MINI-COURSE SERIES
ANNUITIES Part V
Copyright Š 2012 by Institute of Business & Finance. All rights reserved.
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LEGAL RESERVE SYSTEM Since the beginning of the 20th century, insurance companies have had to comply with the “legal reserve system” that requires statutory reserves. The amount that each insurer must have to protect policyowners and annuity investors is based on the contractual guarantees of its annuity contracts and life insurance policies. The foundation of this system of protection is the insurer’s capital and surplus as well as its reserves. The insurer’s net worth is measured by its capital and surplus. For the industry as a whole, capital and surplus represent 7-8% of assets. Reserves are increased from time to time, reflecting actual and potential portfolio losses. Reserves are used to meet the insurer’s guarantees. The invested reserves can only be claimed by creditors after all contract and policyowner claims have been satisfied. NAIC investment regulations adhered to by all insurance companies, greatly limit exposure to affiliate and subsidiary companies’ bonds whose ratings are not investment grade.
STATE GUARANTY FUNDS Each state requires all insurers doing business in its state to regularly contribute to its guaranty fund. The amount contributed by an insurer is based on how much business it writes in the state. Most states also require these same insurers to pay extra to cover expected losses by life insurance policyowners and annuity contract owners. The limit of protection varies by state. Most states provide up to $300,000 of death benefit protection for life insurance policies for any one person; $100,000 for annuities in most states.
States With Annuity Guaranty Funds Different Than $100,000 Arkansas ($300,000)
South Carolina ($300,000)
California (80%, not to exceed $100,000)
Utah ($200,000)
Minnesota ($110,000 adjusted for inflation)
Washington ($500,000)
New York ($500,000)
Wisconsin ($300,000)
North Carolina ($300,000)
D.C. ($300,000)
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Each state guaranty fund provides protection only for its residents; the insurer’s state of domicile is unimportant. Your clients are covered if the failed insurer was licensed in their state of residency. Contract owners who reside in states where the insolvent insurer was not licensed are covered, in most cases, by the guaranty association of the insolvent insurer’s state of domicile. The guaranty fund does not cover any portion of a policy in which investment risk is borne by the individual, such as variable annuities (unless a fixed-rate option is selected). Although insurers fund the “guaranty,” the capital pool is managed by the state. Most states forbid advisors and brokers from disclosing even the existence of the state guaranty fund. The states do not want the industry to rely on the fund for fear they may be more likely to be lax on product design, guarantees and the quality of assets in their general accounts. In 1983, the state guaranty associations founded the National Organization of Life and Health Insurance Guaranty Associations (www.nolhga.com). If the insolvency affects three or more states, NOLHGA coordinates the plan to protect contract owners. The use of a state’s guaranty fund is extremely rare. According to Advantage Compendium, there were only three failed insurers over the last 15 years that did not have 100% of annuity value for all their annuity customers (London Pacific Life, National American Insurance Company of Pennsylvania and Summit National Life Insurance).
THE WALL STREET JOURNAL: Q & A The following is a reprint of an October 29th, 2008 article in The Wall Street Journal, titled “Annuities At Risk Now?” This is the complete text from the article and has not been edited. You may want to photocopy these next few pages and provide copies to clients who have questions about the safety of annuities.
Q: How do annuities work? A: Annuities are tax-deferred insurance contracts bought once, or with a series of payments, that offer the owners either a lump sum or a series of payouts after an accumulation period. Unlike other retirement vehicles such as an individual retirement account or a 401(k), annuities have no legal limits on tax-deferred contributions.
Q: What's the difference between fixed and variable annuities? A: Fixed annuities earn a guaranteed interest rate during a certain period. They are backed by assets in an insurance company's general account, usually bonds. Fixed annuities depend entirely on the financial soundness of insurers, which are regulated primarily by state insurance departments. PART V
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Variable annuities can also come with guaranteed benefits, such as a death benefit and a minimum return, riders for which the buyers generally pay extra. In other ways, though, they are quite different: A portion of deposits goes to the insurance company to cover administrative costs and guaranteed benefits; the rest is invested in a portfolio of mutual fund-like investments. These accounts are separate from the rest of the contract and belong to the annuity owner, so they are not as vulnerable to the insurer's fate. Variable annuities, however, are more exposed to market risks. If annuity owners' investments perform well, there's the potential upside of a bigger payout. But if they do poorly, as many have recently, income falls, too. Investors can shift their fund holdings, however, to lower-volatility choices such as bond funds.
Q: Should I worry if the stock price of my insurer declines? A: Not necessarily. In some cases, analysts say, publicly traded insurance companies' stock prices have plunged partly because of their efforts to raise capital. And while raising capital can dilute existing shares, it also improves an insurer's ability to pay claims. Hence, a decline in the stock value of a company doesn't always spell immediate trouble for annuities or life-insurance policies.
