Bears &Bulls In Sheep Clothing   1/03  
It seems the Wall Street stock shops are trying to be spread the message that they’re no longer in that nasty old investment business where there’s risk and you can lose money. No, No, No. Instead, the investment firms are saying what they are all about is preservation of principal. It’s not the old story of reducing risk by portfolio diversification or asset allocation. It’s a new tale of special products with principal protection attributes. What are some of these new products?

Principal protection funds and equity-linked notes use a split-investment concept that has been around a long time. The concept involves buying zero coupon bonds that mature in 5 to 10 years with an ending value equal to the original principal, and any money that isn’t needed for bonds is used to buy stocks. You could do this yourself, but Wall Street puts it all together in a nice pretty package and charges additional management fees plus typically a front end load or deferred sales charge. If you hold the fund to maturity you get back your money plus any gains from the stocks.

These principal protection funds are traded, so you can sell them before they mature and get the market value of the bonds and stocks on the day you sell, which could be more or less than you paid. And, unless the fund is inside a qualified retirement account it will create phantom taxable income from the bonds and possible taxable dividend or capital gains income from the stocks.

And there’s equity linked certificates being sold that say they’ll give you at least a minimum return if you hold them to maturity, but will let you participate in the upward equity movement. What they do is calculate monthly or quarterly index gains – up to a cap, and subtract monthly or quarterly index losses – without a cap. The problem is that “no cap on downside” bit. For example, let’s say you had a cap wherein the most you’d gain in any month is 4%. The marketing spin on this is you could make up to 48% a year. The reality is a little different. Say the market increased 10% a month for five months. The market would be up 50%. The certificate would be up 20%, that’s 4% a month cap times 5 months. But what happens if the index drops 20% in month six? Even though over that six month period the index rose 50% and then fell 20% so that its still up 30% from 6 months before, the 20% loss wipes out the 20% capped gain so the certificate gain is back to zero

And also from Wall Street there are market index trusts that sort of work like term end point designed index annuities and variable annuities with Guaranteed Return Options, that can work well to poorly depending on how they’re structured.

But all of this talk from Wall Street on how they’re now concerned about safety makes me wonder if they aren’t really trying to fit the bull and the bear into sheep’s clothing and become something they’re not. Wall Street does a great job of providing tools to maximize growth and one associates the stock market with the potential for gain, but with this potential for gain comes the risk of loss. Wall Street offers ways to try to avoid risk, to minimize risk and to manage risk, but they’ve never been in the business of transferring risk. Transferring the risk of loss is the job of another industry.

An insurance company annuity is a tool that transfers the risk of market loss away from the consumer by protecting principal and offering the potential for higher returns. The principal protection offered by a fixed annuity is exceeded only by government insured accounts.

It’s possible that the nadir of the bear market was reached on 9 October and we are finally in the beginning of the next bull market. If that was the bottom, the typical equity mutual fund owner lost 40% to 70% of their assets over the last two and a half years. But not only Wall Street investors have been mauled. A retired individual trying to supplement retirement income with bank instruments has seen their CD interest income drop 73% in the same time frame.

During this period a fixed index annuity owner has not lost a dime of principal in the worst stock market period since the Great Depression and the fixed rate annuity owner is earning typically double the interest currently paid by the bank and neither are worrying about the safety of their money.

There is a safe money place that protects principal and offers the potential for higher returns. That safe money place is an annuity.

2002 Annual Change In Index Value (Measured from 12/31/01 to 12/31/02)   1/03 

2003 – Financial Counselors Will Have To Work Harder   1/03  
Last January I said 2002 would be the most profitable sales environment the insurance industry had seen in years. Short term interest rates had plummeted while long term rates had only begun their decline translating into low CD rates and very competitive fixed annuity rates. Another bearish year was pushing people out of variable annuities and into fixed index annuities. And Congress had given us higher retirement and education plan contribution limits and greater flexibility in how they were used. The environment produced a record year for fixed rate annuity sales, and fixed index annuity sales nearly doubled. I hope everyone enjoyed 2002 because the environment in 2003 will be tougher.

Total fixed annuity sales will decline in 2003, although the index annuity segment will grow. The reason for the overall decline is the broad yield advantage enjoyed by fixed rate annuities over CDs a year ago is much narrower, and will get narrower still if interest rates turn up. The reason why CDs will become comparably more attractive is because short term rates drive certificate of deposit yields and they rise faster than the long term rates that support fixed annuity rates.

Index annuity sales will grow because potential higher returns with protection of principal will be more attractive than actual low yields, bringing aboard consumers that might have instead bought a fixed rate annuity; exchanges from variable annuities into index annuities will keep the pace; and index annuities, both fixed and registered, will grab a bigger toehold in the broker/dealer and bank distribution channels.

There will be pressure to lower both minimum guarantees and commissions on fixed annuities. Insurers receive a yield from their investments, and use this yield to pay expenses and interest on their annuities. A perceived long-term low yield environment will pressure insurers to cut minimum guarantees or expenses or both; commissions are an expense. A low interest climate could also drive more insurers to index annuities where lower guaranteed returns are already the norm.

This isn’t a gloom and doom scenario. Both fixed rate and fixed index annuities will still have an attractive story to tell, it just won’t be the slam dunk of 2002 where all you had to mention was the rate and hand over a pen. And this doesn’t mean a company’s or agent’s sales can’t go up, it just means one person’s growth will come out of another one’s market share. Overall, it will be a decent year. But if you’re looking for last year’s environment to repeat you may have to wait until 2009 or so.

