The Effect Of Volatility On Caps In Indexed Annuities

Several of the staff at Creative meet monthly with our Creative Agent Advisory Board (CAAB) to discuss our programs and services, and get feedback from these representatives of our independent agent field force. Interesting questions come from these meetings. One CAAB member, a registered securities representative, teed up this question: “If today’s extremely low interest environment causes a fixed annuity issued today to have low credited rates for its entire term, what is the effect of volatility on caps in indexed annuities, because most policies rebuy options every year and re-declare caps?” I thought you might want to know my response.

First a few caveats. My conclusions are based on theoretical pricing (with no loading for option seller’s expense) using Black-Scholes modeling. This is a decent approximation of market prices much of the time, but markets can act in “non-normal” ways at times. I also assume insurance carriers actually set their crediting factors fairly in line with original policy pricing and spreads (a critical point in selecting a carrier). Finally, assume that most annuity companies will continue to use a “new money” investment approach to crediting interest, meaning future interest environment changes have little effect on the bonds used to back today’s annuity sale. In contrast most companies use a portfolio rate which floats with the insurance-backing asset portfolio for their life insurance.

Yields for 10-year “A” rated corporate bonds are about 2.80% today, and caps on one-year S&P 500® index crediting are 2% to 3%.

Yields for 10-year “A” rated corporate bonds are about 2.80% today, and caps on one-year S&P 500® index crediting are 2% to 3%. That’s because even with index volatility below historical averages (say 13%-15% today), a company has an option budget of only about 1% after deducting from the 2.8%, a provision for commissions, expenses, profits and some policy guarantees. What happens if volatility jumps to 30% at the next anniversary? Surprisingly little. When volatility is so much higher than caps (15% vs. 2% or 7.5 to 1), there is very little probability that the index change ends up in the variable range 0%-2% (roughly 5.5% probability).

The rest of the time the option payoff is either zero or 2%. If volatility doubles it just makes that variable range slightly less likely (2.7% probability) and the 2% credit more likely. The cost difference is negligible. The conclusion is that unless we get into single-digit volatility, which could cheapen the option and raise caps (historically very unlikely), a 2% cap at issue today is likely to stay that way for the policy term.

What about the other types of indexed interest formulas and indexes?

  • Participation-rate (PR) allocations

    Participation-rate (PR) allocations will experience the full weight of volatility changes. A volatility increase from 15% to 30% would roughly double cost and halve PRs which today are in the 20% range down to 10% (of course contract guaranteed minimums on some contracts may prevent this). Going to 10% volatility would proportionately increase caps.

  • Spread/fee designs

    Spread/fee designs are the most susceptible to changes in volatility for the very reason that PR rate designs are directly related to volatility (in this example) and caps are not very related. A cap design is simply being long a PR option and selling a spread (out of the money) option. Buying a proportionately sensitive option and selling an insensitive option gives you a position highly sensitive to volatility rises. This is the reason that there are no spread designs on point to point (fees would have to be able to go to extraordinary heights to allow for higher future volatility). The monthly average is used to desensitize spread designs to volatility. However, even then, it is still pretty sensitive to large volatility increases.

  • Monthly point to point design

    Monthly point to point design is already insensitive to increasing volatility because high volatility tends to increase unbounded (unfloored) monthly negatives. In fact, rising volatility could cause option prices to actually decline, meaning higher monthly caps are possible.

  • BalancedAllocation Annuity (ANNEXUS)

    The strategy available on the BalancedAllocation Annuity (ANNEXUS) is a participation rate/spread combination strategy, which means it should be somewhat more sensitive, but its two-year calculation term (one less ratchet/reset per term) mutes this sensitivity.

  • Total Value Annuity (Security Benefit)

    The strategy available on the Total Value Annuity (Security Benefit) is an innovative volatility-reducing alternative index (a commodity/currency/interest rate trending index) that is less sensitive than the S&P 500 index and, combined with its longer five-year calculation period (four fewer ratchets and resets), results in nearly no need to change its 100% PR/0% spread/no cap.

I hope this helps your ability to assist clients in planning their annuity and life purchases, both at initial and subsequent allocations. You can always count on Creative for straight talk about sales, products and our industry. Your Creative Consultants can guide you.


Related terms: Word From The Wise

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