Easy To Predict 4/08
Last month The New York Times used the “D” word in a story titled “Depression You Say? Check Those Safety Nets” showing that concerns over this turn of the economic cycle had reached panic levels among reporters looking for a catchy headline. Keeping in mind that my rough research of Wall Street economists finds their predictions are wrong 80% of the time, and that I cannot claim a better accuracy rate, I still wanted to opine on what I see as cycle realities. 

It was easy to see coming 
In August 2005 I wrote that a bear market and recession were coming. I said this would happen by the end of 2006 (not counting on the effects of blind greed and the greater fool theory delaying the start for another year). Part of my concern was interest rates had remained too low in the recovery. The Federal Reserve Board, still fighting the last inflation war, didn’t seem to realize that altho low interest costs might keep corporate borrowing costs low and therefore corporate prices low, it also kept monthly payments too low. American homebuyers do not understand actual value they understand monthly payments, and low interest rates made it possible to pay more and more for the same low value without needing to accept that fact that this was dumb. Financial experts helped by creating new mortgage types that further distorted the value relationship. And the mortgage companies expanded the number of buyers able to buy real estate by not requiring homebuyers to have any skin in the game. Essentially the real estate market turned into a huge poker game where some of the gamblers kept bidding up the size of the pots with the knowledge that if they were lucky they could keep the winnings, but if they lost they wouldn’t be responsible for the losses.

The financial firms blithely ignored the reality that many of the mortgages were worthless because they were paid based on the number of mortgages written and not the ultimate quality. They created instruments that passed along the risk to others, but then failed to evaluate whether the buyers of this risk had the wherewithal to cover the risk.

A reason for this oversight is they made themselves believe the financial quants 99% rule. The 99% rule essentially says if a possible outcome is more than four standard deviations from the average outcome it can be ignored because this means the odds of the outcome happening are less than 1% according to the model used. Since the likelihood of a liquidity crunch caused by bad mortgages was 25 standard deviations away from the expected outcome (Index Compendium Sep 07) it was treated as an impossibility. The shell game was Company A sold the default risk on a package of mortgage bonds to Company B and Company B would be responsible for paying off in case of a default. However, because the risk of default was so low – the 99% rule – no one required Company B to actually have the money to cover the risk. Since the default couldn’t happen, based on the computer models supporting the 99% rule, Company C gladly lent money to Company B to pay for this risk. Of course if a default did happen Company B would not be able to payback the loans to Company C or cover the original mortgage investors in Company A. Good bye Bear Sterns.

Inflation  
The other part of my concern was the effects of $60 a barrel oil (in 2005) on the economy and the deficit spending in Washington (an aspect that is still being more or less ignored). The Consumer Price Index calculates that offering a 25” TV next year for the same price as a “24” inch TV this year offsets the inflationary impact of the price of bread going from $1.50 to $2 a loaf and results in net inflation of zero. The screwy way that changes in the CPI are deduced meant the Fed was able to delude itself that what they were doing was working and inflation was low. In reality, costs on real consumer goods were soaring.

The Economist uses the Big Mac index to compare international prices; I use the Taco Bell indicator. In 2003 you could buy a bean burrito from the Taco Bell value menu for 99 cents. By 2004 the value menu had been revamped with the 99 cent bean burrito replaced by this really gnarly 99 cent bean & rice burrito. The nearest edible food was a new combo burrito for $1.19. Price of the new combo burrito increased to $1.39 in 2006 and $1.59 in 2007. The bottom line is five years ago I could get my Taco Bell lunch for $2.10 with tax and today it costs $3.37 – a 60% increase or an annualized inflation rate of 10% a year. 

It is not only Taco Bell prices that are up. The average family has seen their monthly gasoline bill increase 140% during this time impacting all aspects of their life, and food prices have soared due to poor global wheat harvests and a politician-driven policy on gasohol. Rising prices and recession fears have caused some reporters to dust off old articles on stagflation from the ‘70s

And annuity markets?  
One nice thing about being retired is you don’t have to worry about losing your job. However, recessionary fears cause stock markets to swoon meaning the retirement nest egg gets smaller, and efforts to lower interest rates mean that the interest earned from certificates of deposit and money market accounts drops. Inflation means the cost of staples are going up whilst income is going down. All of this creates a positive environment for fixed annuity sales.

Falling rates means that fixed annuity rates and index annuity caps will continue to fall. The good news is bank rates will fall farther and faster. The 5% fixed rate or 7% index cap that is meeting some sales resistance today will turn into fast selling 4% fixed and 6% cap rates six months from now because CD rates will be at 2%. The sales environment for fixed annuities will steadily improve.

Safety
Northern Rock was a British mortgage lender that got into trouble in 2007. By early 2008 the Bank of England had dumped $108 billion in loans and guarantees to Northern Rock. FDIC has $52 billion on hand. It is interesting to note that the failure of one bank caused British regulators to kick in more than double what FDIC has on hand to cover $4.35 trillion of deposits.

