Annus Horribilis Q.E.D. 7/03 
Fixed rate annuity products are dropping out of the market as fast as November apples falling from the tree and fixed index annuity rates are the worst they’ve ever been.

Three quarters of the index annuity carriers have cut commissions, pulled products, and/or cut back the premium bonus. Although 35% of June 2002 sales were in index annuities with agent commissions greater than 11%, at the end of June 2003 there were only 3 annuities still available with agent commissions over 10%. And it’s not over yet. I spoke with three more carriers that will be lowering commissions in July.

Almost every carrier has refiled or intends to refile products with lower minimum interest rate guarantees. One carrier, United Life of United Fire & Casualty Company suspended the sales of fixed annuities on 30 June. Their news release says the length of the suspension depends on how fast states approve the new lower 1.5% interest guarantee contracts.

The reason for the current problems is a simple one. Interest rates have fallen to 40 year lows. Unfortunately, the solution is not as simple.

From 10 June 2002 to 10 Jun 2003 the 10-Year U.S. Treasury Constant Maturity Rate fell from 5.04% to 3.19%. Three days later the 10-Year Treasury closed at 3.10%, a rate last seen when the American flag had 48 stars. Corporate bond yields have also plunged, and the word from the Federal Reserve Board is these low yields will hang around. Two avenues for insurers to take to remain in the game are to reduce costs and squeeze a little more return out of their portfolio. Carriers will work harder at replacing 3% minimum interest rate guaranteed products in states permitting lower rate minimums. If a state hasn’t approved lower minimum guarantees more carriers will simply stop selling in those states. We should see more registered versions of “fixed” annuities to cut guarantee costs. Commissions and premium bonuses will need to reflect current pricing concerns.

Based on my chats it does not appear that insurers are pursuing more exotic investments in search of yield, but tweaking what they are already doing. Insurers seem to be buying more corporates and BBB rated bonds, and fewer government and AAA corporate bonds, to gain a little more yield. It looks like a tad more high quality junk bonds are coming into portfolios, but insurers are being highly selective.

Average portfolio maturity is creeping up a bit to take advantage of any gains realized from moving up the yield curve; portfolios liabilities are extending a bit pass portfolio asset lengths. Insurer moves and attitudes are cautious.

Index annuities look more attractive than fixed rate annuities because of lower minimum guarantees, and decreasing option volatility means index annuity pricing at least will give consumers a shot at 5% or higher interest being credited to their annuity contract a year from now. More carriers will be entering the index arena because other options are less attractive.

VA Principal Protection  7/03 
If the stock market does a repeat of the ‘80s or ‘90s most variable annuity equity subaccounts will outperform most index annuities. Even if index annuity participation increases to the higher levels of a few years ago, a decent bullish market environment would permit VA equity subaccounts to gain more interest than index annuities. If you believe the stock market will rise and want to maximize potential gains, then variable annuity equity subaccounts give you a better opportunity to shoot for maximum gains than an index annuity. But what if you want protection in case the stock market doesn’t go up?

By their very design index annuities protect principal and credited interest from stock market declines. As the millennium bear market wore on some variable annuity issuers began responding to investor concerns by developing account options to safeguard principal. How do these variable annuity principal protection features compare with index annuities on an investment return level? The answer depends on what the stock market does, cost and structure of the VA protection component, and methodology and effective participation of the index annuity.

Mandatory Account Allocation
A principal preservation method used by some carriers involves splitting premium between fixed and equity VA accounts. It’s the old split investment concept with a new twist providing for protection of principal where the carrier mandates the percentage of premium allocated to the fixed side. A big variable is the issuer’s return assumptions.

Say that the carrier promised 100% of the premium would be there after 5 years and assumed a fixed account return of 5.9%. If $7,500 of an initial premium of $10,000 were placed in the fixed account it would grow back to $10,000 after 5 years.

The remaining 25% of premium, or $2,500, could go into an equity account. If the equity account grew 60% in 5 years the $2,500 would grow to $4,000. If you add the $4,000 from the equity account to the $10,000 from the fixed account you get a sum of $14,000 representing a 40% total return [(14000/10000)-1] on your initial premium.

However, if you had put the entire $10,000 into the equity account it would have grown to $16,000 [10000 x (.60+1)]. By using the carrier’s mandatory allocation you have reduced your overall effective participation in the equity gain. You could have made $6,000. You made $4,000. Your effective overall participation in the gain was 66 2/3% [4000/6000].

In the last example I said the carrier assumed a fixed account rate of 5.9%. What if the carrier wanted to play it safer and base the mandatory allocation at a fixed account rate of 3.3%? At 3.3% we would need to place $8,500 into the fixed account to ensure that $10,000 was there in 5 years. Only $1,500 would be available for the equity account.

If the equity account again grew 60% the $1,500 would become $2,400. The $2,400 would be added to the $10,000 from the fixed account and produce $12,400, or a 24% total return. But if the entire $10,000 were placed in the equity account it would have grown to $16,000. By using the carrier’s mandatory account allocation you’ve reduced your effective participation of equity gain to 40% [2400/6000].

The effective participation gets smaller as the actual equity gain gets bigger. In the first example an actual equity account gain of 80% or 100% translates into respective overall effective participation of 56% and 50%. In the second example actual equity account gains of 80% or 100% translate into respective effective participation of 34% and 30%. Conversely, if the equity gain is small the effective participation becomes greater.

Would an index annuity do better? It depends on the effective participation of the index annuity. An index annuity participating in 90% of the equity gain would probably beat the VA mandatory account option in many cases, and an index annuity with a 25% participation rate would almost always lose. In a variable annuity/index annuity contest the winner will be the one with the highest effective participation.

The Dividend Question
I have heard folks say that variable annuity returns will always be higher because they include reinvested dividends and index annuity returns do not, and dividend yields have been hanging around 2%. However, total variable annuity annual costs are typically 2% to 2½%. It appears, at least for now, that VA charges more than offset the addition of reinvested dividends, and ultimate performance is more dependent on effective participation.

Protected Equity Rider
This variable annuity option is straight-forward, with the carrier promising that at least the original principal will be available at the end of a specified period of time, usually 10 years. In return for the protection the carrier charges an additional fee and may limit the choice of funds available to the investor. The determining factor is the size of the protection fee.

One variable annuity offering this rider charges up to 2.5% a year for the principal protection in addition to regular fees. On the other hand, I am aware of an index annuity that today offers to lock-in a 2.40% annual “asset fee” for the length of the surrender period.

So, I have a variable annuity that includes reinvested dividends, which are currently yielding a little under 2%. The variable annuity charges management, mortality and expenses of 1.82% a year, and an additional 2.5% annual charge that guarantees I will receive at least 100% back after 10 years.

Or, I have an index annuity that does not include reinvested dividends, nor does it charge management, mortality or other annual expenses, but it does deduct a 2.4% “asset fee” from gains, and guarantees I will receive at least 117% back after 9 years.

Which is better? I don’t know; they seem pretty evenly matched. Once again, the best choice will depend on the effective participation.