Fixed Annuity Safety   1/03   
Last November I said I could find no evidence that any annuity customer ever received back less than 100 cents on the dollar because of the failure of the insurance company. I offered to pay for documentation showing annuity owners losing principal due to the annuity carrier failing because I couldn’t find anyone that had lost principal if they stayed put awhile. I researched this question because I’ve heard unsupported claims for years that annuity owners lost principal due to a carrier failing and I personally wanted to see if there was any truth out there.

In a world of opinion, conjecture and unsupported claims, here is a truth I can state so far:

The Advantage Group can find no evidence that any fixed annuity customer that stayed
the course throughout the regulatory relief process of any busted carrier ultimately got back less than all of their principal.
**Note: Based on further research we have found four carriers whereby certain annuity customers lost principal.  http://www.indexannuity.org/ic2004b.htm#safety

This doesn’t mean people didn’t get hurt when a carrier went bust. The case most often cited as an example of fixed annuity holders getting back less is Executive Life. After going through more court briefs and decade old reports than anyone would want to, I can say that people that surrendered their annuities when Aurora National Life Assurance Company took over Executive Life’s business did take a hit to principal – those opting out of the reorganization process were only promised 56% of their account value, and even annuity owners staying with the new carrier did not receive 100% of their accumulated account value. However, I cannot find evidence that would support a statement saying that fixed annuity owners ultimately got back less than 100% of their original principal.

I don’t dispute that a “reorganized” carrier will almost certainly credit less interest (probably at contract minimums), and in an extreme case might retroactively recalculate interest downward, and surrender charges could impact values for years. A company failure is an ugly thing. But waiting to get all of your own money back is a far cry from losing your own money.

I’m not trying to prove that no annuity owner has ever lost money because a carrier failed. My contention is that fixed annuities have very low principal risk and this point would still be valid even if two or three or a dozen carriers had gone under and not paid back one hundred cents on the dollar. The fact that I can’t even find one solid example of loss simply means that instances of principal-impaired fixed annuity owners must be extremely rare, and supports the position that fixed annuities are the safe money place.

Low Interest Rates Force Changes    2/03
As interest rates stay at the lowest levels in over 40 years, fixed annuities are being squeezed. Bonds are the primary investment in an insurer’s portfolio, and as yields drop the money available to pay operating expenses, agent commissions and at least a minimum guaranteed return to the consumer, isn’t there. Something has to give. Insurers are reducing costs, cutting commissions, pulling unprofitable products, or a combination of these actions to try to cope.

At the end of January The Advantage Group asked index annuity carriers if the current rate environment had forced them to cut at least some product commissions, raise minimum premiums to improve the cost effectiveness of small purchases, or pulled any products off the market. Affirmative responses to these questions are listed.

I also asked whether the carriers had filed any index annuities with lower minimum interest rates. Midland National and National Western have introduced index annuities with 1.5% minimum rates to the field.

Half of the carriers have had product reactions to the current environment. Some carriers are developing index annuities with new crediting methods that react more favorably to low rates and high market volatility, some talk about shifting to a registered chassis to avoid minimum guarantee concerns, all are closely watching the situation.

Humble Pleas To Carriers    2/03
I’m not that smart, so I like to keep things simple so I can understand them. One of the areas I like to understand is how index annuity crediting terms are used.

For example, I’ve seen product materials or ads saying that an index annuity crediting method’s rate or cap or spread is “guaranteed for the life of the contract”. When I read that my initial assumption is that there are no moving parts, period. And I continue to believe this if I can’t find any reference to any other crediting parts that do move. However, what I often discover after a lot of digging is that while one part of the crediting structure is locked up, there are other parts free to move, and the carrier can basically do what they want by fiddling with the movable parts down the road. It sounds like everything is tied down, but it’s not.

Or if your annuity has a participation rate that won’t change for the life of the contract, but it has a spread that can change each year and go as high as 7%, then the box would say “participation rate - guaranteed for life of contract, yield spread – resets annually, 7% maximum”. This would make it a lot easier for me to compare different annuities because there’s a difference between an annuity that has no moving parts and one that does.

Another element of crediting that seems simple, but can be confusing is a cap. Some of the first index annuities put a limit, or cap, on the maximum interest you could earn. These insurers would say you could earn, maybe, 60% of what the index did, but the maximum interest you could earn would be 12%. A little later on, other carriers began to use caps that limited the index gain you could participate in. These carriers might say that you get 60% of what the index does up to a maximum of 12% of index movement. The two methods sounds similar, but they’re not.

The interest cap method applies the rate to the index gain and says it won’t recognize more than a certain amount of interest. If the index went up 10% the interest cap method would credit 6%, if the index went up 12% the interest cap method would credit 7.2%, if the index went up 20% the interest cap method would credit 12%, but any calculated interest gain over 12% is ignored.

Either method is fine, because caps based on index movement tend to be higher than caps based on interest, but you need to know which method you’re dealing with. If you think you’ve got a cap on maximum interest, but instead it’s a cap on maximum index gain, you may be surprised. So my second plea is for caps to be labeled interest caps if the cap reflects the maximum interest that will be credited, or index caps if the cap reflects the maximum index movement that will be counted.

I appreciate your listening to me and hope you like the ideas. After all, life is complicated enough.

Consumer Assumptions    2/03
In 1999 Fortune reported on the results of a consumer survey. The survey found more than three out of four consumers assumed they could consistently beat returns of the S&P 500 on their own, even though four out of five mutual fund managers hadn’t beat the index in previous years. Three out of four retirees assumed bond returns had bested stock returns in the preceding two decades, even though the retirees were then experiencing the culmination of the greatest bull market in history. And of course, the average return consumers expected to earn from their investments was 15% to 19% a year forever.

In 1999 many consumer assumptions about investment realities were incorrect. What are consumers assuming today?

