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The following article, originally published Nov. 5, is being republished to provide clarification of certain points about equity index annuities. Responses to the original story from Aviva and American Equity Investment Life Insurance Co. also follow this article.

Insurance companies that have sold billions of dollars worth of annuities that guarantee interest payments even when stock indices fall could face increasing pressure on their general accounts if the current downturn continues for an extended period of time.

Equity index annuities (EIAs), also known as fixed index annuities, pay holders an interest rate that is based on the performance of a market index, such as the

S&P 500

, which is down 38% this year. As the index goes up or down, so does the amount of interest the insurer pays the annuity holder. However, EIAs guarantee the principal and offer a minimum guaranteed interest rate, generally about 3% (the "fixed" component).

Policy holders can be confident that they will receive at least the minimum payments guaranteed by their contracts. Insurers rely on their general accounts, typically invested in high-quality bonds, to cover the cost of making the guaranteed payments.

So there is risk to the insurance company on both the upside (if the index increases substantially) and on the downside (if general account investment yields fall below the rates credited to the guaranteed minimum contract values). It's important insurers manage both risks effectively.

Insurers typically manage the upside risk by purchasing call options timed with the annual interest credit on contracts. Conversely, the downside risk -- that the insurer will have to make good on the minimum guaranteed contract value if the market is flat or falls for a prolonged period -- is managed via the investment yield earned on the company's general account assets.

Since the S&P 500 is down so far this year, insurers will likely have to pay EIA policy holders from general account yields to satisfy the minimum guaranteed contract values. The insurers are required by state regulators to maintain capital in safer, fixed income investments like bonds to back the products. Conversely, regulators allow issuers of

variable annuities

, which have caused trouble for insurers like

The Hartford Financial Services Group

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, to back their products with less capital, as the products are designed to pass more risk onto the policy holders.

Several years of declines in the stock market, as some are expecting, could force the insurers offering EIAs to draw down on general account yields longer than they might have expected, pressuring the companies.

Top Five Equity Index Annuity Providers



is the largest issuer of equity indexed annuities with $2.8 billion in sales, according to the Advantage Index Sales & Market Report published by

. While the U.K.-based company did not break out equity index annuities in its third-quarter financial report, it posted flat capital reserves of 11.5 billion pounds, as declines in the equities markets were offset by factors such as better exchange rates as the dollar gained against other currencies. The company will not report its bottom line until the end of the year.

American Equity Investment Life Holding Co.

(AEL) - Get American Equity Investment Life Holding Company Report

is the third-largest player with $1.1 billion in fixed index annuities sales during the first half of the year. In its third-quarter

Securities and Exchange Commission

filing, American Equity swung to an $11 million net loss, its first this year. Revenue dropped by $105.5 million, primarily due to $59 million in realized investment losses and an $84 million decline in the fair value of derivatives.

Allianz Life

( AZ) is the second-biggest seller of equity index annuities in the first half of the year with $2.1 billion. It reported a 2 billion euro net loss for the third quarter, but did not break out performance of equity index annuities.

Rounding out the top five fixed index annuity companies are

Midland National Life


Old Mutual

, neither of which are publicly traded.

What are Equity Index Annuities?

Buyers of equity index annuities typically pay a lump sum premium up front. The average lump sum amount in the second quarter was $52,460, according to

. Then the insurance company agrees to pay the annuity holder an amount based on the performance of a stated market index such as the S&P 500 or an aggregate Treasury index. If the return of that stated market index goes below a certain percentage, then the insurer pays a guaranteed minimum on 87.5% or 90% of the initial deposit.

This simple concept then gets much more complicated. First, there is what is known as a participation rate. This essentially determines how much of the gain is credited to the annuity value. If the participation rate is 80%, then the interest rate paid to policy holders will be 80% of the gain in the index.

Instead of a participation rate, some companies use a spread that is subtracted from the index gain before it is credited to the annuity. For example, if the index gains 10% and the spread is 3%, the annuity is credited with 7%.

Yet a third way to determine the amount of the index credited to the annuity is via an interest rate cap. This simply means that the insurer puts an upper limit on the percentage it will credit to the annuity, regardless of how much the market index returns.

To further complicate things, there are typically three ways the insurer determines the percentage change in the market index. The first way is an annual reset or annual point to point whereby the change is calculated by comparing the index at the beginning of the year with the value at the end of the year.

The second method is called the "high water mark," which is to take the value of the index at particular points in time during the contract period and compare the highest point it to the level at the beginning of the contract term. This method is rarely used any more.

The third method is called monthly point-to-point, which is simply to compare the index at the beginning of the month to its value at the end of the monthly. Some insurers also average index levels monthly.

The method of interest crediting can have a dramatic effect on the performance of the annuity.


