A breakthrough year: industry sales shot up an estimated 66% in 2004, and major writers reportedly are poised to enter the market.

People familiar with equity indexed annuities used to refer to them as variable annuities with training wheels. Not anymore. This fixed annuity that can kick in greater interest payments through a link to stock indexes last year recorded sales growth that only can be attributed to a product with its own place in the market. In an investment marketplace that had become scary and disheartening, investors near or in retirement bought into the safety and potential for better returns that index annuities provide.

Despite significant sales gains in 2002 and 2003, 2004 will be remembered as the year EIAs came into their own. Total sales climbed more than 66% to $23.3 billion, according to Advantage Compendium, the St. Louis-based company that has tracked the industry for more than seven years. Index annuities accounted for between a fourth and a third of all fixed annuity sales, said company President Jack Marrion.

New premium last year exceeded the amount written from 1995 through 2000, the first six years the products were available in the United States. Marrion predicted that index annuities will grow this year to half of all fixed annuities sold as a half dozen major companies will enter the market.

Like traditional fixed annuities, index annuities protect principal and offer a guaranteed return by investing in fixed-income securities. But index product writers also use a small portion of premium to buy stock index options. If the market index falls, the options are worthless, and the product writer lets them expire. But if the market index rises, the company exercises the options and credits money to policies.

An unusual confluence of forces drove sales last year, and it most affected investors in or near retirement, the age group most likely to buy index annuities. David Hopewell, an actuary and senior manager at consulting firm Ernst & Young, said investors gained a renewed appreciation the past few years for the risk in the equity markets. "It became clear that stocks have not only short-term risk, but medium-term risk," he said. "And equity indexed annuities are the only product that has intermediate term guarantees."

The 3% annual guarantees that many index products offered looked good compared with the record-low interest rates paid last year on fixed-income products, he said. And with the chance of receiving some portion of the stock index return, investors found that index annuities gave them "some hope of making what they hope for and need," Hopewell said.

"The market conditions made a huge difference," said Charles E. "Chuck" Lucius, president of Personalized Brokerage Services LLC, a major seller of index annuities, based in Topeka, Kan. "People got adjusted back to reality. When you look back, if you weren't getting 10% on your money, you were an eight ball. People are more conservative now than they were before." Lucius said that people are now much more realistic about how they're going to live longer, are more open to investment ideas and strategies than when they perceived the stock market to be a sure thing, and are keen to avoid financial setbacks.

To illustrate the ability of index annuities to perform in difficult markets, Allianz Life Insurance Company of North America calculated in February that its FlexDex bonus annuity over the previous five years provided an annualized return of 3.7%, while the S&P 500 returned a negative 3.6%, not counting dividends. Since index annuities buy index options, they do not receive dividend payments.

Independent marketing organizations like Lucius' make up the key distribution outlet for index annuities, and Marrion said sales also grew because more agents are selling them. He said the penetration in the agent market increased 20% in the past two years, to 12% of all agents from 10%. PBS is owned by Allianz.

Allianz' Dominance

Allianz took over sales leadership in 2000 and has become dominant since then. Its sales rose 39% last year to $7.8 billion, nearly a third of total market sales, and it issued about 150,000 new policies. "It's due to a combination of increased consumer awareness of the product, favorable demographics and Allianz' pursuit to develop cutting-edge products," said Patrick M. Foley, president and chief executive officer of Allianz Individual Insurance Group LLC.

Allianz' MasterDex series came out in spring 2004 but already accounts for 70% of the company's new sales, said Foley. The series offers short-, intermediate- and long-term products that Foley says are the most consumer friendly and easiest to understand. Each of the products credits 100% of index gains, if any, monthly. Caps on the monthly gains range from 2.5% to 3%. The annual return is simply the sum of the monthly results. Most other annual-reset products use a monthly averaging crediting methodology that is more complex and subject to participation rates that can be less than 100% of the index, Foley said.

The most significant thing Allianz has learned in the past few years about product design is that the consumer likes the base concept of index annuities, but wants a crediting methodology that is straightforward and understandable, Foley said.

Allianz also has learned that independent agents are looking to companies and independent marketing organizations for more than product, and Allianz' distribution system plays a powerful role in the company's sales success. Allianz markets exclusively through contracts with independent (or field) marketing organizations that recruit and train their own agents. Foley estimated that Allianz has contracts with about 150 field marketing organizations nationwide with about 160,000 independent agents. About 30,000 of those last year actually wrote business, he said. Allianz partners with the marketing organizations to provide education and career-development skills to the agents and reps.

