1 Indexing Options and More June 20, 2012 Tim Hill, FSA, MAAA Milliman, Inc.

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Indexing Options and More

June 20, 2012

Tim Hill, FSA, MAAA

Milliman, Inc.

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A Historical Look at US FIA Annual Sales

Source: AnnuitySpecs

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Full year 2011 FIA Sales Results Full year 2011 VA Sales – Top Ten Companies ($ in millions)

12/31/11

Rank

Company 2011 Sales

% Chg. vs. 2010

Q4 11Mkt Share

1 Allianz Life $6,319 -7.8% 19.5%

2 Aviva 4,506 -13.9% 13.9%

3 American Equity 4,371 6.4% 13.5%

4 GAFRI 1,847 115.1% 5.7%

5 North American 1,673 8.4% 5.2%

6 Lincoln National 1,615 -20.3% 5.0%

7 Midland National 1,554 -1.5% 4.8%

8 Jackson National 1,497 -11.0% 4.6%

9 ING 1,361 -23.4% 4.2%

10 Security Benefit 941 New 2.9%

Source: AnnuitySpecs

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Rate Environment – June 16, 2012

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Product Trends

Surrender Charges Over 50% have 10-year SC Over 75% have SC <= 10-years Continued but slowing trend

toward 10 / 10 IIPRC, Florida

Agent Commission Modest trend toward lower

commissions In low rate environment, seems

like there will have to be additional cuts

In Bank annuity space clear trend to trade comp for volume

Bonuses Vast majority of sales include a

bonus Typical bonuses are 5 – 10% Vesting schedules are a typical

way to recoup bonus Portion of bonus might come with

a rider

Average Issue age is 65 unchanged

Qualified percent is unchanged

Average size unchanged

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Product Trends – GLWBs

GLWBs GLWBs are not as prevalent as on the VA side but growing On some products, portion electing GLWB > 95% Overall election likely in the 50 – 60%

Typical Structure Premiums accumulated at a set percent

6% to 8% compound 7% to 10% simple Often for 10 years with one renewal available

Payout factors that are similar to VA side 5.0% to 5.5% at 65

Charge is typically bps of benefit base assessed against AV Challenges

Low interest rate environment Actuarial Guideline 33 Continued need for bonus and comp

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Product Trends – New Indices

Current fixed buckets in FIAs between 1.0% and 1.5% Current caps are around 3 to 4% on S&P 500 strategies

Difficult to tell upside story How does a company Blended indices

Blend S&P 500 with a fixed crediting rate Fixed crediting rate might be low to subsidize S&P portion 0% credited interest Floor applied in aggregate Use of spread instead of cap to get more upside

Alternative indices Use a index with lower volatility than S&P 500 Trading off return potential for lower costing option Challenges

Need to be able to buy option, less liquid than S&P Limited number of option sellers No historic experience – Must rely on backcasting

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Option Pricing 101

Four Inputs into the price of an option Examples assumes a 2% option budget which would be able

to buy a 4% cap or a 20% participation rate Risk-free interest rate

Typically the swap curve rate for the maturity of the option 1-yr swap curve on 6/14/2012 was 54 bps

Capped strategy If rate rose to 104 bps, cost of option only increases by a few

bps But, if my option budget increased by 50 bps, could buy 5% cap

Participation rate strategy If rate rose to 104 bps, cost of option only increases by a few

bps and pushes participation rate to 19% But, if my option budget increased by 50 bps, could buy 25%

participation rate

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Option Pricing 101

Implied Volatility Volatility is not just a single number but is a complicated surface

1-yr at-the-money vol in example is 19.26% Capped strategy

If vol cut to 15%, cost of option only decreases by a few bps Still can only offer 4% cap

Participation rate strategy If vol cut to 15%, cost of option cut by 19%, pushing

participation to 25%

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Option Pricing 101

Dividend Rate Since crediting strategies typically use index without dividend, the

dividend rate is an input in the option pricing formula In example dividend assumed to be 2.0% Capped strategy

If dividend increased to 3%, cost of option decreases by 10 bps allowing cap to increase to 4.25%

Participation rate strategy If dividend increased to 3%, cost of option cut by 5%, pushing

participation to 22%

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Option Pricing 101

Length of Option The last input into the option pricing formula is length In example assumed 1-year option Capped strategy

If length extended to 2 years, cost of option increases by 11 bps But, since I only have to buy the option every 2 years I have

double the option budget or 4% Can push cap up to 8%

Participation rate strategy If length extended to 2 years, cost of option increased by 55% But, since I only have to buy the option every 2 years I have

double the option budget or 4% Can push participation rate to 25%

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Creating an Uncapped Strategy

Suppose wanted to create a, 100% participation, uncapped crediting strategy with no spread

Willing to push crediting length to 5 years Gives an option budget of 5 times 2% = 10%

S&P 500 option would cost around 21.4% Need to find index with lower volatility

Low Vol S&P 500 uses the 100 stocks subset with the lowest vols

Option would cost around 15% Defensive funds

Option could cost around 12% Other possibilities

Blend fund with bond fund or other low correlation fund Blend with a fixed account paying a crediting rate less than

option budget

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Creating an Uncapped Strategy

Use of spread Products that have used a spread have traditional back-casted well

S&P 500 has thicker tails (meaning more extreme good and bad years) than option pricing assumes

Getting all of the good years after the first x% Very sensitive to implied volatility

Buying-up the crediting parameter Use of a charge to increase the option budget and increase what is

offered Mixed results to date

Extending option reset period beyond 5-years 12-year S&P 500 option in theory could be uncapped with 100%

participation and no spread Would need to find investment bank to price it.

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Challenges of Using New Indices

Backcasting Most indices that would be considered are based on set formula Substitutions can be found for indices that didn’t exist Third party should be used to do calculation

Marketing Challenges of gaining acceptance versus familiar

Purchasing options Limited sources to buy options Likely best to find a single partner and agree upon parameters

Regulatory Insure that no way index could be manipulated Transparency critical Need to carefully craft marketing materials

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FIA Predictions

Vast majority of sales still through IMOs

Continued attention on GLWBs

Significant activity in new indices

Continued and accelerated attention from Banks and

Wirehouses

Partial due to challenges on VA side

Desire to tell income story

Moderated product

Sales likely flat due to low interest rate environment

Progress (hopefully) made on AG 33 issues