Judging by media voices and consumer investment patterns, the assumptions seem to be that we’re in for a long flat stock market, that bonds are the place to be, and protection of principal is more important than returns. Since perception is reality, what do these assumptions mean for index annuities?

Ever since Warren Buffet said in a December 2001 interview that stock market returns would average 7% for the next decade or two, an increasing chorus of voices is predicting a crablike sideways market. The bond bulls are saying this means one should buy bonds instead of stocks. The mutual fund managers are saying this means selecting the right individual stocks is the key in a flat market. Both groups say that broad market indexes aren’t the place to be because index returns will be below historic averages. This would seem to indicate that equity index annuities would be less attractive, but this assumption misses a key point.

Media wags suggesting a sideways stock market don’t mean that stocks stay put and don’t move up or down, and Mr. Buffet didn’t mean that the market would increase an automatic 7% each year. Both parties see years ahead of market increases and decreases, but with the overall result of more modest returns. In this environment index annuities using annual reset interest crediting would participate in the years of index increases and treat years of decreases as zero returns, while safeguarding previously credited interest.

An index increasing 15% in the first year, going down 5% the second, increasing 25% the third, and dropping 4% the fourth, would have an annualized return of 7%. But an annual reset index annuity would only see the 15% and 25% increases, and participate in just those gains, ignoring the losses. Some index annuities could do very well in a sideways market.

As stocks sank over the last three years bonds definitely were the place to be, producing strong single digit returns, because falling yields make existing higher yielding bonds worth more, and interest rates fell dramatically. However, today’s interest rates don’t have much further to fall. At best, rates will remain stable, providing some stability of bond values with very low yields. At worst, interest rates will do what they have done in most economic recoveries and begin to increase, resulting in falling bond values.

I am a great believer that small investors as a group are always wrong. In 1999 and early 2000, just before the bear market, net inflows into equity mutual funds were at all-time highs. In 2002 $27 billion of net new cash flowed out of equity mutual funds, while at the same time a record $124 billion of net new cash flowed into taxable bond mutual funds.⁽¹⁾ When you consider that roughly 70% of these investors aren’t aware that the value of a bond goes down when interest rates go up,⁽²⁾ it is possible that the small investor, by dumping equities and buying bonds, is once again wrong about the future direction of the market. Since index annuities don’t lose value when yields rise, and in fact are able to offer higher index participation as interest rates go up, perhaps the index annuity offers small investors a chance to be right for a change.

A final assumption is protection of principal may be at least as important as returns. After the events of the last three years I wouldn’t debate a belief that safety of principal should play an important part in investment decisions. But where do you go for this safety? Bank instruments are very safe, but yields are in the 1% to 3% range. Fixed rate annuities are very safe, but yields are also low. Fixed index annuities offer the same protection of principal as fixed rate annuities, but also provide the potential for higher yields with zero participation in index losses.

Many consumer assumptions were wrong in 1999 and they paid the price. Time will tell if consumer assumptions in 2003 are correct. Index annuities offer consumers protection of principal and credited interest from market loss, and potential interest earnings linked to index gains. Even if future reality differs from today’s assumptions, index annuities allow consumers to be wrong and still be rewarded.

1. Mutual Fund Facts & Figures, Investment Company Institute, 1/30/03 www.ici.org

2. 2002 Vanguard/Money Investor Literacy Test, 9/25/02 www.vanguard.com

Index Annuity Training & Suitability    2/03
When index annuities were introduced, a handful of carriers required agents to take specific training and testing before they were permitted to sell the products. A recent survey conducted by The Advantage Group found that the only carriers that still require index annuity training and testing before the agent sells their index annuities are Farmers New World and Jackson National Life (JNL waives this testing if the agent is securities registered).

Many carriers do offer some type of training. This training might take the form of product manuals for the agent, infrequent local continuing education courses, web based education, and/or teleconferences. Many carriers rely on the marketing companies or agencies through which the agents are contracted to provide training. None of this training is mandatory, although a few carriers require agents to sign-off stating the agent has read and understands the product.

Existing laws do not require insurers to provide licensed agents additional training on annuities. The last draft I read of the NAIC Suitability Model Regulation was rather vague on the issue of training. The closest it got was the section stating, “An insurer shall adopt and effectuate guidelines and procedures reasonably designed to assure that the insurer or its insurance producers make suitable recommendations”. However, it also says that an insurer’s compliance with the guidelines include, “Training programs or materials that include information regarding analysis of consumer insurable needs and financial objectives.”

One way to deal with the issue of training is to try to avoid it, by maintaining a stance that the insurance carrier is only a product manufacturer and need only require evidence that clear and complete disclosure has been provided as evidence of suitability, and this could be in the form of a customer signed disclosure agreement. In fact, the model regulation says that the carrier may contract with a third party (agency, brokerage, etc.) to ascertain whether agent practices are in compliance with suitability guidelines, and the carrier’s responsibility is merely to audit the third party and assure they are performing their duties.

Whether or not training will be specifically required by any suitability regulations adopted by NAIC is unknown, but a strong case can be made that product training should be mandatory if only because a trained agent is likely to be more successful at identifying consumers needing the solutions provided by the insurer, thus increasing sales, and a trained agent is less likely to inappropriately sell the product, thus getting the insurer sued. The problem with mandatory training is no one wants to be first because agents will follow the easier path to the company that doesn’t require it. Therefore, training should initially be encouraged rather than demanded.

Insurers can raise the bar by encouraging agents to demonstrate they understand how and where the carrier’s products work. One carrier uses voluntary educational programs that reward the agent for ongoing learning. Carrier rewards could be extra “points” earned to qualify for a company conference, an educational allowance, or a special service “hot line” for educated agents. This training would then be documented and could be used as evidence that the insurer takes the issue of suitability seriously. After training programs are the industry norm, training would go from voluntary to required, and all carriers will gain the competitive advantage better trained agents.