Financial Industry Regulatory Authority

does an excellent job of explaining the complexity of equity index securities on its Web site.

EIAs typically have very high fees if an annuity holder wants to withdraw money early. These are known as surrender charges. This charge is the highest during the very early years and generally declines on a sliding scale until it goes to zero in what could be as much as 10 or 15 years. In its second-quarter report, American Equity reported that its average surrender charge collected was 15.3%.

The guaranteed payment from an insurer is only as good as the strength of the company paying it. If that insurer becomes


and is taken over by regulators, policy holders likely will be paid in the end, but regulators could restructure the terms of the contract, potentially making them less attractive. So it's important to know how financially sound a company is before you purchase an EIA or any other retirement product. Ratings issues financial strength ratings on each of the nation's 8,600 banks and savings and loans which are available at no charge on the

Banks & Thrifts Screener

. In addition, the Financial Strength Ratings for 4,000 life, health, annuity, and property/casualty insurers are available on the

Insurers & HMOs Screener


Response from Aviva

A response to this article, submitted by John Currier, executive vice president and chief product officer of Aviva USA, is below.

In her Nov. 5 article, Ms. Gannon not only grossly mischaracterizes equity index annuities by implying that the indexed interest credits of these products create financial strain on insurers in the same way the guarantees on variable products do, she unfortunately has most of her facts wrong.

First and foremost, traditional fixed annuities are insurance products -- not securities that are tied to an index as Ms. Gannon asserts. In addition, equity index annuities provide customers with protection against downturns in markets, such as the one we are now seeing. These policyholders enjoy peace of mind knowing that their assets are protected and growing -- even with declines in the overall market.

Fixed indexed annuities (FIAs) are almost identical to traditional fixed annuities -- both products are backed by the insurer's general account portfolio, consisting mostly of high quality bonds. However, the credited interest formula of the fixed indexed annuity is tied to a specific securities index where a traditional fixed annuity uses a declared rate. However, contrary to Ms. Gannon's assertions, because FIAs are insurance products, the investment risk is placed firmly on the issuer, who backs up, or guarantees, the product. This enables FIAs to provide a guaranteed principal protection and minimum cumulative rate of return. In fact, these returns may be even higher, depending upon the performance of that specified index. The underlying guarantees are met by the general account investments and do not rely on a long-term equity hedge, as the article seems to imply.

Given these product features, FIA policyholders can look forward to guaranteed cash surrender values at any time, and a fixed monthly or annual payment upon maturity of the annuity contract -- with the potential to improve upon those guarantees. When you consider all the facts, it's easy to understand why demand for these types of products continue to reach all-time highs as consumers look to preserve assets in times of great volatility and uncertainty.

As the nation's number-one provider of FIAs, Aviva USA takes great pride in our ability to manage risk on behalf of our shareholders, our customers and our company. As we recently reported publicly, our company has had only minimal exposure to the issues affecting other financial services firms. We are very proud and confident in our resources and in our financial strength. This strength is clearly reflected in our credit ratings: AA/AA- ("very strong") with a stable outlook from Standard & Poor's, Aa3 ("excellent") with a stable outlook from Moody's and A+ ("superior") with a stable outlook from AM Best.

During the worst market performance since the Great Depression, we are proud to say that our FIA policyholders haven't lost a single penny on their annuity contracts due to market movements. It is this protection, coupled with upside potential that provides the peace of mind that our customers need, want and deserve. And we look forward to continuing to provide it.

Finally, Ms. Gannon noted in her story that Aviva plc reported capital reserves of 11.5 billion "euros" in its third quarter interim report released on October 28, 2008, when in fact IFRS shareholders' equity was reported as 11.5 billion "pound sterling."

Response from American Equity Life Insurance Co.

A response to this article, submitted by Marla G. Lacey, vice president, associate general counsel, American Equity Investment Life Insurance Co., is below.

A deferred annuity is a contract with a life insurance company which accumulates funds for retirement on a tax-deferred basis. A deferred annuity may also provide guaranteed income for life or for a period certain such as five or 10 years. There are three basic types of deferred annuities: variable, traditional fixed and fixed indexed. Most deferred annuities have no up-front sales charges.

A variable annuity is an insurance product which is considered to be a security, is required to be registered with the SEC and is sold only by securities registered individuals. A variable annuity typically has a variety of investment fund selections which operate much like mutual funds - the profit and loss of the assets (typically stocks or bonds) of the individual fund are passed through to the holder of the variable contract. As such, the contract holder has direct participation in securities markets, with the potential for market gains as well as losses.

While some variable annuities now offer a type of income guarantee available by rider, most if not all of the investment risk underlying the contract is passed on directly to the contract holder, and the holder is charged an annual fee to obtain the benefit of the guarantee. The investments underlying the variable annuity fund selections are managed in a separate account; in other words, they are not assets held in the insurance company's general investment account.

