Indexing Options and More June 20, 2012 Tim Hill, FSA, MAAA Milliman, Inc.

1. Indexing Options and More June 20, 2012 Tim Hill, FSA, MAAA Milliman, Inc.

2. A Historical Look at US FIA Annual Sales Source: AnnuitySpecs

3. Full year 2011 FIA Sales Results Source: AnnuitySpecs

4. Rate Environment – June 16, 2012

5. Product Trends • Surrender Charges • Over 50% have 10-year SC • Over 75% have SC <= 10-years • Continued but slowing trend toward 10 / 10 • IIPRC, Florida • Agent Commission • Modest trend toward lower commissions • In low rate environment, seems like there will have to be additional cuts • In Bank annuity space clear trend to trade comp for volume • Bonuses • Vast majority of sales include a bonus • Typical bonuses are 5 – 10% • Vesting schedules are a typical way to recoup bonus • Portion of bonus might come with a rider • Average Issue age is 65 unchanged • Qualified percent is unchanged • Average size unchanged

6. Product Trends – GLWBs • GLWBs • GLWBs are not as prevalent as on the VA side but growing • On some products, portion electing GLWB > 95% • Overall election likely in the 50 – 60% • Typical Structure • Premiums accumulated at a set percent • 6% to 8% compound • 7% to 10% simple • Often for 10 years with one renewal available • Payout factors that are similar to VA side • 5.0% to 5.5% at 65 • Charge is typically bps of benefit base assessed against AV • Challenges • Low interest rate environment • Actuarial Guideline 33 • Continued need for bonus and comp

7. Product Trends – New Indices • Current fixed buckets in FIAs between 1.0% and 1.5% • Current caps are around 3 to 4% on S&P 500 strategies • Difficult to tell upside story • How does a company • Blended indices • Blend S&P 500 with a fixed crediting rate • Fixed crediting rate might be low to subsidize S&P portion • 0% credited interest Floor applied in aggregate • Use of spread instead of cap to get more upside • Alternative indices • Use a index with lower volatility than S&P 500 • Trading off return potential for lower costing option • Challenges • Need to be able to buy option, less liquid than S&P • Limited number of option sellers • No historic experience – Must rely on backcasting

8. Option Pricing 101 • Four Inputs into the price of an option • Examples assumes a 2% option budget which would be able to buy a 4% cap or a 20% participation rate • Risk-free interest rate • Typically the swap curve rate for the maturity of the option • 1-yr swap curve on 6/14/2012 was 54 bps • Capped strategy • If rate rose to 104 bps, cost of option only increases by a few bps • But, if my option budget increased by 50 bps, could buy 5% cap • Participation rate strategy • If rate rose to 104 bps, cost of option only increases by a few bps and pushes participation rate to 19% • But, if my option budget increased by 50 bps, could buy 25% participation rate

9. Option Pricing 101 • Implied Volatility • Volatility is not just a single number but is a complicated surface • 1-yr at-the-money vol in example is 19.26% • Capped strategy • If vol cut to 15%, cost of option only decreases by a few bps • Still can only offer 4% cap • Participation rate strategy • If vol cut to 15%, cost of option cut by 19%, pushing participation to 25%

10. Option Pricing 101 • Dividend Rate • Since crediting strategies typically use index without dividend, the dividend rate is an input in the option pricing formula • In example dividend assumed to be 2.0% • Capped strategy • If dividend increased to 3%, cost of option decreases by 10 bps allowing cap to increase to 4.25% • Participation rate strategy • If dividend increased to 3%, cost of option cut by 5%, pushing participation to 22%

11. Option Pricing 101 • Length of Option • The last input into the option pricing formula is length • In example assumed 1-year option • Capped strategy • If length extended to 2 years, cost of option increases by 11 bps • But, since I only have to buy the option every 2 years I have double the option budget or 4% • Can push cap up to 8% • Participation rate strategy • If length extended to 2 years, cost of option increased by 55% • But, since I only have to buy the option every 2 years I have double the option budget or 4% • Can push participation rate to 25%

12. Creating an Uncapped Strategy • Suppose wanted to create a, 100% participation, uncapped crediting strategy with no spread • Willing to push crediting length to 5 years • Gives an option budget of 5 times 2% = 10% • S&P 500 option would cost around 21.4% • Need to find index with lower volatility • Low Vol S&P 500 uses the 100 stocks subset with the lowest vols • Option would cost around 15% • Defensive funds • Option could cost around 12% • Other possibilities • Blend fund with bond fund or other low correlation fund • Blend with a fixed account paying a crediting rate less than option budget

13. Creating an Uncapped Strategy • Use of spread • Products that have used a spread have traditional back-casted well • S&P 500 has thicker tails (meaning more extreme good and bad years) than option pricing assumes • Getting all of the good years after the first x% • Very sensitive to implied volatility • Buying-up the crediting parameter • Use of a charge to increase the option budget and increase what is offered • Mixed results to date • Extending option reset period beyond 5-years • 12-year S&P 500 option in theory could be uncapped with 100% participation and no spread • Would need to find investment bank to price it.

14. Challenges of Using New Indices • Backcasting • Most indices that would be considered are based on set formula • Substitutions can be found for indices that didn’t exist • Third party should be used to do calculation • Marketing • Challenges of gaining acceptance versus familiar • Purchasing options • Limited sources to buy options • Likely best to find a single partner and agree upon parameters • Regulatory • Insure that no way index could be manipulated • Transparency critical • Need to carefully craft marketing materials

15. FIA Predictions • Vast majority of sales still through IMOs • Continued attention on GLWBs • Significant activity in new indices • Continued and accelerated attention from Banks and Wirehouses • Partial due to challenges on VA side • Desire to tell income story • Moderated product • Sales likely flat due to low interest rate environment • Progress (hopefully) made on AG 33 issues