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Record Index Annuity Sales In 2002   3/03   
Fourth quarter sales set a new record, but barely, posting a 3% increase over the previous quarter. Sales were up 68% when compared with fourth quarter 2001 sales. The year closed out at $11.7 billion, an 80% increase over the previous year. The top selling index carriers were:

If you include both fixed and registered index annuity sales, 2002 totals equaled the total cumulative index annuity sales from product inception in 1995 through calendar year 1999.

The record sales occurred as the number of players grew smaller. AmeriBest, Glenbrook, Great American Life, Northern Life, ReliaStar and SunAmerica left the index annuity market. The only new entrant was Investors Insurance Corporation. More carriers have entered and left the market than remain. There are now 30 carriers offering index annuities.

Insurance agents continue to represent 19 out of every 20 index annuities sold. With the exception of the ING Smart Design registered index annuity, banks and broker/dealers continue to avoid the market.

Products with surrender periods of ten years or longer account for 87% of sales. Index annuities with agent commissions of 9% or more represent 85% of index sales. The weighted commission based on index annuity premium paid fell from 10.44% in the third quarter to 9.96% in the fourth. The average index annuity sales premium reported was $36,384; average premium ranged from $16,958 to $50,197. The average fixed annuity premium was $37,761; average premium ranged from $10,273 to $62,787. The average index sales premium was slightly lower than the previous quarter.

Index Life
Index life sales neared the 100 million mark with first year annualized premium totals of $95.7 million.

Bankers Life of New York, a member of the AmerUs Group, has just introduced the first equity index life product approved in New York. It will be interesting to see how overall index life sales are affected.

Pharaoh Finance  3/03
The book of Genesis reports that at 7:00 a.m. on a Tuesday morning in 5000 B.C., or thereabouts, the Pharaoh of Egypt awoke with a puzzling dream and asked a young economist named Joseph to tell him what it meant. The Pharaoh said he dreamt he was catching some rays on the banks of the Nile, when out of the surf seven fat cows waddled ashore and began grazing. And these fat cows were then followed by seven gaunt cows, which proceeded to eat the fat cows, but still remained as thin as before.

In 1992 a financial recovery began that lasted roughly seven years, and brought the stock market and economy to new heights. We have since witnessed the third down year of the stock market and a strong economic recovery is still not in sight. Now, I’m not saying that we’ve got four more years before the recovery begins and the stock market takes off. But the point of this is many of your clients are projecting today’s economic realities into an unending future of gloom and not realizing this is just another economic cycle. Index annuities can be used to help ease your clients back into reality.

Disclosure  3/03
Many years ago I worked for an investment banking firm. Shortly after I joined the firm I was invited to participate in a meeting where our finance people and attorneys were all sitting at a table trying to figure out the proper risk disclosure language for the prospectus of a new offering the firm was trying to underwrite. The product offering was fat in fees and the company would make a lot of money. The problem was that unless a very precise set of unlikely economic circumstances came to pass, the investors would probably lose their money.

There was a lot of banter back and forth about the proper tone the disclosure language should take, so that the firm would be protected and there would still be some sizzle on the marketing steak, but it was tough to strike the balance. Finally, they asked for my opinion. I said we should state in bold letters that “investors in this offering will probably lose their investment, but they might not”. My suggestion was not adopted and I never got invited back to another meeting.

My position has always been that consumers are fully responsible for the consequences of what they are buying as long as the risks are disclosed. I further believe consumers will still buy a product even after all the risks are disclosed if the product fits their needs or desires. An index annuity provides protection of principal and credited interest from market risk. An index annuity also provides a shot at making more than the guaranteed minimum rate of interest. Okay, what are the risks that should be disclosed?

§ Stock Market can be flat or go down for a prolonged period so only minimum interest is earned

§ Unforeseen Political and economic developments negatively affect the value of stocks in the index and thereby lower the value of the index so only minimum interest is earned

§ Interest Rate environment can be so low index annuity participation stinks

§ Option Prices can be so high index annuity participation stinks

§ Economics are fine, but management decides to increase company profits by cutting renewal rates

§ Economics are fine, but carrier pricing people did not hedge index annuity properly so renewal rates stay at guaranteed minimum for years

§ Insurance Company can go out of business and you don’t even get the minimum interest

§This List doesn’t cover everything and something else goes wrong

Another disclosure is often needed when the topic of minimum interest is raised. With two product exceptions, minimum interest is usually not credited until the end of the surrender period, and is only credited if index-linked interest is insufficient. Furthermore, many policies base the crediting on less than 100% of the premium meaning that actual interest paid is less than the apparent interest rate.

If you don’t provide full disclosure you risk an unhappy annuity buyer that doesn’t understand why zero interest was credited in contract year 4, and why the table in the policy shows an effective minimum interest rate of 1.92% a year instead of 3.00%. One way to provide full disclosure is to talk about minimum return and not minimum interest. It’d be something along the lines of “Although the minimum interest isn’t credited each year, you will receive a minimum return of at least 20.95% at the end of ten years” or whatever the minimum return is.

Different index annuity crediting methods require accurate disclosures of risks. Averaging needs to be presented as “driving values to the middle” instead of “smoothes out the low points”. Caps need to be explained as the maximum that can be earned instead of the probable return. A rate highlighted as “guaranteed for the term” doesn’t mean “but we can change the spread or each year”.

A good index annuity protects principal and credited interest from market risk while providing the potential for a higher interest rate than might be earned on other savings vehicles. An index annuity is not perfect, but even with all the risks disclosed it is an excellent financial tool. If full disclosure is made and the consumer doesn’t choose an index annuity, it probably didn’t meet their needs or desires and they should not buy it.

