November 7, 2008

Submitted by Marla G. Lacey, Vice President, Associate General Counsel
American Equity Investment Life Insurance Company

On 11/05/08, TheStreet.com published an article by Melissa Gannon entitled “Insurers in for More Misery” the primary focus of which was on equity index annuities and several companies that issue these products.  Ms. Gannon’s article contained numerous inaccuracies and the purpose of this article is to provide some clarification on that information.

Deferred Annuities

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 ten 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 interested 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. 

Interest Crediting and Hedging

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 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 pre-determined 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 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 AEL “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 AEL “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.

Marla G. Lacey, J.D.
Vice President, Associate General Counsel
American Equity Investment Life Insurance Company