6.1 Annuity Principles and Parties

What an Annuity Is

An annuity is a contract issued by a life insurance company that, in exchange for premium, promises to pay out a stream of income, typically for life. It is the mathematical and contractual mirror image of life insurance. Life insurance creates an immediate estate and protects against dying too soon; an annuity liquidates an estate and protects against living too long (the risk of outliving your savings, called superannuation).

Because an annuity guarantees income that cannot be outlived, the insurer is assuming longevity risk. The same mortality tables that price life insurance are used to price annuities, but read in the opposite direction: in life insurance, an early death is a loss to the insurer; in an annuity, a long life is the loss.

The Two Phases

Every annuity has two distinct time periods.

The act of switching from accumulation to payout is called annuitization. Once a contract is annuitized under a life option, the decision is generally irrevocable and the lump sum is surrendered to the insurer in exchange for the income guarantee.

Accumulation and Annuity Units

In a variable annuity, deposits during accumulation buy accumulation units (a measure of ownership in the separate account). At annuitization, accumulation units are converted to a fixed number of annuity units; the number of annuity units stays level while each unit's dollar value fluctuates with separate-account performance.

The Parties to the Contract

Four roles appear on an annuity. One person can fill several roles at once.

The annuitant must be a natural person because the contract is built on a human life expectancy. The owner, by contrast, can be a person, trust, or corporation. If the owner and annuitant differ, beware of the annuitant-driven vs owner-driven death-benefit trigger, which determines whether payments stop at the death of the annuitant or the owner.

Accumulation vs. Annuity Phase and the Exclusion Ratio

An annuity has two phases. During accumulation (pay-in), money grows tax-deferred. During the annuity (payout) phase, the insurer converts the value into income. The pivotal event is annuitization - the irrevocable election of an income option.

The Parties and Why They Matter

The annuitant drives the payout calculation because life-contingent options depend on life expectancy; owner and annuitant are often the same person but need not be.

Exclusion Ratio Worked Example

For a nonqualified annuity in the payout phase, the exclusion ratio separates the tax-free return of basis from taxable interest. Exclusion ratio = investment in the contract / expected return.

Example: $100,000 basis, expected total return $200,000. Exclusion ratio = 100,000 / 200,000 = 50%. If the annuitant receives $1,000/month, $500 is tax-free return of principal and $500 is taxable. Once the entire basis is recovered, all further payments become fully taxable.

Annuity vs. Life Insurance: Opposite Risks

The exam loves the contrast between an annuity and life insurance because they hedge opposite risks. Life insurance protects against dying too soon (premature death leaves dependents unfunded). An annuity protects against living too long (outliving one's savings). An annuity is sometimes called the flip side of life insurance.

Worked trap: because annuities pool survivors, a poor-health applicant is not a better risk for the insurer - longer-lived annuitants cost more, the reverse of life-insurance underwriting. The annuitant's age and life expectancy therefore drive the payout calculation, while in life insurance the insured's mortality risk drives the premium. Confusing which risk each product hedges is a frequent miss.

Premium Modes and the Surrender Charge

Annuities are funded in one of two ways: by a single premium (one lump-sum deposit) or by periodic/flexible premiums paid over time. Combined with the two payout timings, this produces the product-naming grid that the exam tests heavily (covered in 6.2).

During accumulation, the insurer recovers its acquisition costs through a declining surrender charge (a back-end load). A typical schedule:

Most contracts allow a free withdrawal of up to 10% of value per year without charge. Worked example: an owner with a $100,000 fixed annuity in year 3 (5% charge) withdraws $30,000. The first $10,000 is free; the remaining $20,000 is subject to the 5% charge = $1,000 surrender charge, plus possible IRS penalties (see taxation in 6.2).