How To Eliminate Income Taxes   3/03
Oliver Wendell Holmes once remarked, “Taxes are the price we pay for a civilized society”. Personally, I wouldn’t mind being a little less civilized and a little richer, so I propose the government implement the following proposal that will bring in so much money the government will be able to eliminate personal income taxes for all time. That proposal is the introduction of new one dollar coins.

Now, I know what you’re thinking. We tried getting folks excited about dollar coins a quarter century ago and nobody used them. A couple of years ago we tried it again by plating them with copper to make them look golden, and few people used them – even though they got Wal-Mart involved in the product launch. The only good thing that came out of all of this is America now has so many dollar coins sitting around in underground storage facilities that the nation is firmly anchored and won’t float away if global warming causes the oceans to rise.

The zinc coins showed a profile of Susan B. Anthony. Unfortunately, this was the ugliest woman who ever lived. The reason they used a profile is because every time they tried to capture a front shot of the lady the camera lens shattered. I realize that our nation owes a lot to Ms. Anthony’s early fight for equal rights and I proudly salute her achievements, but trying to get people to use a coin with her mug on it is like having Robert Earl Hughes (also known as the world’s fattest man) as a spokesperson for a diet program.

Since the mint didn’t have a portrait of Lewis and Clark’s guide Sacagawea for the copper coin, they drew an imaginary etching of a somewhat ethnic looking woman with intelligent and attractive features. However, there were a couple problems with the design. The first is it’s an over the shoulder shot of the head and you can’t see any curves. The second is she’s carrying a kid. I’ve watched enough episodes of the show Blind Date to know that you don’t bring out the kid until the third date at the earliest, or else the guy is gone. The dollar coin idea has two strikes against it, here’s the idea to make the next pitch a homer.

Use foxy chicks as coin models. Show a knockout doll from the waist up wearing a bikini top. I guarantee guys will use the coins. In fact, many guys won’t even spend them. They’ll keep the coins displayed in their room. If the guys don’t spend them the government makes money because it only costs the mint 12 cents to stamp out the coin. Every chick coin that’s taken out of circulation makes the government 88 cents in pure profit. Before long, the profits from collected chick coins will offset the revenue needed from income taxes, allowing the IRS to be disbanded.

And why stop there. The mint has been successfully producing quarters representing the fifty states. Just think of the revenue that could be produced if the same concept was used with state dolls. What red blooded University of Iowa fraternity guy wouldn’t be driven to collect dollar coins representing girls of the Big 10. What young Princetonion wouldn’t covet coins featuring Miss New Jersey, Miss Connecticut, Miss Rhode Island and the remaining states with Ivy League schools.

And we needn’t forget the ladies. The same concept could be followed by the state hunk series showing bare-chested males from the fifty states and Puerto Rico. If a more historic theme is desired, the “Pecs of the Founding Fathers” series could be arranged. George Washington may not have been much of a babe magnet when he was president, but I think I remember reading a long lost letter, when our first president was much younger, written to Martha Washington from Abigail Adams stating “Martha, methinks that George of yours is a real stud”.

This centerfold coin concept is such a winner that the national debt should be totally erased within five years at the latest, and personal income taxes will become a footnote in history books. I haven’t patented this idea; the government is free to use it at no charge. All I ask is when I am presented with the Nobel Prize for Economics that they keep all audience cell phones on vibrate.

Jack Marrion spends his days hiding from the local NOW chapter and ducking offers of free sensitivity training

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NAIC Senior Suitability Models 4/03
A pair of NAIC drafts from 20 February attempt to address suitability concerns regarding sales to older consumers. The purpose of the Senior Protection In Annuity Transaction Model Act is “to promote sales practices in the life insurance industry that result in recommendations to consumers aged sixty-five years or older on transactions involving annuity products that meet the insurance needs and financial objectives of senior consumers.” The proposal says that if a producer is found guilty of flagrantly disregarding the act, or if a producer’s business practices frequently violate the act, that the insurance commissioner may require the producer to cease and desist from engaging in violations, pay fines of up to $5,000 for each violation, and have their insurance license revoked or suspended.

Defining suitable sales practices is the province of the Senior Protection In Annuity Transaction Model Regulation that aims to “set forth minimum standards and procedures for insurers and insurance producers who make recommendations to insurance consumers aged sixty-five years or older on transactions involving annuity products so that the insurance needs and financial objectives of senior consumers are appropriately addressed.” The model regulation applies to recommendations resulting in a transaction involving a consumer aged sixty-five years or older on the sale, surrender or other disposition of an annuity, and to recommendations of a series of insurance transactions, where at least one of the transactions recommended results in the sale, surrender or other disposition of an annuity.

The model regulation says that the insurance company and producer shall make every effort to obtain relevant information from the senior consumer and make recommendations only when transactions are appropriate to assist the senior consumer in meeting their insurance needs and financial objectives. The definition of relevant customer information includes similar data collection also required by security regulations like job status, age, income, ability to pay, amount and composition of net worth, investment experience and time horizon, but the insurance suitability regulation also asks the insurer and producer to assess the need for tax advantages, the consumer’s concern for preservation of principle and the consumer’s awareness of liquidity limitations or surrender charges.

The proposal says that consequences for violations of the act may be eliminated if the insurer operates a suitable compliance program and takes action to resolve any violation when they become aware. Producers may avoid consequences if they follow the insurer’s compliance procedures and correct any accidental violations as soon as become aware of their oops.

