiest man I know (who never graduated 9th grade) said you can understand banking terminology or you can understand money.

This is how FIAs have been explained to me by a President and CFO of a major carrier. The product was conceived and spent its early years in a lower volatility than today. Volatility has been something over last 5 years...kinda coincides with a significant change in product, doesn't it?

 

[iceco1d]

Semantics or not, your comment wasn't completely correct. I meant no offense.