Commercial banks originated and purchased mortgage packages and I think we will see several bank failures as a result. I also believe that FDIC coverage will be provided for all covered deposits (tho uncovered deposits in failed banks will get back less than a hundred cents on the dollar).

I have only looked at the balance sheets of a few annuity carriers; some own suspect mortgage loans and some do not. I would not be surprised to see an annuity carrier fail as the mortgage crisis fallout continues. However, it is important to remember that insurance carriers look at the financial world in a different way. Most of the financial world seems to use that 99% rule where if the risk is less than 1% it is ignored. By contrast insurance carriers are trained to look for hidden risk and act accordingly. Insurers do not ignore 1% risks they target them and hedge to cover the risk. This is why I believe fixed annuity carriers will generally weather this financial storm better than banks.

FDIC can borrow all the money they need from the Treasury, so if a bank fails the insured deposits should be available the next day. State Guaranty Funds are funded in arrears meaning that after an annuity carrier fails other carriers are asked for any needed money. This means that even tho an annuity covered by a Guaranty Fund would eventually be paid in full the entire annuity balance may not be immediately available.

Crystal Ball
I think this will be a nastier recession than the last two and that the stock market still has some way to fall (but the fall won’t be as bad as the millennium bear market). I think interest rates will drop in 2007 and then go up because this time there really is price inflation. I also believe fixed annuity sales will increase as bank rates fall and consumers get out of stock market investments and look for a safer place to put their money (however, it probably makes sense to diversify annuities between carriers). All in all 2008 and 2009 will be tough years, but the cycle will turn once again.

2007 Index Annuity Complaints Steady  4/08
In 2004 the index annuity carriers averaged one customer complaint for every $614 million of premium sold, in 2005 the rate was one complaint for every $310 million and in 2006 the index annuity carriers averaged one customer complaint for every $119 million of premium sold. In 2007 there was one complaint for every $109 million of premium. What this means is there were roughly six times as many specific complaints against index annuities in 2007 as there were in 2004.

There is a “but” in all of this. Even tho the rate of complaints increased slightly from 2006 to 2007 for all index annuity carriers if you exclude Allianz the complaints decreased. Without Allianz the rest of the industry had a complaint rate of one for every $145 million in 2007, down from $118 million the previous year. While all index carriers averaged one complaint per $109 million of premium sold the top 25 carriers averaged one complaint per $111 million. The worst ratio for any individual top 25 index annuity carrier was one complaint for each $50 million of sales.

The National Association of Insurance Commissioners (NAIC) gathers data on customer complaints from all of the state insurance departments. This information is available on the Consumer Information Source (CIS) part of their web site http://www.naic.org/cis/index.do on a company by company basis. I reviewed and totaled the number of closed customer complaints for 2007 relating to index annuities. I found no complaints for seven carriers.

Caveats
These closed customer complaints cover the gamut from fraud to delays in policyholder services, and although the complaints are closed I am unable to determine how many were resolved in the carrier or agents’ favor. The data base relies on voluntary reporting from the state insurance departments and may not be thorough. The NAIC database does not include complaints filed with state security offices, NASD or SEC; however, it has been difficult for me to find hard data from these other sources that would radically change the implications of the data collected.

Comment
I saw a slowing in the increase of overall complaints over the previous year, which is good news, but it is not as good as a decline in complaints. Based on anecdotal evidence I believe part of the reason for the increase is that annuity customers are being encouraged to complain by securities salespeople, but the fact remains that there appears to be more unhappy index annuity owners than there were a few years ago.  

But The Complaint Percentage Is Very Small
It is difficult to determine the percentage of complaints because this year's complaint list may include a purchase from a previous year. However, whether the complaint ratio is based on current year sales, in-force annuities, total index annuity owners, or any other parameter the percentage of index annuity owners that did not file a complaint has never been less than 99.7% and maybe as high as 99.999%.

Data Sources:LIMRA, NAVA, Annuityspecs.com

Rainbow Method 5/08
Altho new to the index annuity arena the Rainbow concept itself is not new. It has been used for many years in the investment world, and I wrote about this securities option strategy, as well as several others, three years ago. It is an option basket whose best-performing indices are weighted more heavily than those that perform less well. It is always a "look-back" because the money is allocated based on the ranking of the performance after the period is over. Currently six carriers offer rainbow allocation crediting methods, but not all allocation methods are rainbows. For example, Allianz Endurance and ING Envoy products also credit interest based on the blended performance of multiple indices, but the specific index allocation is fixed at the beginning of each year so they are not rainbow methods. 

Do rainbow methods run a better horserace? 

The Rainbow marketing appeal has been expressed by saying that the annuitybuyer gets to bet on the race after it has been run and that most of the bet will be put down on the horses that “win or place.” To determine whether the different rainbow allocations may be a better horserace I have run calculations going back to 1991 using April 2008 rates to produce hypothetical returns for both rainbow and S&P 500 only crediting methods. I attempted to compare rainbow methods with S&P 500 only methods within the same or similar carrier products. Because index annuities are used, any years with negative returns were replaced with zeros.

