Understanding Options
This way of linking to an equity index like the S&P 500 or Dow Jones is accomplished through an option, usually a call option. A call option is the right but not the obligation to purchase something at a future date for a specified price.
The naming conventions for options used by the insurance industry is different than that of Wall Street but the options are structurally identical. Here's a sample of options commonly seen in indexed annuities:
- Insurance vs. Wall Street
- Point-to-Point vs. European
- Monthly Average vs. Asian
- Monthly Point-to-Point vs. Cliquet
- Performance Triggered vs. Binary
The options in indexed annuities can usually be fit into the following taxonomy developed by the National Association of Fixed Annuities.
Term - the length of time before option matures, usually one year. Two, three, four, and ten are also prevalent in the market. Some longer term options are but have a "highwater" feature that allows interest to be credited more frequently. An example of this would be a ten year Monthly Average option that credits interest each year if there is a gain.
Index - the equity, stock, bond, or other index to which the interest credit is linked.
Gain formula - the method used to determine the gain in the index. Point to point, monthly averaging, daily averaging are the most common methods of calculating the gain. For example of the S&P 500 index starts at 1120 and ends at 1300 then the point to point gain is 16.07%.
Adjustment method - the way the option is limited in order to reduce the cost (and subsequent return) so that it becomes affordable. As an example the point to point option may cost 7% of the account value but will be "adjusted" to reduce the cost.
"Market value adjustment" - the company may reserve the right to adjust the value of your account based on current market conditions. This adjustment is most often applied to distributions, partial or complete withdrawals, and exchanges to other accounts.
The most common adjustments are cap, fee, participation rate or a combination of the three. Other adjustments are less common. In keeping with the preceding example and allowing for an 8% cap as the adjustment the policyholder would not receive the 16.07% point-to-point gain, but rather 8% as an interest credit.
Should provide examples for: P2P with Participation Rate Monthly Averaging with Cap Monthly Averaging with Fee
Should also link to the withdrawal benefits provided in variable annuities and indexed annuities at this point. These concepts were added because of the risk associated with the accumulation in both variable annuities and indexed annuities.
Read more about this topic: Equity-indexed Annuity