CAS Indexed Annuity Crediting Strategies and Interest Rate Concepts 2 — Questions and Answers
Question 1: In the monthly sum crediting method, how is interest calculated over a one-year period?
- By averaging the monthly index closing values over the twelve-month term
- By summing the capped monthly percentage changes and crediting the total at year-end (Correct answer)
- By applying the annual participation rate to the December index value
- By identifying and crediting the single highest monthly index gain
Correct answer: By summing the capped monthly percentage changes and crediting the total at year-end
The monthly sum method adds together each month's index percentage change (subject to monthly caps) and credits the cumulative total at the end of the year, which can be negative if losses outweigh gains.
Question 2: A fixed indexed annuity offers a 65% participation rate on the S&P 500 with no cap and no spread. If the S&P 500 gains 12% over the crediting period, what interest rate is credited?
- 12%
- 7.8% (Correct answer)
- 5.2%
- 19.5%
Correct answer: 7.8%
With a 65% participation rate and a 12% index gain, the credited interest equals 65% × 12% = 7.8%.
Question 3: What does 'index reset' mean in the context of an indexed annuity crediting term?
- The account value is restored to the original premium at the start of each new term
- The beginning index value is set to the current index level at the start of each new crediting term (Correct answer)
- The participation rate is recalculated based on current market volatility each year
- The credited interest is subtracted from the account and re-credited at a higher rate
Correct answer: The beginning index value is set to the current index level at the start of each new crediting term
Reset means that at the start of each new crediting period, the index starting point is updated to the current market level, preventing prior losses from dragging down future crediting calculations.
Question 4: How do insurance companies primarily hedge their obligation to credit interest based on index performance in a fixed indexed annuity?
- By investing policyholder premiums directly in the underlying index
- By purchasing call options on the relevant index (Correct answer)
- By allocating policyholder funds to high-yield bond portfolios
- By entering into interest rate swap agreements with counterparty banks
Correct answer: By purchasing call options on the relevant index
Insurers allocate a portion of the premium (the option budget) to purchase index call options, which provide the upside participation paid to policyholders while the remaining premium goes into fixed-income investments.
Question 5: In which market environment does the monthly sum crediting method typically underperform annual point-to-point?
- A steadily rising bull market with consistent monthly gains
- A volatile market with large swings both up and down within the year (Correct answer)
- A flat market where the index ends the year unchanged
- A market where the index rises sharply only in the first quarter
Correct answer: A volatile market with large swings both up and down within the year
In a volatile market, monthly sum caps limit upside in strong months while full monthly losses reduce the running sum, causing it to underperform point-to-point which only captures net annual movement.
Question 6: What is a 'volatility control index' feature sometimes offered in indexed annuities?
- A contractual provision that limits surrender charges during volatile markets
- An index strategy that dynamically adjusts equity and bond allocations to target a specific volatility level (Correct answer)
- A rider that guarantees a minimum credit regardless of market volatility
- A feature capping the maximum index volatility used in participation rate calculations
Correct answer: An index strategy that dynamically adjusts equity and bond allocations to target a specific volatility level
Volatility control indexes automatically shift allocations between equity and fixed components to maintain a target volatility level, typically resulting in more stable but potentially lower returns.
Question 7: Which of the following best describes the 'option budget' in a fixed indexed annuity?
- The total amount of premium the insurer accepts per policy year
- The portion of investment earnings available to purchase index options determining caps and participation rates (Correct answer)
- The maximum surrender charge the insurer may assess over the contract term
- The annual fee deducted from the account for administrative expenses
Correct answer: The portion of investment earnings available to purchase index options determining caps and participation rates
The option budget is derived from the spread between bond yields and the guaranteed minimum return; it funds the purchase of index call options and directly determines how competitive the caps and participation rates can be.
CAS Indexed Annuity Crediting Strategies and Interest Rate Concepts 2
In the monthly sum crediting method, how is interest calculated over a one-year period?