What is Equity Indexed Annuity?

An equity-indexed annuity (EIA) also called simply indexed annuity is a non- variable annuity contract whose interest crediting mechanism is tied directly to some external index, such as the Standard & Poor’s 500 Index in the United States. Introduced in 1995 in the United States, EIAs contain elements of both fixed-value and variable annuities but that are not found in either. First, they offer a minimum guaranteed interest rate, typically 3.0 percent. This provides a downside guarantee. Second, they offer the potential for stock-market-like gains by tying the current crediting rate to equity indexes, thus providing upside participation. Most EIAs are issued as single-premium deferred annuities, although flexible- premium varieties are emerging. Most carry a maturity date of from five to ten years from issuance.

The upside participation generally is stated as a percentage, often called a participation rate, of the increase in the index from issue to maturity. A few companies subtract a spread (e.g., 200 basis points) from the increase in the index each year and credit the difference to the contract. Some companies allow contract owners who surrender before the maturity date to participate in a portion of any appreciation, but many do not. EIAs are particularly attractive to insurers that do not offer variable annuities and to agents who are not licensed to sell variable products. As a general account-based product, it is subject to the same types of marketing and financial regulation as other fixed products. No special licensing, expense and investment management control, or disclosure requirements apply.

As might be suspected, however, the product requires sophisticated design and asset—liability management by the insurer. Design decisions revolve around:
• the choice of equity index and guarantee period
• the indexing method
• participation percentage or spread
• administration, especially for FPDAs
• how to deal with surrenders and partial withdrawals
• commissions

Asset—liability management, including reinsurance, can be particularly complex with ETAs. The investment to secure that guaranteed rate might be zero-coupon bonds or possibly coupon bonds, depending on cash surrender values. An index option with a strike price equal to the minimum guarantee value could cover the upside participation. The ETA is appealing to consumers. One gains upside participation with downside protection. This appeal explains its amazing increase in popularity. Numerous insurers have designed EIAs, with the sales potential said to be enormous, especially in a low- interest environment that enjoys a rising stock market, which was the situation in the United States during the decade of the 1990s. Simultaneously, EIAs cause some concern. For one thing, the guarantees in the contract carry a cost. For another, the owner does not participate fully in the index, as noted earlier. The great variety of ways for calculating the equity return means that consumers might easily be confused and possibly even misled. Some have expressed the view that the products’ risks and rewards might not be clearly and fully enough explained, thus possibly leading to market conduct difficulties for agents and insurers in the future. Indeed, a few insurers have designed products that qualify as variable annuities, at least in part, to have the products fall under SEC disclosure and other regulation.