Principal Withdrawals Back
A third type of principal protection rider promises to pay out at least the original premium if you limit your withdrawals. Typically, the deal is if you take out 7% or less a year the carrier guarantees you will at least get paid back what you started with, and the cost of this protection is 0.35% to 0.40% a year. The risk this covers is that your investments take huge market hits during the 14 and a third years (which is how long principal lasts if you take out 7% a year).

An index annuity guarantees you will get at least 100% of the principal back at the end of the surrender period. Although you could select an annuity with a 14 year term, you could also be assured of at least having your money back at the end of 10 years, 7 years or 5 years by selecting a shorter surrender charge period.

In A Sideways Market The Annual Reset Index Annuity Always Wins
Variable annuities with principal protection features can be compared with index annuities using term end point crediting methods – it’s a matter of which offers the highest effective equity participation. Index annuities using annual reset credit methods are a different story.

No variable annuity offers the protection of an annual reset index annuity because no variable annuity locks in previous credited gains nor resets the starting point to take advantage of market declines. In a sideways stock market of peaks and valleys, annual reset index annuities will perform because they do protect credited interest and have minimum interest guarantees.

If the market steadily rises the variable annuity should have higher returns than the annual reset index annuity, and that’s fine. Index annuities are designed to provide the potential for higher interest than other savings vehicles that also protect principal, and to be an alternative if the stock market doesn’t perform as desired.

Annual Inflation Rate  1948 - 2003    7/03 

To Earn More Be Manly 8/03  
It is a hard fact that women rarely reach the top corporate levels and over 90% of senior managers in Fortune 500 companies are men. A reason often cited for the lack of executive women at upper levels is pure sex discrimination. But research indicates there may be other reasons.

Studies by Uri Gneezy at the University of Chicago imply that one reason more men than women reach the top is men and women have different attitudes about competition. In one study when men and women were paid for each problem solved both sexes solved the same number of problems, but when payment was only paid to the individuals solving the most problems, men won the money 50% more often. Other studies also indicate that when men are placed with others they try harder than women, even when the job doesn’t require competition.

Linda Babcock of Carnegies Mellon University finds women earn less then men because they don’t ask for more money. She found that male graduates earned 7.6% higher starter salaries than female graduates. When Babcock dug deeper she discovered that when a job offer was made 57% of the men asked for more money but 93% of the women simply accepted the initial offer. In another study she told players they would earn between $3 and $10 for playing a game. She then offered every player $3 when the game ended. Nine times more men than women negotiated for more money.

So maybe a solution to ending the wage gap and glass ceiling between men and women isn’t legislation, but women’s courses in power negotiation and an understanding that men and women view competition and work differently.

 Source: Be a man, The Economist, 6/28/03

Return Drought Ends In July 8/03 
July saw annual reset indexed annuities credit meaningful interest for the first time in three years. Many contracts, especially those with crediting cycles renewing late in the month, credited 3%, 5%, and even 9% interest with a few crediting double digit interest rates.

Depending on the date selected, annual gross index returns for a one-year point-to-point period ending in July ranged from roughly zero to around 20% for the S&P 500 and Dow Jones Industrial Average; Nasdaq gains were over 20% for much of the month. Averaging the daily or monthly values of any of the indexes produced lower increases, which turned generally positive around midmonth. The reason for the positive news were flat to modestly higher July 2003 index ending values, combined with lower starting values due to a falling July 2002 index.

Last year’s summer index drop means most annual reset index annuities will be crediting index-linked interest for one-year periods ending during the next few months even if the current stock market simply runs in place. In fact, the next ninety days could see many annuities capping out on the interest credited, as long as the market doesn’t go backwards.

Investing Through The Rear View Mirror  8/03 
Just for fun, before you get into your car tomorrow, I want you to tape over the windshield and drive forward only using your rear view mirror. Does it sound impossible? Do you think driving in this manner might eventually lead to a crash? Yet this is precisely how most people invest. And not only do most people try to go forward in their investment planning by looking behind them, they look and overreact to the wrong sections of road. Let me show you what I mean.

“Financial forecasting appears to be a science that makes astrology look respectable”
Burton Malkiel, author of A Random Walk Down Wall Street

The first chart ⁽¹⁾ shows the 3-month rolling average of the S&P 500 index values and equity mutual fund cash inflows from January 1996 through June 2003. Inflows are positive when mutual fund purchases exceed redemptions and negative when redemptions exceed purchases.

The lines from 1996 until the summer of 1998 show a steadily rising stock index and a disciplined looking approach of steady purchases into equity mutual funds. In August 1998 a trio of financial threats caused the index to dip for the next few months, but the market resumed its upward climb by late fall 1998. And yet equity mutual fund buyers backed away, purchasing mutual funds at roughly half the rate at which they’d been buying them, while in the meantime the index broke through 1100, 1200, 1300. When the S&P 500 set record highs investors began buying equity mutual funds in record numbers, and they kept buying as the equity index slid back from 1500 below 1300 below 1100 and below 900. These same investors finally began taking more out of equity funds than they were putting in by the summer of 2002. All-time record outflows took place in the third quarter, which, coincidently, now appears to have been the final stage of the millennium bear market. Finally this spring, after the index had already risen 18% from its low, equity fund buyers began buying more funds than they were redeeming.

Over the last five years the typical investor strategy of “buy high – sell low” was amply demonstrated. Investor patterns show a consistent overreaction to both market dips and market gains. If people dressed like they invested, we’d see the average person finally putting on their winter coat on Memorial Day, and getting out shorts and sandals for their Maine Thanksgiving. However, moves of the average equity mutual fund investor looked extremely rational when compared with the typical bond fund owner.

Sic faciunt omnes (Everyone is doing it)

The second chart ⁽²⁾ compares 3-month rolling averages for taxable bond mutual funds with composite bond yields determined by the Advantage Bond Rate Indicator. From 1996 until the summer of 1997 interest rates were strong and taxable bond inflows were zero. As rates began falling investors began buying bond funds, with greatest inflows to bond funds occurring in 1998 as rates bottomed out for the cycle.

As interest rates rose in 1999 bond fund redemptions steadily increased. Bond mutual fund outflows set all-time records just as bond interest rates reached their highest point for the cycle. In fact bond fund purchases didn’t turn positive until rates had again declined to where they had been almost two years before. Money flowing into taxable bond mutual funds continued to set new records as bond rates fell to their lowest levels in 40 years. A funny story about issued bonds is they go down in value when interest rates go up and go up in value when interest rates go down. The punch line to this joke is roughly 70% of theinvestors buying these bond funds aren’t aware that the value of a bond goes down when interest rates go up and vice versa.(3) This may help explain why the average taxable bond mutual fund investor consistently picks the absolute dumbest times to buy and sell bond mutual funds.

“If I have learned anything in my 52 years in this marvelous field, it is that, for a given individual or institution, the emotions of investing have destroyed far more potential investment returns that the economics of investing have ever dreamed of destroying.” - John Bogle ⁽⁴⁾

The last three years have been wonderful times for bond mutual funds with many posting double digit annual returns. However, based on actual investor patterns I would hazard a guess that most individual bond fund investors have not come close to realizing these higher returns because they came to the “declining interest rate dance” too late, although they are now perfectly positioned to lose money as rates go back up.

