Insurance Education – Interest Rates On Annuity Reserves

The impact of reserves of a change in the interest assumption can be understood as if the rate of interest assumed in the reserve calculation is decreased, then it follows that there will be an increase in reserves. The rule, simply put, is that the smaller anticipated earnings must be offset by a larger reserve at any point in time. Remember, in calculating the present value of $X, the higher the interest rate assumed, the lower the present value of $X will be, all things taken into consideration.

What does this have to do with anything? If the interest rate – which undoubtedly will go no lower than it was during the first part of 2004 (no such thing as a negative interest rate) is what the insurer is getting on its investments – which consist primarily of the premiums received – then at time of claim since it did not make as much money on investing of the premiums as assumed in the premium and reserve calculations, the insurer would not be able to meet its financial projections, etc. Fortunately, interest assumptions on new business drops as the interest the company receives on its investments drops. Unfortunately, the company still has to pay the income promised under the policy, regardless of what their interest income had been during the accumulation period.

This simply means that an annuitant that took out a deferred annuity would still collect – as an example – $100 for every annual payment (premium) of $14 and change which was promised when the annuity was purchased some time back when interest rates were high. For another new annuitant, the premium for $100 for comparative coverage might be as high as $18. The offset, of course, is that the annuitant cannot put the same money into another investment and receive a much higher interest than what is received by the insurance company, who has the advantage of large portfolios professionally managed and therefore can get higher interest than Joe Lunchbucket.

Interestingly, the nation’s life and health insurers had a 310.8% jump in net income last year, earning $30 billion compared to $7.3 billion in 2002. The rebound in the equity market was responsible for the increase in earnings as insurance companies saw improvement on the sale of invested assets. Insurers had a $4.6 billion capital loss in 2003, compared to a $15.5 billion capital loss just a year earlier. Capital and surplus of the insurers had its largest increase in profits since 1997.

“The equity markets were much kinder to the industry in 2003, and we expect to see positive gains as 2004 progresses. Insurers didn’t need to dip into capital as much to absorb the higher losses and maintain reserves.” So, things are looking up!

ANNUITY NONFORFEITURE VALUES

Nonforfeiture values are understood by most as a life insurance policy function but it also applies in slightly different ways for an annuity. Basically, in life insurance it is a provision that the insured may receive the equity in some form, even if the policy is cancelled. For annuities, it is described as the vested benefit usually to a retirement plan participant and is enforceable against the plan.

It is of importance as the National Association of Insurance Commissioners (NAIC) promulgates “Model” legislation for the regulation of the insurance industry in the various states, and that is usually adopted by most, if not all, of the state insurance departments. Changes to the annuity nonforfeiture law were made in 2002 to address the reduction in interest rates in and after 2002, and a standard nonforfeiture law for deferred annuities was proposed by the NAIC. The change, which is temporary, would be from 3 percent to 1.5 percent to the minimum interest rate in the annuity nonforfeiture law, and which would be effective for 2 to 3 years (by state determination). When such provision “sunsets,” which would be sometime between July 2004 and July 2005, the minimum rate will be returned to 3 percent. (This may have happened at the time of the writing of this text, so it may have already expired in some states where it was enacted.)

The NAIC Model Standard Nonforfeiture Law for Individual Deferred Annuities proposes 6 principal changes:
1. (For deferred annuities) a minimum interest rate indexed to the five-year Constant Maturity Treasurer (CMT) rate, minus 1.25 percent. For equity-indexed plans, the minimum rate could be reduced by an additional 1 percent, but subject to guaranteed equity-indexed benefits of at least as great as the rate reduction.
2. The minimum interest rate will be the lesser of 3 percent or the rate determined by the 5-year CMT index, but it may never be less than 1 percent.
3. The interest rate can be redetermined at specific contract dates; the reset rate can be as of a single date or averaged over the most recent 15 months.
4. An annual charge of $50 can be recognized. No collection charge is allowed.
5. The net considerations are 87.5% for all products.
6. Premium tax can be reflected in the nonforfeiture law.

Every annuity issued must contain certain provisions :
1. When annuity premiums cease or when the annuity owner requests, the insurer must provide a paid-up annuity benefit.
2. If the annuity provides for lump-sum settlement when it matures – or at any other time – a cash surrender benefit in lieu of a paid-up annuity benefit. Payment may be deferred for no longer than 6 months with the permission of the Insurance Department.
3. The annuity must contain a statement of the mortality table and interest rates that are used in calculating minimum paid-up annuity benefits, cash surrender, or death benefits that are available under the annuity and any other information necessary to calculate these benefits.
4. The annuity must state that these benefits are equal to or more than the minimum benefits required by the state in which the annuity is delivered.

Regardless of these requirements, any deferred annuity may provide that if there have been no consideration received for a period of two years, and the present value of the annuity is less than $20 monthly, the present value of the annuity is determined according to the Code, and may be paid in cash.

For annuities issued before 1/1/04 and prior to 1/1/06, the California Insurance Code provides for minimum nonforfeiture values. For flexible contracts, the amount is specified by formula which assigns an interest rate of 3% for accumulations less withdrawals, indebtedness to the insurer plus additional amounts assigned by the insurer. The percentage of net consideration must be 65% for the first year and 87.5% for later years.

For fixed premium contracts, the portion of the net consideration is the same as for flexible contracts (65% and 87.5%). For single premium contracts, the minimum nonforfeiture amounts shall be defined as those with flexible considerations except the minimum nonforfeiture amount shall be equal to 90% ad the contract charge shall be $75.

For contracts issued on and after 1/1/06, the determination of the nonforfeiture values resembles the calculations shown above, but with annual contract charge of $50 (instead of $30) and the interest rate used in determining the nonforfeiture values will be 3% per annum. If the interest rate is offset, then the code requires a Constant Maturity Treasury Rate to be used for each redetermination date.

For equity indexed plans, provisions for determining the nonforfeiture values is stated in the Code. Each revaluation must show that each redetermination the additional reduction shall not exceed the market value of the benefit.

For a paid-up annuity, the benefit available under the annuity shall be the present value on annuitization which must be at least equal to minimum nonforfeiture on that date.

For a paid-up annuity which provides cash surrender benefits, the Code provides a (145 word) sentence outlining the cash surrender benefits available. Simply (very simply) put, the present value of future benefits less payments made on the annuity, would be the non-forfeiture amount, but the cash surrender benefit may not be less than the minimum nonforfeiture amount at that time. The death benefit must be at least equal to the cash surrender benefit.

For annuities that do not provide cash surrender values, the nonforfeiture amount shall not be less than the present value of the maturity value of the paid up benefit, adjusted by payments and obligations.

Not all annuities provide for cash surrender benefits or death benefits, and those plans must so state in a “prominent” place on the contact.

If a contract provides – by rider or otherwise – annuity benefits and life insurance benefits or a return of premium or gross considerations with interest, the minimum nonforfeiture values of the annuity portion will be calculated individually and then combined.

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