Market volatility and its impact on FIA participation rates

Volatility is a word that has been thrown about a lot lately when describing the state of the stock market and the general economy. But what does market volatility have to do with fixed indexed annuities? A recent webinar by the National Association for Fixed Annuities explained the connection.

Volatility impacts FIA participation rates – the percentage of an index's gain credited to the FIA – said Josh Levine, director of insurance sales at Bank of America.

As investor demand for annuities grew over the past decade, so did demand for a range of proprietary indices for FIAs, he said, and the market began shifting more toward those types of indices.

The fundamental question, Levine said, is what volatility is and why controlling it matters in terms of FIAs and pricing.

The volatility of a financial price refers to the intensity of the fluctuations affecting this price. “The more a particular asset moves around, the more volatility,” he said. “And the greater the possible distribution of returns, the greater the volatility.”

Why does volatility matter to FIAs?

Why does volatility matter to FIAs? Levine explained that volatility is an input into options pricing. The cost of an option is a key factor when an insurance carrier is determining participation rates. The higher the volatility, the higher the option cost and the lower the participation rates.

When individuals purchase an FIA, the insurer deposits the money from the premium into a general account. Each period, the general account portfolio generates returns. Some of those returns go toward expenses, profitability and commissions, while a budget is used to purchase index options from investment banks. Returns from the index options allow for index crediting.

To determine participation rates, you need to know how much a carrier has to spend on options and how much they actually cost, Levine said.

To calculate participation rates, take the insurer budget and divide it by the price of option.

Levine gave a hypothetical example of this:

Investible indices inside FIAs are accessed via call options, Levine said. A call option provides upside, but limits the downside to the upfront premium paid.

“So now the question becomes, why are we talking about call options here? Why are we showing you a call option? And the reason why we're doing this is because a call option has a very similar return profile as an FIA,” he said.

Volatility is a key factor in participation rates calculation, Levine said. Higher implied volatility leads to a higher option price, which leads to a lower participation rate.

The lower the volatility of an index, the cheaper some options cost and the higher the participation rate.

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