I don’t have hard data on what actual returns were realized by the average bond mutual fund investor – my assumption could be wrong – but I was able to find hard data on the actual returns earned by equity mutual fund investors.

According to DALBAR between 1984 and 2002 the annual S&P 500 return was 12.9%. Over the same period the average equity mutual fund, including reinvested dividends and net of fees, returned 9.6% a year. And yet, the individual investor in equity mutual funds during this period got an annual return of 2.7% because they wouldn’t leave their portfolios alone. ⁽⁵⁾

Think about that. If the question were “Between 1984 and 2002 which number would have been lowest?” And the possible answers were A) Average Investor Equity Mutual Fund Return, B) Average January Temperature of Anchorage Alaska or C) Average Season Wins of the Cincinnati Bengals, the correct answer would be A.

From 1901 through 2002 a basket containing only American stocks would have produced an average annual return of 9.3%, outperforming every other asset class on the planet (Treasury bills averaged 4.1%). ⁽⁶⁾ Even if American stocks are not as competitive in the future as they once were, the typical long-term investor should be much better off simply buying index funds with the stipulation that no changes can be made to the portfolio until retirement. Unfortunately, the typical investor wants to fiddle around because emotion and not logic is the driving force. Enter the index annuity.

The typical mutual fund investor only participated in 21% of the actual S&P return for the last 18 years.

Although the average investor also buys at the wrong time, the real damage is done when the investor sells at market bottoms, thus missing most of the growth of the next cycle. The reason for panic selling is fear of continued loss. Index annuities minimize this fear by protecting principal and credited interest from market loss, and in the case of annuities with annual reset designs the index annuities take advantage of index drops and calculate growth anew. It should be noted that currently no index annuity provides 100% participation in index growth. However, from 1984 through 2002 the typical equity mutual fund buyer participated in only 21% of total index return. I am optimistic that future index annuity participation will be at a higher level than this.

A portfolio of quality index annuities with term point-to-point strategies and annual reset methods discourages investor tinkering and should result in better long-term returns than those of the do-it-yourself investor. An index annuity portfolio means you can ignore what is happening in the rear view mirror because you know you will never crash on the road ahead.

1. Data Source: Investment Company Institute, Standard & Poor’s    
2. Data Source: Investment Company Institute, The Advantage Group
3. 2002 Vanguard/Money Investor Literacy Test, 9/25/02
4. John Bogle June 5 2003 from his speech titled The Policy Portfolio in an Era of Subdued Returns
5. The Economist 7/5/03 “The law of averages” p.7
6. The Economist 1/4/03 “From 1901-2002...” p. 57

NAIC On Senior Suitability 8/03 
The July 21, 2003 draft of the NAIC Senior Protection In Annuity Transactions Model Regulation was adopted by the Life Insurance and Annuities (A) Committee. This regulation applies to any recommendation to purchase or exchange an annuity made to a person over age 65 by a producer. If no producer is involved the insurer is responsible.

This model regulation does not apply to non-annuity transactions, and NASD authority preempts the law if the product is a variable annuity. In short, if producers sell unsuitable life insurance polices and long-term care polices to senior consumers, or unsuitable annuities to consumers under age 65, or variable annuities falling under the jurisdiction of NASD, the model regulation does not apply.

Section 6 of the model regulation says an insurance producer shall have reasonable grounds for believing that the recommendation is suitable for the senior consumer on the basis of the facts disclosed by the senior consumer as to their investments and other insurance products, and as to their financial situation and needs. The producer shall make reasonable efforts to obtain information concerning the senior consumer’s financial status, tax status, investment objectives and such other information used or considered to be reasonable by the insurance producer. However, if the consumer won’t provide accurate information, and if the sale looks suitable based on what is known, then the producer is off the hook. The regulation does not define what reasonable grounds are nor what a reasonable effort is. The remainder of Section 6 contains additional undefined areas.

The insurer must develop written procedures and conduct “periodic reviews of its distribution methods that are reasonably designed to assist in detecting and preventing violations of this regulation”. However, the insurer may contract with another party to do all of this. Who is the third party? It is the agency or marketing company through which the producer is contracted with the insurer. A senior manager of the third party will certify each year that the third party believes all producers are in compliance with this act and that they are performing the required monitoring.

What constitutes adequate monitoring of producers by the agency or marketing company? Good question. Although the regulation states that the insurer is not required to review every producer solicited transaction, it doesn’t say that the third party won’t be required to review every senior citizen annuity transaction. And when the producer obtains all of the consumer information the regulation does not say what parameters should be used by the producer and the third party to determine suitability.

The goal of the regulation is promote better sales practices when working with seniors, and provide a regulation that will better enable states to punish those producers that consistently do not make suitable recommendations to consumers (and discourage the carriers and agencies that help the ethically impaired producer to remain in the business). The NAIC Fall National Meeting will be held September 13-16 in Chicago.

Up, Up & Away 9/03

The delight generated by the upward movement in index participation was happily coupled with news that annuities were crediting the first meaningful index-linked interest in three years. For the first time since the last millennium producers can compare index annuity statements (showing up to double digit returns) with bank CD statements (showing one or two percent interest earned).

And even before the recent joyous tidings emerged, the industry posted a record quarter setting the pace for another record year. We are now riding on the upward curve of the next cycle. Enjoy.

Record 2nd Qtr Index Annuity Sales 9/03 
Sales for the second quarter of 2003 were $3718 million compared with sales of $2798 million for the second quarter of 2002. Second quarter index annuity sales were up 14% when compared with first quarter index sales and up 33% when compared with the same period one year ago. First quarter index life premium was $21,332,809. The top selling index annuity carriers were:

Index annuity sales for the first half of the year were $7 billion, a 40% increase over the first half of last year.

This is the twenty-fourth quarterly index sales survey conducted by The Advantage Group. National Western declined to participate in the annuity survey and their sales number were obtained from SEC filings. BMA was unable to furnish sales data. In all, 97% of the active index product companies accounting for over 99% of sales are represented.

There are 29 carriers offering index annuities. If you separate available products by features, there are:

115 Index Annuities - By Surrender Period & Method
123 Index Annuities - Plus Bonus Rates, & Cap Option
187 Index Annuities - Plus Other Available Indices

Eight of the carriers offer a single product, 21 of the carriers offer multiple surrender period products, different crediting options or additional indices. Clarica exited the market in June, and over the years 37 carriers have entered the field and then exited. Most of the other product news was higher minimum guaranteed rate products being replaced by lower minimum rate ones.

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. Annual reset designs represent nine out of ten sales, and averaging of index values takes place in seven out of ten 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 8.12% in the second quarter of 2003. There were five times more sales of annuities with a street level commission of 6% or less, when compared with sales of annuities with an agent commission of 11% or more. The quarter ended with only three products offering commissions over 10%. The market share of bonus annuities rose to 58.4%.

At the close of 1998 58% of the products guaranteed no moving crediting parts for the full surrender period. Today, 12% of the index annuities guarantee no change in rate, caps or spreads for the full surrender period, 84% reset at least some aspect of index participation each contract year, and a few companies offer different periods.

The complete second quarter Advantage Index Product Sales & Market Report is available now. Single copies cost $100; an annual subscription of four quarterly reports is $250.

