Chapter 2 mentions that a high income bond may consist of: A temporary annuity to provide the income A zero coupon bond to provide a minimum capital guarantee Call options to provide exposure to equity price movements Would the aim be to buy a zero coupon bond which matches only a small proportion of the return of capital guarantee (say 10% of the single premium)? How do call options provide exposure to equity price movements? In the UL version of the product, what I initially thought was that these options would allow the insurer to buy the underlying assets / equities at a given price at some point in the future (as premiums are received). But this is a single premium product so I'm a little confused. Also, how does it work in the index-linked version?
Hi Traditionally, the ZCB is used to match the entirety of the capital guarantee, which is some proportion of the initial single premium. The call option is also bought from the initial single premium. The remainder of the initial premium is used to purchase the temporary annuity. If the call option is in the money, then the maturity payment of the ZCB is used to fund the exercise of the option. If the option is not in the money, then the maturity payment of the ZCB is returned to the investor. Index linked version are similar but would invest in index-linked flavours of assets. E.g an index linked temporary annuity or an index linked ZCB. Thanks Amit
Also on this topic, in a later paragraph, it is said that "for a guaranteed equity bond, the income earned from investment in the index will be lower in a low-interest environment and so the residual cost will be higher". Is it assumed that low interest rate implies low stock/share return? How is this assumption justified? What is the residual cost? Why is it higher? Thank you.
Hi A low interest environment could imply corporate bonds are not performing well, and in such an environment, equities may also be negatively impacted. Residual cost is referring to the resulting higher guarantee cost. Does this help? Thanks Em
Hi - just to add: the sentence quoted is about the income earned from the equity investment, not the total return. Dividend yields could be lower in a low interest rate environment. Remember that the insurer keeps the dividend income (only the share price growth is passed to the investor). This is intended to contribute towards the insurer's expenses, profit and the cost of the equity index participation. If the dividend income is lower, this contribution is lower, so the 'residual cost' (ie what it has to find from elsewhere to cover these items) is higher.
