The insurance industry has long been considered a black box, shrouded in secrecy, with endless (negative) connotations around carriers being a scam or even a rip off. Let’s be honest, we’ve all had a bad experience with reporting a claim or dealing with outlandish hold times and or customer service. Worst part yet, this experience ranges across the insurance landscape and you can often be reminded when you see their name in the airport, on a building, or even on a ballpark/arena. To no surprise, insurance carriers are often misunderstood from the start.
In this article I hope to dispel some of the myths surrounding the annuity industry. My goal is to provide a conceptual explanation around how annuity companies make money. Along the way, we’ll tackle some of the more common questions like, “How does the agent get compensated?” and/or “How does my contract charge no fees?” These are both reasonable questions for consumers to ask. But first, why exactly are annuities (from fixed to indexed) so popular right now? The answer is two-fold. Continued stock market volatility + Increasing interest rate environment = Annuity Opportunity Zone. Let me explain further.
From a business cycle standpoint our economy is nearing the end of an inflationary cycle, which means we’re headed towards a recessionary period. We’ve seen annuity rates and benefits continue to rise with the Federal Reserve’s rate hikes throughout the past twelve months. When interest rates rise it becomes more expensive to borrow money, which can discourage spending on big ticket items such as an estate, automobile, etc. At some point the increased interest rates will lead to lower inflation, lower economic growth, and higher unemployment. The government does this with the hope that the demand for consumer goods and services will drop. That said, consumers are in what we call the “Opportunity Zone” as mentioned earlier, where they can lock in some of the best annuity rates ever declared. The consumer’s failure to act could potentially mean suffering further losses in retirement and lower annuity rates in the future.
With billions of dollars flowing from the stock market into more stable instruments to protect and grow their wealth, consumers aren’t the only ones winning. The primary winner in this general trend is the insurance company who manufactures annuity products and, in turn, provides fixed rates, guarantees, tax deferral treatment and peace of mind. Whether or not we like to hear how profitable these carriers are right now, this opportunity zone that we’re in should be treated as a catalyst for steering prospective clients in the right direction. More profits for the insurance company translates to more benefits to the policyholder. The next question is, how do carriers do this?
The profit made by insurance companies is achieved using an “interest rate spread.” In its simplest terms, this means that the insurance company will deduct all expenses/profits before paying out interest to the policyholder. I’ll explain this in more detail in a moment, but this is a notably different approach to how banks make money. Banks use leverage to generate returns by taking on more risk with less reserve requirements. In some instances, banks are able to leverage the policyholder’s dollar 10 times. Woah. While this has the potential to produce more income for the bank, it also involves some risks. Need I not remind you how the 2007-2008 stock market crash panned out? It’s no surprise that, during this historic financial crisis, approximately 532 banks went under and completely failed compared to approximately only 19 insurance companies.
Let’s look at a hypothetical scenario. Remember, this is a conceptual explanation to show how the interest rate spread method works. When you contribute $100,000 to an indexed annuity, this money is placed in what’s called a general account. Typically, this general account and the yield generated is contingent on interest rates and market volatility at the time and that return is aligned with the future anticipated liabilities. Lot to unpack, I understand. In this example, let’s use a five percent yield from the general account. This yield is generated from highly safe liquid instruments such as investment grade bonds, corporate bonds, Muni bonds, treasury bonds, and some exposure to equities, cash, and mortgages. The five percent yield generates a $5,000 return at the end of year. From this point forward, the insurance carrier will deploy this capital to three key areas: General overhead (profits built in), Distribution (commissions paid to reps), and Options (budget for hedging).
If we look at the sequence or priority, the return is first applied to their overhead. Ever heard of the saying “pay yourself first?” Insurance carriers are great at it. We often forget these insurance companies also have to meet payroll, pay their electric bill and keep their brick and mortar office from going under. From the $5,000 yield, approximately $500, or 0.5 percent, of the total premium is earmarked to cover for this, which also includes the company’s profits. Once the company pays itself, the distribution is second in line. I mean, rightfully so, they did move the product which is no layup. As we know, distribution is not cheap so this expense would take away roughly $1,000 from the $4,500 remaining yield, or one percent of the total premium contributed. You might be asking yourself, “If the carrier is only collecting one percent for comp and I’m getting paid 6.5 percent, how can the carrier sustain this business model?” The carrier is taking a loss upfront and is able to provide a safeguard through the use of surrender charges (typically 5-10 years). At the end of the surrender period, the insurance company has recovered the cost of commission. “So, is the commission coming from my premium?” Sort of but not directly. The commission and where it stems from does alter how the contract is built, priced, and issued. This is more reason to fall back on reputable, highly rated, AAA rated carriers. Why?
Poorly rated carriers = Pay higher (above average) comp = Requires more risk in general account/higher yield = Increased renewal rate volatility (to the downside) = Unhappy/confused agent come annual review time = Pissed off clients = No referrals.
If we continue down this path, we have approximately $3,500 of yield remaining or 3.5 percent of the total premium. The amount left over is then used to purchase options (caps, pars, spread) tied to an external index, such as the S&P 500, which provides the policyholder with potential upside. This is called hedging and carriers are experts at insuring against loss. In this case if the external index returns negative one year later, the option contract would expire worthless and we can fall back on the downside protection features (thanks to the general account). In other words, the principal would remain intact and sheltered from negative stock market volatility. 2022 was marked as one of the worst for stocks and bonds in history, which has filled clients with a lot of fear today and going forward. However, for those who had the foresight of incorporating indexed annuities as a hedging instrument as part of their retirement plan, they were able to avoid a stock market crash, are now 100 percent whole, and now ready to go on offense as the recovery takes shape.
In conclusion, insurance companies make money using an interest rate spread, where costs to run a business are deducted first (off the top) and the remaining net amount is passed to the consumer. As interest rates rise, so will the carrier’s bottom line. However, as we saw earlier, this will only translate into more potential return and long term value for the consumer. The next time a prospect asks what fees to look out for or how commissions get paid, direct them to the fundamentals of how insurance companies make money to help dispel any concerns when it comes to annuities. Transparency and honesty will sell the case for you.