A traditional fixed annuity carries a declared interest rate which is payable for a specific period of time. In many cases the declared interest rate may be raised or lowered by the insurance company on an annual declared basis for the next contract year. These products contain a minimum guaranteed interest rate to be credited to the contract as specified by state law, typically in the 1% to 3% range depending upon a particular state's requirements.

An indexed annuity is a type of fixed annuity which simply uses a different formula to add, or "credit" interest to the policyholder's contract. An indexed annuity typically offers several interest crediting strategies from which to choose, including a fixed rate strategy and one or more strategies using an interest calculation based upon some type of market index. For the policyholder who selects interest crediting keyed to the performance of a market index, this product may offer the potential for higher interest crediting than the traditional declared interest rate product, but is always subject to state required minimum guarantees.

Like traditional fixed annuities, the premium deposited in an indexed annuity and all interest added to that premium is backed by the general account assets of the life insurance company. General account assets include predominantly fixed income securities, not equities, and the types of investments within the account are regulated by state insurance laws. Insurers that issue indexed annuities are required to maintain capital supporting those contracts at the same level as traditional declared rate fixed annuities.

In contrast, little capital is required to support variable annuities because the investment risk is passed through to the holder.

The company's budget for crediting interest to policyholders on both declared rate and indexed annuities typically will take into account the yield it receives on its general account investments as well as the company's target spread, or desired profit margin. For example, a company with an investment yield on its general account assets of 6.00% and a target spread of 2.75% would have a budget of 3.25% to pay out as either declared fixed interest or to utilize for purchasing index call options to fund the interest crediting in contracts with those index strategies.

Ms. Gannon incorrectly characterizes the outcome of hedging strategies typically employed by issuers of indexed annuities. To clarify, hedging strategies with respect to indexed annuities do not "offset losses" for the company. Rather, hedging strategies, typically in the form of purchasing index call options, are utilized by companies to actually provide the funding for interest crediting in contracts with index strategy positions. Per the contract specifications, if the index is lower at the expiration of the strategy term than it was at the beginning, no interest credits are paid by the company to the insurance contracts.

However, unlike a variable annuity the contract holder does not experience any loss in value. If the index is higher at the expiration of the strategy term, index credits are paid to the insurance contract based upon the increase in the measuring index. In either case, the insurer has expended a predetermined amount for the option, and the cost of the option, not its value at any given point in time, determines the insurer's profit margin.

In order to fund the interest credits for the contracts, the company typically will purchase a call option. For example, if today the S&P 500 index is at 1000 the company would purchase a one-year call option on that index at a strike price of 1000. If the index closes at the end of that year at anything above 1000, the company would receive its return on the option, which in turn is credited to the insurance contract with the corresponding index crediting strategy. If the index closes below 1000, the call option will expire with no value and the insurance contract will not be credited with any interest earnings for that particular strategy that year but will not lose any value either.

Ms. Gannon inaccurately states that American Equity Investment Life Insurance "lost $231 million on its call options, intended to hedge interest payouts, during the six months ending June 30." The options held by American Equity during the reported time frame experienced a decrease in fair value, which in turn lowers the amount of interest crediting on index strategies by the same amount.

This figure represents an unrealized asset valuation decrease with a corresponding offset in liabilities -- in the amount of interest crediting applied to its contracts. In other words, if the index does not increase during the applicable measured time frame, the option held by the company will not produce a return, which in turn results in zero crediting on a contract for that applicable time period. A policyholder who receives a zero credit does not lose any premium or interest credited in prior contract years; he or she simply receives no additional interest for the year the index has declined.

Ms. Gannon also states that American Equity "also reported $42 million paid out primarily on contracts with fixed-rate options and minimum guaranteed interest, which was five times the $7.8 million it paid out based on appreciate of underlying indices." The $42 million referenced in American Equity's 10Q represents interest which was primarily credited on the fixed-rate strategy portions of our indexed annuities.

A very small portion of this figure represented interest crediting solely do to contract minimum guarantee requirements. The $7.8 million represents interest credited to indexed strategy portions of our contracts, and reflects the fact that more contract holders moved funds from index strategies to the fixed strategy. There is no other relationship between these two figures other than to show that a total of just under $50 million was credited to annuity contracts in the way of interest.

Melissa Gannon is director of insurance and bank ratings for Ratings, formerly Weiss Ratings, where she directs the operations of the company's insurance and bank ratings division.

In keeping with TSC?s Investment Policy, employees of Ratings with access to pre-publication ratings data must pre-clear any potential trade through the legal department, and are prohibited from trading any security that is the subject of an unpublished rating revision until the second business day after the rating is published.

While Gannon cannot provide investment advice or recommendations, she appreciates your feedback;

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