Unnatural Laws 9/03
“This is a billiard table...And you have hit your white ball and it is traveling easily and quietly towards the red. The pocket is alongside. Fatally, inevitably, you are going to hit the red and the red is going into that pocket. It is the law of the billiard table. But, outside the orbit of these things, a jet pilot has fainted and his plane is diving straight at the billiard room, or a gas main is about to explode…And the building collapses on you and on top of the billiard table. Then what has happened to that white ball that could not miss the red ball, and to the red ball that could not miss the pocket? The white ball could not miss according to the laws of the billiard table. But the laws of the billiard table are not the only laws, and the laws governing the progress of you to your destination are also not the only laws in this particular game.”

Kerim Bey to James Bond in From Russia With Love

In the ‘90s the laws governing Monte Carlo simulations concluded that the probability of the major domestic stock indices declining over a third in value were less than 1 in 50, and the possibility of the stock indices declining three years in a row were statistically nonexistent. The Millennium Bear Market produced equity index losses of as much as 75% and a bear market hat trick last seen when Hitler invaded Poland.

Millions of hours are spent on researching the past movements of the stock market and millions of dollars are spent on publications from companies such as Morningstar, Lipper or Value Line in attempting to unearth a new undiscovered law that will enable past performance to predict future results. And yet, with the possible exception of viewing long-term market cycles, the past is usually a lousy predictor of the future. The top ten performing mutual funds from 1996-1999 ranked in the bottom ten percent of the same fund universe for the period 1999-2002.⁽¹⁾ The investor looks at past performance as a law governing future results. Unfortunately, investing is more akin to alchemy than chemistry because there are no absolute laws in investing since human emotions always get in the way.

“Poisonally, I never studied law” - Bugs Bunny

We make up investment laws to govern different situations because humans are uncomfortable with uncertainty. One financial planning law often stated to determine the percentage of a portfolio that should be invested in equities is to take 100 and subtract the person’s age. So, an 85 year old would invest 15% of their portfolio in stock instruments and a 25 year old would invest 75% of their investable assets in stocks.

I believe the logic behind this is that the older one gets, the less time there is available to recover from loss, but it’s not a law. The reality is a 25 year old that won’t touch their money for forty or fifty years has sufficient time to recover from any market setback, and therefore should be 100% invested in equities, and the 85 year old probably has insufficient time to recover from a severe downturn and shouldn’t have any money exposed to market risk.

And there are other factors. Suppose the 85 year old doesn’t need current income from the assets – does it still make sense to only put 15% in stocks? And what if a jumping stockbroker killed the father of the 25 year old during the October crash of ’87 and the young man becomes catatonic whenever he sees a mutual fund statement – perhaps placing three-quarters of his assets in stocks would be harmful to his mental health?

So what do you do? Go beyond the laws and examine the reasoning behind them to determine if the reasoning makes sense to you. If it seems logical, see if you can adapt it to your personal situation.

To try for good future returns focus on why the past returns happened. Say that a mutual fund uses a team management approach and has consistently ranked in the top quartile over the last 25 years and produced an 11% annualized return for the period. The 11% figure is irrelevant because we don’t what will happen to the market in the next 25 years, but we do know that this fund’s style of management has produced above average returns when compared with its peers, and investing style is a controllable element in the future.

In a similar vein, many annuities have the ability to change interest rates or index crediting rates before the end of the surrender period. Although a history of excellent renewal rates on past annuities may not necessarily mean good renewals in the future, I’d be willing to bet that a pattern of below market renewal rates will continue.

Index annuities erect a protective firewall between market risk and your principal ©

The other thing you can do to break free from false rules is by trying to minimize emotion in investing. Index annuities are excellent for this purpose because they erect a no-market-risk firewall between the ups and downs of the market and the annuity protection of principal and credited interest. Two advantages of index annuities are that one cannot check their value on a daily basis, and the surrender charge helps to limit spur of the moment financial decisions to reallocate assets, that usually hurt rather than help.

The problem with most laws in investing is they are only laws within their own little world. When a more universal event occurs the little world’s laws become irrelevant. And even when a law does work, it is usually sabotaged by the whims of the investors. To be successful investors need to understand the real economics that drive investing, and minimize the emotional element. Blindly obeying unnatural laws and following your heart instead of your head means you will ultimately lose the game.

1. The Economist 7/5/03 “The law of averages” p.7. "S&P 500" is a trademark of The McGraw-Hill Companies, Inc., which does not sponsor, promote or endorse any index annuity.

Can You Explain It To A Jury? 9/03

The index annuity concept is a simple one. An index annuity is a fixed annuity that offers the potential for earning more interest due to linking interest earnings to movements of an external index. But almost immediately insurers began to complicate this story by adding more moving parts to the crediting methods, or creating products that sounded simple, but really were not, and many annuity producers backed away from index annuities dismissing them as gimmicky and too complicated. Although index annuities have been around for almost 9 years over 90% of annuity producers do not sell them.

In the last couple of years carriers, for the most part, have climbed back from the irrational exuberance of methodology manipulation and are creating index annuities that are truly less complicated and simpler than many of those that came before.

I’ve said many times that complexity is not necessarily a bad thing; you can’t build an internet network using two cans and a piece of string, but to continue with the internet metaphor I believe index annuity methodologies should be written as WYSIWYG (what you see is what you get). The question I always ask when looking at a crediting method is “Will a jury understand this?”

My desire for simplicity in index annuity methods is to a large extent based on the target market for the product. Fixed index annuities were designed as an alternative to fixed rate annuities, providing the same protection from market risk with the potential for higher interest. Based on anecdotal evidence, the typical buyer of an index annuity is not a sophisticated investor, but a retiree with some certificates of deposit, a fixed annuity, and maybe some other money in stocks, funds or variable annuities. It is very easy for these index annuity buyers to not understand what they are buying. The key to avoiding the problem of unrealistic expectations is to ensure the consumer understands exactly how interest crediting works and to detail any ways in which the method differs from what the consumer might assume.

I have always maintained that there are no bad crediting designs, simply designs that need more explanation than others to correct erroneous assumptions. Regardless of the methodology, the consumer needs to understand specifically how index movement is calculated or there will be problems. If you feel the consumer doesn’t understand how a particular annuity works, find an annuity they do understand.

The Summer The Returns Returned 9/03
It was a long dry spell. Over the preceding three years most index annuities did not credit any index-linked interest and many producers were asked to explain how those minimum interest guarantees really worked. However, since the end of June, many annual reset structured index annuities have credited meaningful interest with many point-to-point methods generating double-digit returns.

Over the preceding two months one-year S&P 500 returns have been higher than 10% over a third of the time and this has resulted in many index annuity owners “capping out” on their credited interest. Annuities using monthly or daily averaging of index values have enjoyed fewer periods of index-linked interest and interest calculated from averaging methods has also been lower, due to the baggage of a really ugly year that dragged down the index to its lowest point in the bear market.

But whether the annual reset styled annuities resetting this fall use a point-to-point or averaging method both should be crediting interest-linked interest for the remainder of the year, even if the stock market remains relatively flat, because last year’s values were so bad.