Absent from the Senior Protection Model is the friendlier specific language used in section 5(F) of the previously proposed Life Insurance And Annuities Suitability Model Regulation whereby an insurer could contract with an insurance agency or brokerage firm to perform suitability and compliance functions, and the insurer’s compliance could be achieved by sampling, testing or auditing the efforts of their contracted third parties. However, the Senior Protection Model does say that vendors, including general agents and managing general agents, can carry out the insurer’s obligations under this section by supervising or training insurance producers, with the insurer monitoring vendor compliance, performing periodic compliance audits and enforcing the compliance requirements. Unlike the previous model that specifically exempted registered contracts, the Senior Protection Model applies to fixed and variable annuities.

Comments
The focus of the Senior Protection Model is annuity sales to retirees. An earlier attempt at defining suitability failed in part because it was perceived as too broad based; this appears to be another stab at the suitability issue using a smaller focus. The emphasis on seniors may be a backlash to a few recent media stories about how some advisors are targeting retirees and suggesting the retirees move poorly performing assets from mutual fund holdings into the no market risk arena of fixed annuities.

Existing insurance laws do not adequately address suitability needs given the complexity and range of today’s products, and workable suitability regulations are needed for annuity sales, but the Senior Protection Model is not that model and will not be passed. Somewhere between a standard where the producer and insurer are “guilty until proven innocent” and one where everything is “legal until we’re caught” is a realistic suitability model for the selling of annuities.

The insurance industry wants a standard of “not unsuitable”, whereby the sale of an annuity would be proper unless it could be proved that the purchase was unsuitable for the buyer, with the burden of proof on the regulator. Some regulators wish to adopt a position similar to the NASD standard of “is it suitable” in which the producer would need to prove the annuity purchase was suitable for the buyer. The practical difference between these two positions is worlds apart.

Insurers need to develop suitability guidelines, procedures and controls now to provide templates for regulators to review and modify, rather than reacting to finalized regulations after the fact. The Advantage Group is currently drafting a comprehensive Annuity Compliance Program prototype designed to meet the guidelines, training, and monitoring issues of consumer suitability in a manner that benefits all parties. If annuity suitability requirements are passed that mimic the security industry’s approach, without taking into account the uniqueness of the insurance industry, both the public and the insurer will be ill served.

Nonforfeiture Law Changes Will Dramatically Affect FIAs  4/03
Changes in the Standard Nonforfeiture Law For Individual Deferred Annuities adopted by the NAIC on 9 March will significantly change the index annuity landscape. The most consequential redact says that guarantees will be based on 87.5% of gross considerations (premium) for both flexible and single premium contracts. This will impact index annuities with minimum guarantees based on less than 87.5% of premium and initial surrender charges greater than 12.5%. Although only 25% of index annuities currently marketed have minimum guarantees below this level or surrender charges above that level, they represent 45% of 2002 total sales.

Perhaps the biggest effect is that some carriers will need to invest in shorter term bonds. A more substantial surrender charge provides a large degree of protection against early policy lapses. A stronger surrender charge allows carriers to invest in bonds with longer maturities and take advantage of higher yields. Shorter maturity translates into lower yields meaning fewer dollars available to provide index participation, high commissions and bonuses.

Bonuses will be more limited. As one actuary explained to me, it’s difficult to pay an initial 10% premium bonus, a 10% commission and pay the bills with a maximum 12.5% surrender charge. The type of bonus that will best survive is the vesting bonus that pays for persistency; the F&G Loyalty Rewards is an example of a winning bonus structure after the changes. The trend towards shorter surrender periods and lower commissions, which began last year as yields plummeted, will speed up.

Although the new rules don’t impact annuities with shorter surrender periods, with minimum guarantees at or above 87.5% and ones that do not pay a premium bonus, the lower minimum rate is a significant change. The lower minimum interest rate calculation may benefit some index designs by allowing lower minimum guarantees than currently required, thus freeing up cash to increase participation rates.

A couple of years from now, today’s average surrender period of almost twelve years and average agent commission of almost ten percent may be memories, with both moving, perhaps, three points to the left. The next year may be the final act of the high commission-high initial bonus scene, with a host of new performers emerging from the footlights. But for those producers desiring an encore of the final act, never underestimate the creativity of actuaries.

Index Annuities Beat Most Mutual Fund Returns Over Last Five Years   5/03
Over the five year period from 3/31/1998 to 3/31/2003 index annuities had higher returns than 63% to 75% of all mutual funds for the same timeframe. This analysis is based on the crediting rates of the majority of index annuities that were available for the period as determined by The Advantage Group, and total returns reported for 2344 mutual funds. Returns of the 25 largest funds, and available index annuities categorized by crediting method, were as follows:

For the 5-year period the typical index annuity with an annual reset design using a point-to-point methodology, as well as annuities using the term high point method, had total returns of 19% to 22%. This return would have bested the returns of over 90% of the equity funds, or 71% to 75% of total funds, for the same period.

Even though 5-year term end point index annuities available five years ago would only have earned the minimum guaranteed rate, they still would have outperformed 89.6% of equity mutual funds. Annuities using averaging of annual index values returned 7%-8% for the period, which was still better than four out of five equity funds. But burying your money in the backyard would have bettered three-quarters of the equity funds or 56% of total stock and bond fund returns over the last five-years.

On the other hand, 70% to 75% of the domestic fixed income funds would have bested most index annuities, as would all CDs and every fixed rate annuity I looked at. It was a good era for bond funds. About the only way you could have screwed up is if you had only bought junk “low quality” bond funds because only 1 in 7 of these beat index annuity returns and almost 60% managed to lose money over the last five years.

The S&P 500 fell 23.02% over the five years. The index has reported losses before, but you have to go back a quarter century to find another five year period that was worse (from January 1973 to January 1978 the index dropped 23.08%). Over the last fifty years fewer than 15% of the five year periods ended in losses, and almost all of these tumultuous down periods ended their term in the 1970s.

