In a really perfect world, the indices underlying a Fixed Index Annuity (FIA) would remain unchanged throughout the lifetime of the product. Consultants would do their research, make recommendations, and proceed to trace the identical indices.
However, in point of fact, airlines sometimes withdraw an index from further investment, citing “capacity issues”. This may cause frustration and uncertainty for advisors and lift questions for investors, particularly in the event that they have made significant efforts to grasp an index that delivers good returns.
How can advisors explain to their clients that, as annoying because it could appear, insurers are literally acting responsibly when making such decisions?
Define capability
In a broad sense, Capacity refers back to the assets under management (AUM) beyond which a technique cannot achieve performance consistent with its stated return objectives or expectations over time. Reaching capability is one reason a hedge fund may close a fund to latest investors, thereby protecting the interests of existing investors. When it involves risk control indices utilized in FIAs, the considerations are similar, although not similar.
When a carrier issues an FIA, it typically engages a number of banks as hedging providers to offer the choices on the indices that make up the FIA. The hedge providers trade the components of those FIA indices within the markets, replicating the performance of the indices and “delta hedging” the choices they’ve sold to the carrier. The following figure illustrates the connection.
The various units involved in an FIA
If this hedging activity represents a significant slice of each day trading in a selected component of a FIA index – for instance, a stock or exchange-traded fund (ETF), it might probably have a big impact on the worth of the component. For example, if a hedger needs to purchase a stock value $100 million and the typical each day trading volume is $200 million, the hedge could be 50% of usual each day liquidity. This hedging activity may impact the extent of the FIA Index itself, potentially to the detriment of the FIA’s performance – and the retirees who purchased it.
Both the carrier and the index sponsor should need to avoid this case – the carrier within the interest of its end customers and the index sponsor within the interest of the integrity of its index.
Impact capability
The capability of an index isn’t a hard and fast number, but somewhat a benchmark where the required hedging activity can have a non-negligible impact on index performance. In the case of an FIA Index, the capability is estimated by the protection provider on the time it agrees to begin selling the choices to the operator.
So how can problems arise?
The simplest case is when an FIA sells very successfully. This is probably going as a result of the strong performance of a number of of the danger control indices utilized in the FIA, which is attracting inflows. The carrier must purchase more options from the protection provider, who in turn must insure a bigger volume. Everyone is joyful until the required hedging amount of certainly one of the FIA indices reaches the capability of that index.
And what about changing market conditions? The risk control indices utilized in FIAs typically consist of other indices, ETFs, stocks and futures. Component liquidity can change significantly over time. An underlying ETF may experience lower volumes if it underperforms and investors withdraw. or an underlying future could also be thinly traded and open interest may fall. In each cases, the decline in liquidity can reduce the capability of the danger control index.
ICLN: An illustration
In the ETF world The iShares Global Clean Energy ETF (ticker: ICLN) provides an excellent example of an index capability problem. The ETF was launched in 2008, but as investors responded to the sustainability narrative and clean energy became a key initiative of Joseph Biden’s administration, the U.S. ETF’s assets under management grew from around $700 million to about $5 billion, while the equivalent European version tracking the identical index also grew to around $5 billion. The ETF was also a preferred underlying for U.S. structured products, creating hidden demand for the stocks. The problem was that the underlying index had only 30 constituents, two of which were small, illiquid stocks listed in New Zealand.
When it got here time to rebalance, the ETF needed to sell 40 to 50 times the each day liquidity of those two stocks. That would have caused significant price movements. After deliberations, index sponsor S&P took a drastic step: it redesigned the index and increased the variety of stocks to a goal of 100.
While this instance applies to an ETF and never an FIA, it illustrates how changing market conditions and demand may cause serious capability issues for index-linked products.
Design is very important
So if index capability isn’t a preset, hard-coded value, how can network operators best avoid future capability issues when choosing risk control indexes?
Index capability depends totally on the liquidity of the underlying instruments: typically other indices, ETFs, stocks and futures. Careful selection is due to this fact essential. However, the capability of the index also is dependent upon the weighting mechanism that allocates these instruments, the balancing mechanism that implements these weights, and the danger control mechanism that maintains the volatility of the index at its goal level.
The demand for an index, its performance and market conditions all change over time, creating challenges for product developers and their protection providers to make sure the delivery of an index over the longer time periods of annuities. When conducting due diligence on proposed risk control indices, carriers must consider detailed facets of index design.
With proper consideration, they’ll maximize the probabilities of avoiding capability issues in the longer term.
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Photo credit: ©Getty Images / GoodLifeStudio