Annuity Elements - Indices   10/03  

Indexing
The benefits of indexing are diversification and simplicity. Indices are not static, because the securities making up the different indexes change over time to adjust for changing market and company conditions. No index-linked product is sponsored, endorsed, sold or promoted by the respective index provider. Only insurance companies may underwrite index annuities.

Indexes currently offered by index annuity carriers are Dow Jones Industrial Average, Lehman Brothers Aggregate Bond Index, Lehman Brothers Treasury Bond Index, Nasdaq-100, Russell 2000, S&P MidCap 400 and S&P 500.

Dow Jones Industrial Average
The oldest index is the Dow Jones Industrial Average, often shortened to simply “the Dow”. Unlike the S&P 500 the Dow Jones Industrial Average is price-weighted rather than market value-weighted. The Dow Jones Industrial Average first appeared on 26 May 1896 and the closing average for that day was 40.94 (the Dow’s all-time low was reached 8 August 1896 when it stood at 28.48). The first Dow index contained 12 companies. The Dow increased to its current roster of 30 companies on 1 October 1928. 

Numerous Changes have been made to the Dow over the last 75 years. Of the original 30 companies only General Electric and General Motors remain the same. Allied Chemical changed its name to Allied signal in the 1980’s and merged with Honeywell on 2 December 1999. Standard Oil (NJ) changed its name to Exxon on 1 November 1972 and became Exxon Mobil on 1 December 1999.

S&P 500^®
The S&P 500 includes a representative sample of 500 common stocks from companies trading on the New York Stock Exchange, American Stock Exchange and NASDAQ stock market. The objective of the index is to be a benchmark for U.S. stock market performance and represents approximately 80% of the domestic equity market capitalization. Although the S&P 500 was introduced in 1957 its predecessors go back to 1923 when an index including 233 companies was introduced.

The S&P 500 is capitalization-weighted (market value-weighted) in which an individual company’s influence on movements of the index is in direct proportion to its market value. The index includes stocks from 10 economic sectors: consumer discretionary, consumer staples, energy, financials, health car, industrials, information technology, materials, telecommunication and utilities. Ten of the largest companies included in the index are AIG, Citigroup, Exxon Mobil, General Electric, IBM, Johnson & Johnson, Merck & Company, Micsoft, Pfizer, and Wal-Mart.

Index values do not include reinvested dividends; however, when an index return is compared to securities like mutual funds a separate total return is usually calculated that includes the effect of reinvested dividends. No index-linked annuity returns include reinvested dividends. The S&P 500 is selected in 95% of index annuity sales.

Russell 2000^® Index
The small-cap Russell 2000 Index measures the performance of the 2,000 smallest companies, representing approximately 8% of the total market capitalization, in the Russell 3000 Index. Top ten holdings of the Russell 2000 are currently Andrew Corp., Amr Corp., Anntaylor Stores, Bjs Wholesale Club, Cymer Inc., Overture Services, Pacific Sunwear Of California, Rf Microdevices, Skyworks Solutions and Zale Corp

S&P MidCap 400^®
Introduced in 1991, the S&P MidCap 400 includes companies with market capitalization between $900 million and $3 billion. These middle capitalization companies cover approximately 7% of the domestic stock market. In June 2003 the largest companies included in the index were Affiliated Computer, Gilead Sciences, IDEC Pharmaceuticals Corp., Lennar Corp, M&T Bank Corp., Microchip Technology, Mylan Laboratories, Washington Post, Weatherford International Ltd.

The index is frequently updated to reflect the current market. In September alone Rent-A-Car, JetBlue Airways, O’Reilly Automotive and Cullen/Frost Bankers were added to the index while Express Scripts, Hispanic Broadcasting, A.K. Steel Holding and InFocus Corporation were deleted.

NASDAQ-100 Index
Started in 1985, the NASDAQ-100 Index represents the largest non-financial domestic and international issues listed on The NASDAQ Stock Market based on market capitalization. The index includes companies across industry groups ranging from internet companies such as Amazon, eBay and Yahoo, to the biotech stocks of Amgen and Biogen, to retail shops like Staples and Starbucks, and computer companies including Cisco, Juniper and Sun Microsystems. It does not contain financial companies, including investment companies.

The NASDAQ-100 Index is calculated under a modified capitalization-weighted methodology. The methodology is expected to retain the economic attributes of capitalization-weighting while providing enhanced diversification.

Lehman Brothers Aggregate Bond Index
Composed of the Lehman Brothers Government/Corporate Bond Index, Mortgage-Backed Securities Index and Asset-Backed Securities Index. Bonds have at least one year to maturity, are investment grade, and outstanding issue of at least $100 million.

Don’t Hang The Spammer, Shoot The Buyer  10/03
Like millions of my fellow consumers I am frequently bothered by unwanted emails. I pay to have an internet connection for my personal use, and I consider it to be thievery when my time is stolen to dispatch these unwanted electronic intrusions.

I have occasionally attempted to stop these intrusions at the source. I was able to get an email purveyor of pornography expelled from Michigan once, and I sent a letter to the editor of the local paper in a New Zealand town identifying their resident spammer (a major producer of those emails offering potions and pills to men desiring enrichment below the belt). I was later informed that the Kiwi citizenry ran the spammer out of town.

But I have come to realize that I’ve been approaching this problem from the wrong angle. Even though 99.99% of those being spammed consider these emails to be a nuisance rather than a service, a few people do buy, and since the cost of delivering all of this electronic vomitus is so inexpensive these morally impaired sellers can still make a profit. I have the solution - eliminate the email buyers and the spammers will disappear.

If you observe a coworker sitting in front of their computer quietly pulling out a credit card, take a discreet glance to see whether they are getting ready to order something like “larger loin lotion” as the result of an unsolicited email. If so, walk over to the coworker, firmly grasp their keyboard in your hands, raise the keyboard up over their head, and proceed to bash the coworker to death. Or, if a firm’s IT Manager observes a reply-to-sender email coming from a vice president’s terminal requesting the monthly e-magazine Lusty Ladies of Latvia, the manager could have the maintenance staff connect the vice president’s mouse to the 220 volt outlet and terminate the subscriber.

It won’t be easy to ferret out those few impulse control challenged individuals that actually buy this stuff, and thereby subject the rest of us to a billion collective hours of wasted time, but I believe with perseverance it can be done. It may presently be a minor infraction of some law to improve the human gene pool in this manner, but laws can be changed. After all, over 99% of the population dislikes spam and most should support a new law legalizing spamanasia and thus improving the human condition.

Senor Suitability Annuity Reg Passes  10/03 
Six months after being introduced, the Senior Protection In Annuity Transaction Model Regulation setting forth minimum standards for insurers and insurance producers that make recommendations to consumers aged sixty-five years or older on transactions involving annuity products has been adopted by NAIC at its September meeting

The new rules state producers must have reasonable grounds for believing the annuity presented is reasonable for their customer, if that customer is over age 65, based on the information presented by the customer. The suitability regulation does not appear to be a concern if long term care or life insurance are involved, if the client is age 64 ½ or under, or if the consumer refuses to furnish necessary information. Compliance with NASD rules will satisfy variable annuity suitability under the regulation.

The regulation requires insurers to develop written guidelines, but little direction is provided by the regulation as to the specifics. A complete discussion of the new regulation will be included in next month’s compendium.

