Index Crediting Method

An adviser is considering a hedge using an option series with very low open interest. The chief practical concern is that

1. A.the Options Clearing Corporation does not guarantee a thinly traded series.Wrong. The guarantee applies to every listed contract regardless of how actively it trades.
2. B.the bid-ask spread will likely be wide, raising the real cost of getting in and out.Correct. Execution cost is what thin trading imposes, and a round trip can consume much of the hedge value.
3. C.low open interest prevents the option from being exercised before expiration.Wrong. Open interest counts outstanding contracts and has no bearing on exercise rights.
4. D.the exchange will withdraw the series before the hedge reaches maturity.Wrong. A listed series remains available until its expiration once it has been opened for trading.

Why: Open interest measures how many contracts in a series remain outstanding and is a reasonable proxy for how actively it trades. A thin series usually shows a wide gap between the bid and the offer, so the client pays above fair value to enter and receives below it to exit, and that round-trip cost can consume a large part of whatever the hedge was worth. The problem is amplified for a hedger who may need to adjust or unwind at short notice, precisely when markets are disorderly. None of this affects the rights under the contract, which are identical to those in a heavily traded series.

A married couple elects a joint and last survivor payout on a single annuity contract instead of a straight life payout measured on one spouse. Compared with the straight life option, the joint and survivor payment is

1. A.larger, because two lives are now contributing premium to the same annuity contract.Wrong. The premium is unchanged by the election, and only the expected duration of the payout moves.
2. B.the same, because the insurer prices both options from one identical mortality table.Wrong. The same table yields a different factor for one measuring life than it does for two.
3. C.smaller, because the insurer expects to pay over the longer of the two lifetimes.Correct. More expected payments out of the same contract value necessarily means a smaller payment each period.
4. D.smaller only where the surviving spouse is older than the primary annuitant is.Wrong. The reduction reflects the combined expectancy and applies whichever spouse is the elder.

Why: An annuity payment is the contract value divided by an annuity factor built from the expected number of payments the insurer will have to make. Adding a second measuring life extends that expectation to the longer of two lifetimes, so the same contract value must be spread over more expected payments and each one is smaller. The reduction is a function of the combined expectancy and does not depend on which spouse happens to be older. If the couple wanted the larger payment, they would have to accept that the income stops at the first death.

The reference index for an indexed annuity issued by Thackeray Life falls over the contract year. Ignoring any rider charge, the interest credited to the contract for that year is

1. A.negative, in proportion to the index decline multiplied by the participation rate of the contract.Wrong. The participation rate scales gains only, and applying it downward would contradict the contractual floor.
2. B.zero, because the guaranteed floor in the contract prevents any negative credit for the period.Correct. A general account product cannot pass an index loss to the owner, so the formula bottoms out at zero.
3. C.zero, but the insurer may recover the shortfall out of the credit for the following contract year.Wrong. There is no carry-forward of a bad year; each crediting period is measured independently.
4. D.equal to the declared fixed rate, which replaces the index credit whenever the index falls.Wrong. The floor sets a minimum index credit of zero, not a substitute fixed rate for down years.

Why: An indexed annuity is a general account product, so the insurer absorbs index declines and the owner never receives a negative credit. In a down year the crediting formula simply produces zero and the contract value stands still, protected by the guaranteed floor written into the contract. The participation rate and the cap operate only on an index gain; they scale upside and have no role when the index falls. If the owner were instead in a variable subaccount or an index-linked contract that passes losses through, the account value would decline with the market.

An indexed annuity uses an annual reset crediting method rather than a point-to-point method measured across the full contract term. The practical consequence for the owner is that

1. A.interest already credited in an earlier year is locked in, and a later index decline cannot remove it.Correct. Re-benchmarking the index each anniversary is what makes each year of credited interest permanent.
2. B.the contract credits interest only where the index finishes the term higher than at issue.Wrong. That is the point-to-point design the annual reset is chosen to replace.
3. C.the guaranteed minimum value falls away, since crediting is now measured every single year.Wrong. The contractual floor is an independent guarantee and no crediting method disturbs it.
4. D.the owner shares in index dividends in addition to the price movement of the index.Wrong. No indexed annuity crediting method pays index dividends, because the reference is a price measure.

Why: Under an annual reset the index level is re-benchmarked at each contract anniversary, so any interest credited for a year is locked into the contract value and a later index decline cannot claw it back. A point-to-point method measures only the beginning and ending index levels, so a strong middle period is worth nothing if the index finishes below where it started. The trade-off is that insurers usually attach a lower cap or participation rate to the annual reset, because the lock-in feature costs them more to hedge. If the index rose steadily and never fell, the two methods would produce far more similar results.