I recently had someone ask me how insurance companies are able to make the guarantees on the annuities they sell to people.

Because of the recession, continuing economic downturn and the volatility of the stock market, droves of people have been putting their money in guaranteed instruments (CDs, Annuities, Treasuries).  The obvious question is, what do they guarantee?

It depends.  Some guarantee a return of principal (your original investment).  Some guarantee lifetime income.  And still others guarantee a certain rate of return.

The answer to the question about how they make those guarantees is a little more complicated.  The first answer is fees.  A variable annuity, “all-in” for expenses can cost nearly 4% of your money per year.  Not all are like that, but there are several layers of fees.  If it is a variable annuity, they are charging M & E (Mortality and Expense) which is a fancy way of saying that they are protecting the insurance company from you living too long or if they have to pay out.  There is also the mutual fund fees (what gives the annuity “growth).  And any riders (guaranteed income rider, etc.).

Fixed annuities don’t work like that.  Basically, the insurance company invests the money you give them and gives you the fixed interest rate, keeping the difference for themselves.

Another answer is that insurance companies are required to keep enough capital so that they can pay out all of their claims should they have to.  That can be quite a bit of money, but they usually manage to do that.  In the event that they cannot pay all of their claims, often another insurance company will buy the contract.

Then there are fixed indexed annuities (or FIAs).  These were formerly called Equity-Indexed Annuities (EIA’s).  Basically, these annuities guarantee a fixed rate of return (2% or something to that affect).  The insurance company takes the money you give them and invests it in bonds (or some other fixed income security).  They utilize the income off of the bonds and a portion of the principal to buy call options.  Some of the income off of the bonds is used as your “guarantee”.  The call options are usually bought on a specific index (example the S & P).  If the S&P 500 goes down, the options expire after a set time period worthless, and the client receives the guaranteed amount.  If the S&P 500 does nothing, then the options expire worthless, and the client receives the guaranteed amount.  If the S&P 500 goes up enough so that the options have increased in value, then the insurance company exercises the option, “calling” the stock to them at a lower price, then selling it at the premium price immediately.

Using a specific crediting formula, the insurance company gives a portion of that gain to the annuity holder.  In good times, this can result in a pretty decent return on your annuity.  In bad times, it protects your investment.  But how is the insurance company making money?  They take a portion of the gain, which may or may not be significant, depending on the contract and insurance company.  With so many people fleeing to annuities, they have reached economies of scale so that they can offer better terms.

It is possible to have the benefits of an annuity without actually paying an insurance company.  There have been reports of unscrupulous annuity salesmen.  These people are in the minority.  There are good annuity salespeople out there that want to do the right thing for their clients.  That said, be careful what you sign.  Just because someone guarantees you something, doesn’t mean there isn’t a catch.  Have a third party advisor or insurance expert look at the contract before you sign it.