Five Year Index Annuity Returns Very Respectable In A Disrespectable Time    11/03
On 30 September 1998 the S&P 500 closed at 1017.01. On 30 September 2003 the S&P 500 closed at 995.97. Although the 2003 value was 28% higher than the nadir reached in the millennium bear market, it was still 2% below where it had been five years before. However, index annuities performed competitively in spite of enduring the worst bear market since the Depression.

There were fourteen carriers available five years ago offering index annuities that today have completed their index period or posted five years of interest crediting, ten of these provided me with copies of 2003 customer statements, or similar documentation, with personal data blanked out, for a customer that had purchased their index annuity as close to 30 September 1998 as possible. I compared the total return of these annuities with various other vehicles for the same period. The results are as follows:

Since the five-year period ended at a lower index value than when it began, term-end point structured index annuities only credited the minimum guarantee for this dismal market period. Term-end point methods tend to perform well in rising market periods.

Although some annuities had higher total returns than others, the focus should be on the success of the index annuity concept and not individual results. This market period rewarded annual reset annuities with strong first year index participation rates. Market dynamics of the next period might favor caps or daily averaging or term-end point structures. The bottom line is index annuities went through their baptism by fire during this period and all performed as they were designed to do.

The annual reset structured annuities did exactly what they were suppose to do – participate in the index advances in 1998 and 1999, protect the interest credited in the early years during the index declines in 2001 and 2002. And then reset at the indices’ lower levels to take advantage of the index climb in 2003. The average total return for only annual reset annuities was 35.67%.

It is interesting to note that all of the index annuities posted higher returns than index funds for the same period and two of the index products bested returns of the nation’s largest bond fund.

The average index annuity total return at 33.7% was considerably higher than the average stock mutual fund or variable annuity equity sub-account return for the period – which is probably not surprising when the swings of the stock market are considered – but the average index annuity return was better than typical bond vehicles during a reportedly strong bond market, and was also almost 50% higher than the return of the average certificate of deposit.

The first index annuity was purchased almost nine years ago. During their brief existence the stock market has produced years of exuberant irrational returns and historical losses, not a gentle environment for a nine-year-old. In spite of this, index annuities are building a tangible record of performance and protection. Although the future path of the market has yet to be walked, index annuities have proven they offer safety in bad times and extraordinary potential in good.

Ignores sales or surrender charges. Mutual fund returns include reinvested dividends; index annuity returns do not include reinvested dividends. Information believed accurate, but not warranted. Standard & Poors does not sponsor or endorse any index product. AmerUs return period 9/28/98-9/28/03, LSW return period 9/21/98-9/21/03, Lafayette return average of periods ending 9/15/03 and 10/15/03. Lincoln Benefit return period 10/2/98-10/2/03, Standard Life return period 9/25/98-9/25/03. Sources: The Advantage Group, Wall Street Journal 10/6/03, Federal Reserve Board.

Can You Top 1%?   11/03
The main story in this issue is that index annuity returns were very competitive over a difficult period for the financial markets. But another amazing story is seeing the poor yields realized on other vehicles also designed for safe money.

The Investment Company Institute reports that at the beginning of October there were $2.1 trillion sitting in mutual fund money market accounts earning an average return of 0.61%.

Latest numbers from the Federal Reserve Board show there were $3.1 trillion sitting in passbook savings accounts earning an estimated yield of 1.25% and $0.8 trillion parked in small CDs earning around 1.60%.

That’s a total of $6 trillion dollars earning a weighted average return of 1.07%.

Some of this money will probably be moved to bond or stock fund accounts in time, but a lot of money will be kept in place earning returns that don’t even keep up with inflation. If the benefits of fixed annuities – both fixed rate and fixed index – were told to these savers, and even 1% decided to shift money to the annuity side of the safe money street, annual annuity sales would increase 50%.

Annuity Elements - The O Word     11/03

SPEAKER: Index annuities provide the potential for earning more interest than one might earn from a stated rate annuity by linking the crediting of interest to an external index. This index-linked interest is the power side of the power & protection index annuity story. This is a fixed annuity with minimum guarantees. The fixed index annuity has the same advantages and disadvantages of any fixed rate annuity, but it has the potential for crediting more interest because of the index-link.

SPEAKER: Many insurance carriers provide the index-link by buying options on an index...

SPEAKER: An option is a form of derivative…

4^th ROW: Whoa! Derivatives! Didn’t that guy in Singapore or Hong Kong bring down an entire bank by using derivatives? Didn’t USA Today have an article last week saying derivatives killed Enron, Tyco and cause male pattern baldness?

SPEAKER: …that allows the insurer to use the leverage power of options to provide potentially higher interest making this an “extra” ordinary fixed annuity.

When I am speaking to groups and I get to the option part that explains how index annuities can do what they do I can almost see the thoughts expressed above forming in the heads of some audience members. The reason for this reaction is a lack of understanding of how options and derivatives work, and people not realizing that they are already using derivatives and options.

How much money would ordinary people invest in a Managed Bank Portfolio Of Mortgage & Bond Derivatives? The answer is $800 billion according to the Federal Reserve Board. Of course, the bank marketing department name for these derivatives is certificates of deposit.

All the word derivative means is that the value is derived from a larger something else. The rate paid on CDs, and savings accounts as well, is derived from the yield earned from the bank’s investments, just as a fixed annuity rate is derived from the return earned by the insurance company on their portfolio. The auto or homeowners insurance premium you pay is derived from the expectation of total claims that will be paid. (On a side note, I’ve never understood how some people happily assume that the insurance company will give them $250,000 on their homeowners’ policy that has an annual premium of $800 – a 300 to 1 premium-to-payoff ratio; and believe will provide $1 million in crash injuries for a $1,200 auto premium – an 800 to 1 premium-to-payoff ratio; and yet have a tough time accepting that the carrier will be able to return to them the money from the $50,000 annuity policy that they just put $50,000 in). An option’s value is derived from the value of the underlying security.

If you’ve ever given a car seller $100 to hold a car for you at a certain price you’ve participated in options. You put $100 on the table to hold a car, the car seller agrees to accept your $100, the seller is obligated to sell you the car at the agreed upon price. But as the option buyer you are not obligated to buy the car, you simply have a right to buy it at that price. You can walk away and the most you can lose is your $100.

Index options work the same way. Say that an index is currently at a level of 50. The 50 level represents the total value of the securities underlying the index and someone owning a representative portfolio of these securities would also have a portfolio value of 50.

The insurance company could go to this owner and offer, say, $2 to buy the performance of the index beginning at a level of 50 at anytime over the next year. If the owner agrees, he becomes the option seller. The insurance company as the option buyer has the right to essentially buy the index at anytime in the next year at 50. The owner as the option seller has an obligation to sell the index at a level of 50 during the year.

What if a year from now the index value was 60? The carrier would use their option to buy the index at 50, sell it at 60, and make a 20% profit (60/50 – 1) less the $2 cost. But what if the index was at 40 a year from now? The carrier wouldn’t use the option. The owner/option seller’s portfolio lost 20%, cushioned by the $2 received from the insurance company. The insurance company as the option buyer has the right to buy the index at 50, but is not obligated to do so; however, the option seller is obligated to sell the index at 50.

