It then explains that insurance companies can offer index annuities by investing premiums in bonds, and using the interest earned to purchase options on a market index. If the index rises, gains from the options are credited to the annuity; if it falls, no interest is credited but the principal remains protected.

1. Index Annuity Guide
By
The Annuity Report 2011
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2. In this report we’ll explore the inner-workings of index annuities in simple terms.
Generally speaking, advisors who consider index annuities complicated have just
been too lazy to do research and develop a fact-based understanding of the
product. I know because that used to be me.
Index annuities are not complicated, especially when compared to many of the
futures, derivatives and options contracts available to investors. It should be
easy for you to gain a firm knowledge of index annuities and apply that to
individual products when you decide to buy one. Let’s get started…
How Do Index Annuities Work?
Index annuities are nothing more than fixed annuities with a different method of
crediting interest. With a fixed annuity, the contract owner receives a stated rate
of interest each year. With an index annuity, the stated rate is calculated based
on growth in an outside market index. If the index goes up, the contract makes
money but if the index goes down, the principle is protected and the contract
does not lose value.
Index annuities give consumers partial participation in the equity markets in
exchange for principle guarantees. Annuity owners will not lose money no matter
how bad the market performs. It is a place for safe money.
Now that’s all well and good in theoretical terms but how can insurance
companies make that work? It only makes sense after you think about it a while.
Let’s start with the structure of a fixed annuity as that is easy to understand.
When you purchase a fixed annuity, you give the insurance company your
premium and they essentially invest it in bonds.
Whatever return the bond portfolio generates, less company operating expenses,
equals the interest credit rate available for the annuity contract. The insurance
company has all this calculated ahead of time and makes the fixed interest rate
offer accordingly.
As an example, let’s assume an insurance company can make 6% return on
investment and that annual operating expenses are 2%. This is fairly accurate
and representative of today’s market. In this case, a fixed annuity will be
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3. credited with 4% interest.
It works the same way with an index annuity where the insurance company
invests the principal in the same type of bonds. But with an indexed annuity, you
have two basic options with the interest income. You can elect to take the base
interest rate (which is roughly equivalent to what a fixed annuity would pay) or
you can opt for the possibility of more growth.
If you opt for more growth, the company will instead use the interest earned from
the bond portfolio to purchase an option position in a market index. An option is
simply the right- but not the obligation- to purchase securities at a future date for
a contractually stated price. If the market goes up, the company will exercise the
option and credit the gain on that option contract to your annuity contract based
on the gain. If the market moves sideways or down, the option expires worthless
and no interest – or gain- is available for crediting.
Because the money that the underlying bond portfolio earned from its holdings of
corporate bonds was spent on the option, the account earns nothing, but still,
your principal is safe and nothing is lost.
This is really important- your principal is not at risk- only the earnings from your
principal are invested in potentially high yield options. Thus, an indexed annuity
is a safe asset with upside potential.
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