Q: Should I worry if the rating of my insurer declines? A: Possibly. Financial-strength ratings, supplied by rating agencies, are an evaluation of the ability of a company to make good on its guarantees. A slip from an excellent financial-strength rating from one of the five agencies—Fitch Inc., A.M. Best Co., Moody's Investors Service, Standard & Poor's or TheStreet.com—to a slightly lower rating that is still in the secure range isn't cause for alarm, experts say. But multiple downgrades are a good reason to keep an eye on the company. Through Sept. 30th 2008, 6.5% of the life/annuity and health-insurance companies followed by rating agency A.M. Best had been downgraded, though most remained in the "secure" range, meaning they are still regarded as financially sound. Of course, buyers of new annuities should only buy from top-rated companies, consumer advocates say. You can find information on the financial strength of companies by linking to your state's insurance department, at www.naic.org, the Web site of the National Association of Insurance Commissioners (NAIC).
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Q: What happens when a company flounders? A: State regulators usually monitor struggling companies and work with them to try to get additional capital—or to sell the company to a stronger insurer that can make good on all of its claims. State receivers, who include the state insurance commissioner of the company's home state, often help find other insurers to take over the annuities from the troubled company. Annuity owners then make payments to the new company and collect payouts from it. Otherwise the terms of the annuity usually remain the same.
Q: What happens if no insurer takes over a failed insurer? A: If an insurer is declared insolvent by a court and is liquidated, state laws require companies to pay annuity (and insurance policy) owners first and in full before paying claims of other creditors. State guaranty associations—funded by other insurers—then make good on the annuities and policies. Death benefits, for instance, are often protected up to $300,000. Cash values are often protected to $100,000. (See www.nolhga.com, the National Organization of Life and Health Insurance Guaranty Associations, for state-bystate terms.) With variable annuities, as with fixed contracts, the associations protect the death benefits, guaranteed minimums and other contract guarantees. But account losses because of market declines generally are not covered.
Q: What are my options if my insurer is at risk of insolvency? A: Regulators and consumer groups warn that annuity owners, especially those who bought contracts recently, often stand to lose more when rashly surrendering an annuity than they would risk from the insurance company's failure. That's because the guaranty funds protect their money up to legal limits, while surrender charges and other penalties can take a chunk of an annuity's balance. Check with your state insurance department for updates about the financial strength of insurers. If your annuity contract is still in the surrender period, often five to seven years, and the contract is below state guaranty limits, you may decide to wait and see if the company can muddle through. But if your surrender period is over or nearly finished, and a company has deteriorated enough to make you uncomfortable, consider a Section 1035 tax-free exchange, named for a section of the Internal Revenue Code, into another annuity contract from a higher-rated insurer. Starting a new con-tract will involve a new surrender period and charges, new commissions and new fees. Do not allow a sales rep from a competing company scare you into replacing an annuity. There are state laws against "poaching" customers by making false claims about the financial condition of another insurer.
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PRESENT VALUE OF SOCIAL SECURITY PAYMENTS According to IRS Publication 590, the life expectancy of a single 65-year old is 21 years; joint life expectancy for a couple is 26 years. The table below shows the present value (PV) of a $30,000 annual benefit for someone age 65 whose life expectancy is 20 years. Viewing the Social Security income stream as a lump sum figure means the present value of cash flows can now be added to the client’s equity/fixed-income computation, resulting in a higher percentage for fixed income and a likely increase as to how much should now go into equities. This means the PV of Social Security payments can be characterized as a fixed-rate annuity with an annual CPI adjustment.
Present Value of Social Security [$30,000 annual benefit / age 65] Discount (Inflation) Rate
PV of Cash Flow
3%
$452,000
5%
$380,000
7%
$324,000
9%
$280,000
GENERATING LIFETIME INCOME Generating Lifetime Income With $500,000 Investment Mix
Average annual income for 30 years
Median portfolio after 30 years
100% fixed-rate annuity annuitized
$26,300
$0
50% stocks & 50% in bonds
$26,200
$775,800
25% in stocks & bonds 75% fixed-rate annuity annuitized
$26,300
$193,950
25% in stocks & bonds 75% fixed-rate annuity annuitized
$26,300
$387,900
25% in stocks & bonds 75% fixed-rate annuity annuitized
$26,200
$81,800
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THINGS TO DO Your Practice The safety and reserves of annuities is just one more benefit this investment vehicle offers. Your existing annuity clients may be interested in learning about reserve requirements and state guarantees. The Next Installment Your next installment, Part VI, covers annuity contract ownership issues. It also includes a year-by-year comparison of fixed-rate annuities with government bonds (note: you will be shocked by this information). You will receive Part VI in a few days. Learn Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about its designation programs: o o o o o
Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)
IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.
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