 Which is less risky – $50 put in the stock market, or $48 put in bonds and $2 exposed to stock market risk?

Reinvested Dividends & Index Annuities    11/03
Equity investments, including index mutual funds, include reinvested dividends. The S&P 500 index values used by 96% of index annuity policies in computing index gains do not include reinvested dividends, because the S&P 500 index does not, by itself, include reinvested dividends.

I have heard the lack of reinvested dividends used as a rationale for not buying index annuities. The argument usually stated is a dollar invested in the stock market from 1927 until 2003 would be worth 40% more when you include reinvested dividends, with the implication being that index annuities are inherently inferior because they don’t include reinvested dividends. I don’t dispute that overall stock market gain was 40% larger with reinvested dividends than without them over that 76-year period, in fact the effect of reinvested dividends would enhance returns 40% even when you look at much shorter periods, but I have a few problems with this approach.

Net Returns
Dividend yields on the S&P 500 are currently 1.60% a year. Let’s examine the benefit of reinvested dividends on a year-by-year net return basis for various financial vehicles.

Mutual Funds
John Bogle, founder of The Vanguard Group, says over 80% of mutual fund managers have failed to hit index average returns over the last 20 years, indeed, the typical managed account return is more than 3% below the index return. If one is earning 1.6% a year in reinvested dividends, but losing 3% a year due to poor money management, it would appear one would be worse off in the typical fund than in an unmanaged index that didn’t include reinvested dividends. And this 3% penalty ignores the additional costs of management fees that range from 0.25% to 1.5% a year, and the tax costs that the SEC says lowers the average fund’s return by 2.5% a year.

Variable Annuities
Morningstar reports typical VA fees are 2.2% a year. If you are earning 1.6% a year from reinvested dividends, but paying 2.2% in fees, it would appear you are losing ground.

And of course, if your subaccount is managed by one of those typical money managers mentioned previously, you could be down another 3% in the variable annuity due to bungled returns. In addition, this ignores charges for any optional principal protection riders that might be selected in a VA policy in an attempt to provide some form of index annuity style protection from market risk that is a standard feature of index annuities.

Term End Point Index Annuities
You can select an index annuity that measures total index growth over a period of five to twelve years. These index annuities do not include reinvested dividends, but they do include tax deferral, an increasing death benefit, and guarantee a minimum return at the end of the period of at least principal plus some interest back. Today, you can find a term-end point index annuity with an annual spread of around 2%. It would appear that on a true net return basis that this index annuity would be competitive with many funds and variable annuities.

Dividends vs. Protection
The calculations of index annuity returns using an annual reset methodology do not include reinvested dividends, but neither do they include years with negative returns. An annual reset index annuity doesn’t participate in market losses and thereby turns those years of losses into years of zero gains. If you go back over the last 40, 50, 60, 70 years of the market and replace the negative years with zeros, you wind up with 40% more money.

An index investment that includes both reinvested dividends and years of market losses has produced a total return 40% higher than the naked index. An annual reset approach that does not include reinvested dividends nor years of market losses will have a total return 40% higher than the naked index. It would appear that reinvesting dividends, or eliminating years with losses, have the same effect.

Index Annuity Goals
The annual reset point would be an excellent defense in rebutting the reinvested dividend argument, except for one major flaw. At current rates no annual reset index annuity will credit 100% of effective index movement. At best, annual reset models would effectively participate in half to three-quarters of actual index movement. But that’s okay, because annual or biennial reset structured index annuities weren’t designed to be pseudo-mutual funds or cyborg-VAs.

Apples-to-Apples
What some people tend to forget is index annuities are savings instruments. Their goal is to be competitive with other savings vehicles that also protect principal and credited interest from market risk, and they have done this. Although there will be times when index annuities outperform mutual funds and variable annuities – as they did over the last five years - that isn’t what they were intended to do.

My comments are not intended to disparage either mutual funds or VAs. My point is you shouldn’t take one aspect of one product and apply that aspect out of context to another without considering all of the relevant information.

The next time someone attempts to dismiss index annuities by bringing up the reinvested dividend question enlighten them about what index annuities are designed to do – provide the potential for higher returns than one would get from other savings vehicles while providing a level of protection from market risk that funds and variable annuities can’t match.

3rd Qtr Index Annuity Sales Dip  12/03 
Sales for the third quarter of 2003 were $3328 million compared with sales of $3324 million for the third quarter of 2002. Third quarter index annuity sales were down 11% when compared with second quarter index sales and up 0.1% when compared with the same period one year ago. Half of the carriers reported decreased sales from the previous quarter. The top selling index annuity carriers were:

Index annuity sales for the first nine months of the year were $10.3 billion, a 23% increase over the first nine months of last year. Third quarter index life premium was $20,073,376. This is the twenty-fifth quarterly index sales survey conducted by The Advantage Group. In all, 97% of the active index product companies accounting for over 99% of sales are represented.

There are 31 carriers offering equity index annuities. If you separate available products by features, there are:

121 Index Annuities - By Surrender Period & Methodology

127 Index Annuities - Plus Bonus Rates, Cap/No Cap Option

193 Index Annuities - Plus Other Available Indices

American National and Physicians Life reentered the market with the Equity Index Annuity and Vista Index Solutions, respectively. They represent the first increase in provider ranks since January. New product introductions were Fidelity & Guaranty Spectrum Rewards Bonus, ING Secure Extra Return, and Jefferson-Pilot Eclipse and OptiPoint.

Insurance agents represent over 49 out of every 50 index annuities sold. In the third quarter products with surrender periods of ten years or less had more than half of the market for the first time since the third quarter of 2000. Annual reset designs represent nine out of ten sales, and averaging of index values takes place in seven out of ten sales.

The weighted agent commission based on index annuity premium paid has fallen from 10.44% in the third quarter of 2002 to 8.10% in the third quarter of 2003. Average weighted commission paid by carriers ranged from 3.57% to 12.14% of premium. The market share of bonus annuities declined from 58.4% to 48.5%. Sales rankings of the top ten index annuities are as follows:

I asked the carriers what percentage of their agents had sold an index annuity. Although too few responses were received to produce a statistically valid result, the majority of responding carriers reported low single digit percentages of index annuity selling agents. The Advantage Index Product Sales Report will continue to gather index sales data on a quarterly basis; the report for the fourth quarter of 2003 will be available in February 2004.

Senior Protection With Ethereal Form  12/03 
In September 2003 Model Regulation #275 was adopted by NAIC. The Senior Protection In Annuity Transactions Model Regulation set forth standards and procedures for recommendations to senior consumers that result in a transaction involving annuity products so that the insurance needs and financial objectives of senior consumers at the time of the transaction are appropriately addressed. It should be noted that a model regulation does not become effective in a state until it is adopted by the state, and there is no certainty that this regulation in any form will ever be enacted in a given state.

