On the other hand, Fixed Annuities had been initially developed to compete for bank customers (this should be self evident insofar as both institutions offer principal guarantee protection). But fixed annuity providers competed primarily on the playing field of interest rates, tax advantages and liquidity differences. The success that variable annuity providers were having in the late 80's and well into the 90's, however, catalyzed fixed annuity providers to come up with more innovative features to arrest the interest of the investing public.
And, the fixed annuity did lack one thing
in comparison to it's more restless cousin the variable annuity: the ability to capitalize on the powerful equity markets.
The inventors, nevertheless, had to discover a method that
would not jeopardize policy principal. The solution fixed annuity providers came up with was something that had already existed within our market economy system for some time:
call options.
After meeting annual reserve requirements to guarantee policy holders principal, insurers could pull from their surplus and buy call options
on an index, such as the S&P 500
for a 12 month period (known as the annual point to point crediting option) for example, and capitalize on only the growth (flow) only, not the
recession (ebb) of the market.
Call options
are market contracts written by a writer, (also known as the seller) and are not direct investments in a stock or fund. They are merely contracts, or rights, that give the holder (in this case the insurance company) the option or right to purchase a stock at a set price (known as the "strike price") for a predetermined time period. These options are literally purchased for a fee from the seller and can be exercised by the purchaser when the strike price is met. If the strike price for a stock, for example, is $80, and an insurer holds that particular call option, the insurer will exercise the right to buy that stock if the stock is "in the money", meaning when that stock price is $80 or higher. Ideally, the purchaser would have the ability to obtain a stock presumably at a lower cost than what it is currently valued at — by virtue of owning the option.
In such positive scenarios, the insurance company would earn profit and the owner of the annuity policy would see growth in their "point to point" crediting strategy.
However, if perchance the reverse was true and the stock price, in our example, was less than $80, then the insurer would simply not exercise the option, and the only loss to the insurer would be the cost they had invested in buying the option in the first place. In this case, the indexed annuity policy owner would see no growth in their "point to point"
crediting strategy, however, they would also see NO LOSS as well.
In this manner the indexed annuity remained, from a regulatory standpoint, within the confines of annual principal guarantees as obligated to do so, but remarkably now having the ability to offer some of the upside of the equity markets through the device of option contracts.
Some limitations to this 1994 "invention" included the inability of the call option to include dividends (since the call option is not an actual investment in the stock itself). In addition, insurers sometimes had to limit the returns to policy holders in their crediting strategies (option contracts) with what are called annual caps, spreads, or participation rates. (Always read your policy to know if this applies to your case). These limitations were, and are, sometimes necessary to hedge against future losses, but in no case would an indexed annuity policy holder suffer loss (based on the claims paying ability of this insurer, of course).
Thus, in conclusion, the index annuity was invented to capture some of the markets growth, and ideally, this would be superior to what a fixed CD, from a banker could provide, for example.