According to Marrion's survey statistics tot last year's third quarter, independent agencies accounted for 93.2% of EIA sales. Banks accounted for 3.5%, career agents for 2.7% and broker/dealers for 0.6%. Career agents sell so little because companies with career agents typically don't offer the products. But that is likely to change this year and next as major insurers enter the market, Marrion said. Their entry also is likely to increase sales through banks and broker/dealers, such as Charles Schwab and Smith Barney, he said. "Index annuities won't be the stepchild annuity by the end of next year," said Marrion.

Hopewell, who is preparing an index annuity report for this spring, said the industry is embarking on a second round of product development that will incorporate the lessons of the first round. He didn't want to divulge his report's findings, but he said new products likely will be structured more flexibly to address buyers' needs. They also will help manage intermediate-term market risk-one to five years--so as not to compete with variable annuities, which manage risk over longer periods, often 10 years or more, through living-benefits options.

Marrion's third-quarter survey found that more than 82% of index annuities sold in the quarter had surrender periods of 10 years or more, but that more than 83% of all annuities sold reset guaranteed values annually. Products with long surrender periods still can meet an intermediate-term planning need since annual-reset designs are tantamount to consecutive one-year contracts, and most provide some liquidity without incurring the surrender charge, Hopewell said.

Index Annuity Sales Surge in 2004

Allianz Life Insurance Company of North America again dominated the
market in 2004, but several competitors more than doubled their sales.

                                                           % Change
Company                      Total Sales    Market Share   from 2003

Allianz Life              $7,854,985,000          33.64%      80.54%
* Old Mutual               2,215,139,307           9.49      223.58
American Equity            1,623,934,851           6.96       51.34
Sun (Keyport) Life         1,620,761,342           6.94      208.57
AmerUs Group               1,524,096,999           6.53       16.56
ING                        1,447,765,464           6.20      146.07
Jefferson-Pilot              981,100,344           4.20      151.23
Midland National Life        957,900,000           4.10       34.57
Jackson National Life        735,033,840           3.15       92.93
Lincoln Benefit Life         550,289,033           2.36       90.95

Top 10 Companies' Share of Total Market           83.57%

* Old Mutual was reported in 2003 as Fidelity & Guaranty Life and
American Life & Annuity Source: Advantage Compendium

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Allianz Life Insurance Company of North America

A.M. Best Company # 06830

Distribution: Independent agents

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Key Points

* The sales explosion shows that index annuities have become a legitimate way of addressing intermediate-term market risk.

* As large insurance carriers introduce products this year, distribution should broaden beyond independent insurance agencies to brokers and banks.

* Class-action attorneys, regulators and the general press have greater incentive to search for sales abuses now that the product has become successful.

Index Annuity Success Could Mean Greater Scrutiny

Now that index annuities have become a successful product line, will regulators and class-action lawyers target the industry? Jack Marrion, president of research and consulting firm The Advantage Compendium, believes they will. He predicts index annuities will provide a "juicy target for trial lawyers," that the general press will "write some sensational articles about alleged index annuity consumer abuses," and that a regulator or politician will ask for an investigation. He also predicts the Securities and Exchange Commission will reopen the question of whether index annuities ought to be considered securities. This will make wirehouses and the National Association of Securities Dealers happy because growing index-annuity sales can detract from sales of securities, he said.

The incentive and potential for improper sales certainly exist. According to Marrion's surveys, commissions in last year's third quarter averaged 8.31% of premium, higher than for most investment products and higher than for fixed-yield annuities. Surrender periods of most index annuities sold last at least 10 years, and the longer the surrender period, the higher the commission. Also, the products are so complex that buyers--and even some agents--are hard pressed to understand them. Advantage Compendium identifies 35 crediting variations among products today. They consist of a mixture of such techniques as term index end points, high points, participation rates, caps, annual resets, monthly averaging, yield spreads and average daily values.

Allianz Life Insurance Company of North America, the leading seller of index annuities, has simplified its products, and it partners with its independent marketing organizations to educate agents. "We have conducted more than 300 workshops all over the United States with more than 15,000 agents attending" said Patrick M. Foley, president and chief executive officer of Allianz Individual Insurance Group LLC. The company also sponsors "Webinars," training sessions on the World Wide Web.

