There are certain times that I will invoke the use of a fixed index annuity, or indexed universal life policy that have certain crediting strategies that appear too good to be true. The indexed annuity, or indexed universal life may be beneficial in certain portfolios for a portion of the overall strategy. If a client is looking for income, or wants to place an amount of their money in a vehicle that can grow without equity market risk, a fixed indexed annuity may be a good fit. An indexed universal life policy may be a great addition to a portfolio if you want a death benefit, with potential cash accumulation, and maybe even some chronic illness benefits. What most fixed indexed annuities and indexed universal life policies have in common, is a crediting strategy that allows for growth that is in relation to an equity index, i.e. the S+P 500 that is capped on the upside but usually has a floor of zero for losses. The client has no market risk regarding losses. When I explain this to clients, the next question is “How can they do that”! The answer sounds very technical but is quite simple. First off, all this is done in the insurance companies “Hedging” office or whatever firm they use to hedge for them. Typically, but not always, the insurance company takes your premium dollars, let’s use $100 as an example. Using approximate dollars, the first $95.00 is invested in investment grade corporate bonds for the insurance companies benefit. Another $ 2.00 is paid in expense for the policy, like administrative, commission to agent, para-med exams if it was a life policy. The last three dollars go toward an option contract that will be for the index cap and crediting strategy that you chose. You must understand that a variable contract, whether it’s annuity or life, is a totally different structure that I do not advise for my clients. Variable contracts typically do not protect the principal, and have market risk and high fees. The “guaranteed benefit base addition” is often mis-understood by the client, and/or not explained by the agent.
Having been a manager, and trader of a fund that uses options and futures hedging strategies, I can guess that they are using a spread strategy and buying a call option at the strike price of where the index is trading when you fund the policy, and selling a call at the upper limit of your index cap. The sale of this call option funds a portion of the purchase of the more expensive “near the money” call. It sounds confusing, but when you do it on a regular basis, it’s one of the simpler option strategies employed by fund managers.
The insurance company is typically invested very conservatively, allowing the client to get credited the capped upside to the index, with no market risk. However, there are many moving parts that must be evaluated.