This isn’t the last five-year period that will be negative for the index. The S&P 500 ended the second quarter of 1998 at 1133.84, a mark unlikely to be reached by June of this year. And although the third quarter of 1998 ended at a more attainable 1017.01, calendar year 1998 finished at 1229.23 and 1999 saw the index climb to 1469. Five-year returns on mattress money will still be beating most equity funds for periods ending over much of the next two years.

This nasty time showcases the guarantees of index annuities in general, and the ratchet advantage in particular. Annual reset annuities ignore the losses of the past and only preserve the gains. They build upon past credited interest and credit new gains while other vehicles struggle to merely recapture old ground or risk losing gains not locked in. As consumers rummage through their financial tool kits to attempt to fix the damage wrought by the financial storm, many will find the index annuity ratchet is the right tool for today.

Registered Index Annuity Sales Fizzle    5/03
Sales of registered index annuity sales fell back to earth with ING SmartDesign Multi-Rate Index Annuity reporting first quarter index sales of under $10 million. The total for the quarter was less than the average daily sales level reported for the annuity one year ago.

Although the majority of money going into Smart Design has always gone into fixed account options, last year there was still enough left over to account for respectable index-linked annuity sales. And these sales were taking place in new distribution channels, like wirehouses and regional B/Ds, that had not yet offered index annuities. I had hoped that the broker/dealer world was finally beginning to listen to the index annuity call. I may have been premature.

Although a few major firms have expressed renewed interest in index annuities, the wirehouse share of the current index market has not increased. The new principal protection riders available on some variable annuities – although a pale imitation of the protection afforded by index annuity annual reset designs – may be being used to address consumer fears of loss. It is unclear when index annuities will be embraced by the world of registered reps.

12 Ways Insurance Companies Can Still Make Money   5/03

Even though times are tough, there are still many ways for insurance companies to make money. Here are some ideas:

1. Sell obsolete marketing materials to paper mills to make excellent insulation and confetti

2. Throw blankets over unused staff cubicles and rent out space to mushroom farmers

3. Lease unused telephone lines to phone sex centers

4. Offer underutilized marketing staff as temps to fertilizer manufacturers

5. Convert product development floor into homeless shelter for tax write-off

6. Invite agents to a “bring back 6% rates” revival meeting and pass the collection plate

7. Raffle off excess airline frequent flier award trips

8. Set up sidewalk stands to sell overstocks of company name imprinted pens, stress balls, golf tees, calculators and clocks

9. Change the Customer Service toll-free 800 number to a toll-charge 900 number

10. Replace compliance department chairs with bicycle generators and sell electricity to local utility

11. Try to get a refund on the fee paid to the consultant that said the downturn would be over in 2002

12. Have your actuary explain how the new reserving rules will affect future annuity pricing. It won’t save you money, but by the time you wake up things should be better.

Cheer Up – Good times will return

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Changes     6/03
I was talking to Danny Fisher the other day and he said the number of fixed annuities reported in the Fisher Annuity Index had declined from around 1000 at the start of the year to 696 by the end of May. Almost a third of the annuities on the market last New Year’s Eve are no longer for sale. Why? For the most part because these annuities were no longer profitable for the insurers and were pulled.

Insurers depend on the earnings from their investment portfolios to cover costs and generate profits. Bonds make up much of these portfolios and yields are at their lowest levels in 40 years, and so income has dropped. Many insurers are working at cutting business costs and this involves reducing some commissions, taking advantage of lower minimum guarantees, and pulling higher cost products off the market. Within the last couple weeks National Western and LSW joined the other dozen annuity carriers by reducing agent commissions, and effective 1 June Clarica is out of the fixed annuity business. The goal for many carriers now is not gaining market share, but to keep from sliding backwards.

Although my crystal ball says the difficult times won’t be over for the insurers for awhile, it’s not the end of the world. The consensus of economists is that the recovery will continue, that we will avoid a deflationary spiral (but a couple other countries may not be as lucky), and that profits will be better down the road (and regardless of what you will read the effect of the new tax law on fixed annuity sales will be very minor). It was a nasty spring, but seasons change.
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1st Quarter Index Annuity Sales Dip      6/03
Sales for the first quarter of 2003 were a $3290 million compared with sales of $2168 million for the first quarter of 2002. First quarter index annuity sales were down 4% when compared with fourth quarter index sales and up 52% when compared with the same period one year ago. First quarter index life premium was $22,265,529. The top selling index carriers were:

This is the twenty-third quarterly index sales survey conducted by The Advantage Group. The only carrier that declined to participate in the annuity survey was National Western and I have estimated their total sales for the quarter and included these estimates where noted.

Physicians Life left the index market; Southland Life leaves at the end of May. There are now 30 carriers offering fixed index annuities, and over the years 36 carriers have entered the field and then exited. AmerUs MultiChoice 10 dropped their Long-Term Equity Index Strategy, and Conseco has suspended sales of the SIMPLE Index and Choice products.

The major product news was the introduction of two equity index life products into New York by Bankers Life of New York, an AmerUs company. Americom is introducing the Spirit 7 index annuity. American Investors introduced the Bonus Select and AmerUs brought forth the Multi Choice Annuity Bonus Plus. Jefferson-Pilot introduced the Smart Choice and New Directions index annuities. Midland National replaced two bonus products with similar products with lower minimum guaranteed interest rates.

Insurance agents continue to represent over 19 out of every 20 index annuities sold, and products with surrender periods of ten years or longer account for 87% of sales. The weighted agent commission based on index annuity premium paid has fallen from 10.44% in the third quarter of 2002 to 9.96% in the fourth to 8.64% in the first quarter of 2003. For the first time in years there were more sales of annuities with a street level commission of 6% or less, as opposed to sales of annuities with an agent commission of 11% or more.