To monitor the suitability of individual sales, an agency review committee within Allianz' home office performs spot checks on the ages of buyers, purchase amounts and appropriateness. "We're constantly on the lookout for situations that don't seem suitable," Foley said. The company also runs background checks on recently contracted producers.

Allianz is not a member of the Insurance Marketplace Standards Association, the independent organization formed in 1996 by the life industry that promotes ethical conduct among its members selling life insurance, annuities and long-term-care insurance. Foley said the company considered joining, but chose not to because the reporting requirements of its parent company in Germany are so intense that IMSA certification would represent an unneeded "extra layer."

Charles E. "Chuck" Lucius, president of Personalized Brokerage Services LLC, a field marketing organization, said his company trains contracted agents to seek out both facts and feelings during client interviews. It also has joined the National Ethics Bureau, which provides verification of agent credentials and confirmation of ethical conduct. Sales materials are vetted and approved by Allianz, said Lucius, and PBS makes extra efforts to ensure that sales material makes fair representations.

Based in Topeka, Kan., PBS is owned by Allianz and employs 150 to serve about 20,000 contracted agents. It writes about $1 billion in annual annuity premium through the marketing name Annuity Masters. The company sells product for about 30 annuity companies in all.

A Typical Buyer

Index annuity buyers at PBS are typically 58 to 65 years old, younger than in previous years. A majority are still working, and a lot have considered index annuities to be good alternatives to the recent historically low yields on bank accounts and certificates of deposit, said Lucius. "They were so conservative that they had not been doing well," he said of annuity buyers. "Another segment was in the stock market, but they lost money and can't afford to take risk any longer. In fact, they shouldn't have been taking risks, and they just realize that now." The average size of a PBS index-annuity sale is about $52,000, Lucius said.

Helping these people earn higher returns means encouraging them to lock up their money with a company for a period of time. "Companies need to have money for set periods to make the returns that people need to have," said Lucius. "People need to layer their money and ensure that some is liquid. Most annuity writers allow 10% withdrawals each year without penalty. So there are a lot of things you can do to get to your money, and you don't put all your money into annuities."

Who sells and doesn't sell index annuities may attract the interest of both lawyers and regulators. Agents do not need a securities license to sell them, and many professionals that have securities licenses, such as stock brokers and financial planners, sell hardly any of the products. But the distribution of index annuities may not be due to the way professionals judge product efficacy, but to the way registered and nonregistered products are traditionally sold in different channels. "Index annuities are fixed-annuity substitutes," said David Hopewell, an actuary and senior manager with Ernst & Young. "The issue is the way the insurance companies are organized."

Meanwhile, the perception that only those producers without securities licenses sell index annuities may not be accurate. "I can't speak for the industry, but of our top 3,000 agents, who do about 50% of our production, more than 80% have securities licenses," said Foley.

Nor are long surrender periods unique to index annuities. "They are also a potential suitability problem for any fixed annuity with back-end loads, so if I start thinking that way, I would have to think that way for a lot of other insurance-based products," said Frank Sabatini of Ernst &Young's Insurance and Actuarial Advisory Services Life/Health practice. "I'm sure surrender charges are things some people will understand and others will not. It depends on how well the person selling a product explains them." Sabatini said buyers have a better chance of receiving good disclosure with an SEC-registered product, but that doesn't mean they get inadequate disclosure with nonregistered products.

Marrion said that in his first-quarter sales report, he would recommend that carriers act swiftly to address several concerns:

* To show, probably through the use of independent experts, that they know what they are doing in managing the financial and hedging risks of index annuities. His assessment is that carriers know what they are doing.

* To "clean up the products." Both agents and consumers have often had trouble explaining to him how the products work, and he said carriers need to consumer-test their products and materials to see if the consumer gets close to being right.

* To train and police the producers. Advantage Compendium has a template titled "Annuity Producer Guidelines" that is free to any carrier.

* To help regulators redefine what a fixed annuity is. Marrion said the third of three SEC safe-harbor rules must be clarified. It says a product is not a security when it is "not marketed primarily as an investment." Even aluminum siding and luxury cars are marketed as investments, Marrion said.

Crowded at the Top,
Combined Market Share

Most of index annuity sales volume
was concentrated among the
top companies in 2004, but that
may change this year if and when
the largest insurance companies
enter the market.

                     3rd Quarter 2004
                         Market Share

Allianz                        42.66%
Top 3 Companies                57.08%
Top 5 Companies                67.70%
Top 10 Companies               85.16%

Source: Advantage Compendium