It is a “free form” type of document in that there are no rules, suggestions, nor templates mentioned to aid a carrier or producer in attempting to meet the stated purpose of the regulation. The model regulation does say a regulator may take appropriate action for violations of the act, but offers no suggestions defining what a violation is or what the punishment may be. The whole thing is kind of like driving a car where the police could say, “We can’t tell you what a traffic violation is, but depending upon how we feel, running a stop sign could bring you a $25 fine or the death penalty!” However, even though trying to get your arms around the model in its present form is like hugging a cloud of steam, the model regulation needs to be broadly written because the definition of an “appropriate recommendation” is in the eye of the beholder, and the lines will be shaded in as time goes along.

How It Works
The way this is intended to work is the insurance company will create guidelines defining what an appropriate recommendation is, and will establish a system of supervision to ensure the producer is acting properly. The insurer may require the agency between the producer and carrier do the actual supervision, but the insurance company is ultimately responsible.

What Isn’t Covered
The model is specific on what it doesn’t cover. The Senior Protection Model is not extended to transactions involving life insurance, long term care insurance, Medicare supplement policies or annuities purchased by consumers under age 65. Annuities used to fund 401(k) or 457 plans, an employer’s nonqualified deferred compensation arrangement, or any ERISA covered pension plan are also outside the scope of the regulation.

Loopholes
Is there a loophole the producer can use to avoid the whole “appropriate recommendation” question? Yes, a big one. The regulation states the producer (and insurer) is off the hook if the senior consumer:

(a) Refuses to provide relevant information requested by the insurer or insurance producer;

(b) Decides to enter into an insurance transaction that is not based on a recommendation of the insurer or insurance producer; or

(c) Fails to provide complete or accurate information.

A producer could conceivably escape all consequences if all of his senior annuity buyers signed an insurance world equivalent of an “unsolicited transaction” form used by stockbrokers, whereby the consumer said the buying of an annuity was all the consumer’s idea.

A First Step
Although the language of the model regulation is not perfect, it is at least a first step in attempting to rein in ethically challenged producers and insurers. Something had to be done. Insurance market conduct rules are so weak that some state attorney generals and state security departments have been going after rogue agents by themselves, essentially bypassing state insurance departments. There is sustained talk of the need for a national insurance commission to supplant state supervision. A 2003 report for the Insurance Legislators Foundation says the whole approach to market conduct regulation by the states needs to be rethought.

The Senior Protection Model is a response by insurance commissioners that requires insurers to develop compliance guidelines and attempt to police their own producers. Insurance carriers need to develop meaningful senior annuity protection programs that they can work with and control, or risk the chance of rigid, mandated procedures being forced upon them.

Template
The insurer needs to create a framework to recognize when an annuity recommendation may be inappropriate. The first step is deciding which consumer information is needed and relevant to the recommendation process. In addition to basic financial data the consumer should provide information relating to their needs and goals, their risk tolerance, their time horizon, the source of the premium, as well as any unique elements that could affect appropriateness. A Fact Finding & Information Form helps the producer get the relevant information needed and provides a basis for review by the insurer.

The next step is to establish a system of written procedures to supervise recommendations and detect inappropriate recommendations. The system developed by The Advantage Group does not review every producer solicited transaction, but instead is designed to detect situations that may provide a higher potential risk for inappropriate recommendations, and also to identify producers that may be involved in a greater proportion of these higher potential risk situations than would normally be expected. The advantage of a “by exception” review process is resources are used only when there is increased likelihood of an inappropriate recommendation; however, insurers could also develop procedures whereby reviews would be conducted on a random basis, or a system in which every senior transaction is reviewed.

The final step is deciding upon the action taken if a recommendation is found to be inappropriate. If a recommendation is suspect The Advantage Group system has the designated supervisor conduct an interview with the consumer and then forward a copy of their findings to the senior manager responsible for certifying all is in compliance with the Senior Protection Model. The senior manager then determines if a senior consumer has been harmed by the producer’s violation of these guidelines, and takes reasonably appropriate corrective action.

Proactive or Reactive
The insurance industry is heading towards a future of enhanced regulatory supervision; the Senior Protection Model is merely the first brush. The question for insurers is does it make sense for them to be ahead of the regulatory curve and begin addressing the appropriateness issue now, or wait until required to do so and then act at the minimal acceptable level?

The disadvantage of a proactive approach is the possibility of developing and being held accountable to tougher standards than the law currently requires. Greater emphasis on appropriate recommendations should lead to happier annuityowners and fewer complaints, but it could also result in producers heading towards less supervised pastures and reduced sales for the carrier with the guidelines. In addition, a supervision program creates a documented transaction trail and leaves open the possibility of someone second-guessing “why a recommendation was not found inappropriate when it’s easy to see now why it was”. An insurer needs to carefully weigh whether it is better to lead the coming regulatory wave or float with the tide.

Situation Realization Marketing  12/03 
The financial services industry has usually used the spaghetti school of marketing, which states that if you throw enough promotional strands at a wall of consumers something will hopefully stick. The problem is it doesn’t matter whether you use media advertising, direct mail, telemarketing or emailing, on any given day a consumer is bombarded with thousands of marketing messages and the standard defense is to tune everything out. Your only hope is to somehow get your message of a solution across at the same time the consumer realizes they have a problem. The situation realization utilizes a window for a marketing message to reach the target.

This strategy does not go after the demographics of the consumer segment that should need your product, but instead targets the situation that causes awareness of the need for your product. Here is an example of what I mean: Whenever the weather forecast in my town is for snow, the radio station I listen to runs ads for a local hardware store talking about their fine snow shovels and handy bags of salt. When I hear this ad I go to the hardware store to get my yearly supply of rock salt, and find the store is doing a brisk business in all snow related merchandise.

This approach is not based on demographics. The store did not determine that the average snow shovel buyer is a male, age 48, with 2.3 children, and develop a campaign to penetrate this segment. Instead the store waited for a situation where the consumer’s thought realization process would go something like this – see snowflake, see snowflakes fall to ground, remember blizzard of ’82, oh-oh, need shovel – and then uses a radio ad to inform the consumer where the shovel may be purchased.

The same strategy can be used with annuities. Instead of marketing annuities to a 62-year-old home-owning consumer, the situation is targeted so that at the same time the prospect realizes…

the interest from their CDs won’t cover the light bill anymore…
the last bond mutual fund statement showed they had lost money…
the article in Modern Maturity said some widows outlive their money and are reduced to poverty.

There is a solution told by…

A statement stuffer or a postcard received stating whom to call for the higher rates on fixed annuities…
radio ads inviting folks to a seminar talking about avoiding market losses with index annuities…
a print ad opposite the Modern Maturity article explaining the benefits of immediate annuities.

This is not a new approach, but it’s a more effective one than dripping your message in the river of other messages and hoping it somehow finds the consumer. The approach depends on understanding what situations will create the realization of need and acting in a timely fashion.

In 2002 mailing current fixed annuity rates to almost any consumer was like dynamite fishing in a trout farm, but I was amazed by the number of producers that didn’t exploit the marketing opportunity because they didn’t realize this was a temporary situation. As the spread between annuity and CD rates narrowed, the urgency to obtain the annuity solution faded, and although fixed annuity sales are still strong it is a tougher sales environment than last year. The opportunity must be exploited when the realization occurs. What are other situations that can create the realization that an annuity is a solution? I’ll discuss a few of these in a future issue.

Top