There are a couple of alternative reasons given for the decrease in commission levels. The first is that the investment income generated by carrier portfolios has declined as bond yields have fallen, and this has been coupled with higher option prices, thus resulting in a scenario in which costs must be reduced because net income is down. The alternative reason is covered by the explanation, “Hey, actuaries need Porches too.”

After a small decline in the previous quarter the market share of bonus annuities rose to 55.3%. However, the overall allocation of index annuity premium into fixed account options again fell.

There are 30 carriers offering equity index annuities. If you separate available products by features, there are:

136 Index Annuities - Segmented By Surrender Period & Methodology

145 Index Annuities - Previous Segments Plus Bonus Rates, Cap/No Cap Option

230 Index Annuities - Previous Segments Plus Other Available Indices

Eight of the carriers offer a single product, 22 of the carriers offer multiple surrender period products, different crediting options or additional indices. Eleven carriers offer bond or equity indices beyond the S&P 500. With two exceptions, the percentages of all non-S&P 500 index sales at carriers that offer multiple indexes ranges from 1% to 5% of their total sales. The S&P 500 Index represents 95% of index sales.
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Suitability Must Address “What Is An Insurance Agent?”   6/03
The idea of suitability is new to the insurance industry. Suitability is a security regulation concept driven by the “know your customer” tenet of SEC rules in which the representative needs to show that a financial product is suitable for the client. The insurance business uses the principle of market conduct whereby as long as the producer doesn’t break the specified rules the conduct is okay; these rules are often strictly defined.

The insurance regulatory mode of governing agent market conduct worked quite well as long as insurance agents were simply selling insurance, and were perceived by the public as sources of insurance. Just as a consumer wouldn’t go to their grocer to get a haircut, they didn’t go to an insurance agent for investments. And just as there is a limit to the needs a grocer can provide for, there was a limit to the number of financial problems an insurance agent could solve with insurance products. If a consumer wanted something other than insurance the consumer went elsewhere. If an insurance agent wanted to broaden their services by offering investments, they could always obtain securities registration and operate under security suitability rules.

However, there were agents that felt they could expand their offerings, and avoid the scrutiny of security regulators, by selling investments that weren’t technically securities. Some insurance agents began offering high return opportunities to consumers and these opportunities definitely were not insurance products, but they definitely were very risky.

Often existing state insurance or security laws did not regulate these “opportunities” and often consumers were burned. One result from all this was increased regulatory attention focused on all life insurance agents by all regulators.

With every passing year it has become more difficult for providers of any financial service to rise above the promotional noise of their competitors and gain the attention of the consumer. Over a decade ago producers discovered that they could reach more prospects by teaming up with an attorney specializing in estate planning. The attorney would often help the consumer by creating trusts to facilitate transference of the estate, and the life insurance agent would provide annuities and life insurance when needed.

However, in some instances the role of the attorney was so minimized and the role of the insurance agent was so unclear, that the consumer did not know they were working with an insurance agent whose goal was to sell insurance, and thought an “estate planner” was advising them. These agents misrepresented their role in the sales process and tainted the legitimate use of annuities and life insurance in estate planning.

The millennium bear market decimated the investment portfolios of consumers. Fixed annuities during this period did not lose money. Because of recent experience, many consumers are interested in the protection from market risk offered by fixed annuities and these consumers often buy fixed annuities with money received by selling their securities. If the producer is only acting as an insurance agent in the purchase of the fixed annuity, and is not involved in the sale of the security, then the insurance laws of the state in which the purchases occurred should govern the annuity transaction

One state security division appears to be saying that if securities are sold and these proceeds used to buy a fixed annuity, then the insurance agent offering the annuity is acting as an investment advisor and should be security registered. The Massachusetts Securities Division cites state securities law in claiming jurisdiction in a complaint against an insurance agent selling annuities saying “"the [Securities] Act defines the term "investment adviser" to mean: ...any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities”.

If this line of logic is judged correct the implications are staggering, because what Massachusetts appears to be saying is if a consumer tells an insurance agent that they want protection of principal from market risk, can’t sleep at night because of the volatility of the stock market and want something that will produce an income they can’t outlive, and the agent suggests that the consumer might be happier in a fixed annuity instead of their mutual fund, that now the agent is acting as an investment advisor and must be security registered. That the securities department decided they had the authority to even file a complaint illustrates the jurisdictional problem facing insurance regulators and the agents they regulate.

A life insurance agent once sold insurance for their carrier by determining the customer’s coverage needs and then selling the policy that fit. Today, the agent may be consulting on the use of life insurance to reduce estate taxation or fund a business buy-sell agreement, or the use of an annuity for retirement savings, while at the same time auditioning carriers to win the role for this one performance. Although the producer is usually legally an agent of the carrier the actual role of the producer is often more that of the buyer’s insurance advisor.

A report for the Insurance Legislators Foundation titled The Path To Reform – The Evolution Of Market Conduct Surveillance Regulations dated 1 May 2003 says the whole approach to market conduct regulation needs to be rethought. It proposes an integrated system for identifying market conduct problems that would vest the domicile state of the insurer with primary responsibility, develop guidelines for insurers to put compliance programs in place, and reward carriers that participate in independent assessment programs. The NAIC is attempting to define the parameters of annuity suitability and their most recent effort will be discussed at their June meeting.

The blurring of lines between investment and insurance products has increased the regulatory authority of security regulators because state insurance departments have been too fragmented to develop a long-term comprehensive plan for their industry, and security regulators are filling the regulatory void. Before insurance regulators tackle the question of suitability though, they first need to redefine the question of what is an insurance agent. If insurance regulators fail to answer this question, a federal security commission will eventually regulate all insurance suitability, with all agents subject to their standards.

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