A problem with most rainbow indices is short history. With the exception of DJIA and S&P 500 the other indices generally have been around less than 25 years, and I am unsure whether this provides enough track record to be meaningful. Three of the four carriers include the EuroStoxx 50 in their mix and this index has only been around for 6 years, with almost all of its history occurring in a bull market. However, I discovered that a composite index made up of half German DAX and half French CAC 40 values had a 0.99 correlation with the EuroStroxx 50 since its inception. In others words, a 50/50 mix of the DAX and CAC has essentially mimicked the EuroStoxx 50, therefore I have used my composite index as a proxy for the EuroStoxx 50 prior to July 2003. 

I examined rainbow products from AIG, Aviva, National Western and North American Company. Rainbow products are also offered by American Investors and Midland National, but these were basically the same as the respective Aviva and North American ones. I picked products without bonuses and with surrender periods of 10 years or less. These examples apply current rates to 195 past rolling 12 month periods. The past does not predict the future and all of these rates could change wildly in years to come, so the returns should not be viewed as real numbers or investment advice. Finally, no index sponsors or endorses any index product.

Comments
If the S&P 500 is having a rotten year a rainbow method probably will not produce a great return; all stock markets tend to respond to news and changing economic conditions similarly. However, the rainbow method could offer higher returns than the S&P 500 alone in good times if pricing of the options was similar.  

The advantage of the rainbow method in having greatest participation in the top performing index is handicapped by a cap. Capping the rainbow method somewhat defeats the main attraction of using the method. However, if the option cost of the rainbow method permits higher caps than the S&P 500 alone might receive, then using the rainbow method would be justified.

In all hypothetical cases the Rainbow method produced higher average returns

The goal was to see which would have hypothetically performed better – the Rainbow method or the S&P 500 only methods. I discovered that in all cases the Rainbow method produced higher average returns, but there is insufficient data to deduce whether this is due to any inherent superiority of the rainbow method or simply an aberration in current option pricing. The rainbow method is a legitimate addition to index annuity methodology. I believe it provides the greatest potential interest when offered without a cap, even when offered at lower participation rates or higher spreads. However, if the rainbow method uses a cap, and the rainbow cap is higher than the cap for the S&P 500 alone, I would pick the rainbow method at a higher cap every time.      

Savings Bonds Are A Terrible Investment Now 5/08
Altho one might have purchased Savings Bonds in the past because they offered safety, tax deferral, minimum guarantees and usually rates that were at least competitive with banks, I would not buy one now. The new long-term rate on Series EE bonds is 1.4%. That's it, and the 1.4% is locked in and will not change. Series EE bonds still promise to return double your money in 20 years - an effective return of 3.5% - but if you take out your money early you would only earn 1.4%. In actual dollars this means if you put $5000 into a Series EE Bond today you would get back $10,000 in 20 years, BUT if you cashed in the annuity in 19 years and 364 days you would get back $6,602; this is equivalent to a 68% surrender charge!

Existing bonds have also taken a hit. Any Series EE bond purchased in the last 11 years is currently earning 2.74%.

I Bonds were attractive because they gave you a fixed rate of at least 1%, plus extra interest that was index-linked to the rate of inflation. But any I bonds purchased today do not have an interest rate floor. If inflation stays low I Bond returns could be much worse than other safe money places because the fixed rate is zero. Today, it does not make sense to buy U.S. Savings Bonds.

First Quarter Index Annuity Sales Drop   6/08
The Advantage Index Product Sales Report produced by AnnuitySpecs.com shows first quarter 2008 index annuity sales were $5776 million compared with sales of $6436 million for the previous quarter. First quarter sales were flat when compared with the same period one year ago.

The top ten carriers for the first quarter:

Average Commission
The index annuity commission received by the agent averaged 8.00% of premium. .  

  H.R. 5840 6/08
In April Congressman Paul Kanjorski (D-PA), Chairman of the Capital Markets, Insurance and Government Sponsored Enterprises Subcommittee, introduced the Insurance Information Act of 2008 (H.R. 5840). The Act would establish an Office of Insurance Oversight (OIO) that was outlined in the U.S. Treasury Blueprint for a Modernized Financial Regulatory Structure. 

The main purposes of the bill are to give the Federal Government an insurance resource that could talk about international insurance regulatory issues, and advise Congress, the President and the Treasury about important insurance concerns. The big teeth in the law is it would give the Treasury Secretary the power to preempt state insurance laws if they were at odds with U.S. policy. 

The NAIC reaction to previous attempts at federalizing insurance regulation has been to vigorously defend their turf, but not this time. NAIC proposed working with the Feds to fix problem areas and said they would be open to creating an insurance self-regulatory body – regulated by NAIC – that would work with the Treasury.  

The National Association of Professional Insurance Agents (are there amateur insurance agents?) does not like the bill, the National Conference of Insurance Legislators (NCOIL) expressed concern, and the American Council of Life Insurers seems to like it. I like it because it could stop the securities regulators from grabbing more insurance turf and requiring all annuities and cash value life insurance policies to be only sold by securities regulated agents. 

Nothing will happen with all of this in 2008, but a federal insurance department is closer than it has been before.