IVAs level of protection
In exchange for giving up some of the upside, IVA investors with the index allocation receive a level of downside protection through the buffer. In our hypothetical example structure, the 10% loss buffer means that the insurance company issuing the IVA will absorb the first 10% of losses on the index each year. Insurance companies currently offer buffers ranging from 10%-30%, and higher or lower levels may be offered in the future.
Survey respondents also identified 10% on the downside as a reasonable level of risk for the insurer to absorb. So, for purposes of this discussion, let us define "downside risk" as the potential to lose 10% or more in a year. Or, conversely we can define "protection" as the lack of losses of 10% or more. Expanding on the previous analysis, the bond benchmark showed the strongest protection with 0 years (0%) with a loss of 10% or more. The equity benchmark had the most downside risk with five years (14%) with a loss of 10% or more. The 65/35 benchmark and IVA fell in between the bond and equity benchmark and showed matching levels of protection against downside risk with two years (5%) that had losses of 10% or more each. Note that using a buffer larger than 10%, such as 20% or 30%, would further reduce the frequency of losses of 10% or more. Smaller buffers would yield results that converge to those of the equity benchmark itself, which would be similar to using an IVA with a 0% buffer.
Historically, an IVA with a 10% loss buffer would have performed very well compared to other index allocation choices. The IVA provided a similar level of protection as a balanced portfolio using bonds as a source of fixed income. However, the IVA avoids potential market value losses of bond funds when interest rates rise.
As the hypothetical examples have shown, IVAs can be effective in creating a new way to balance risk and return. The potential for index returns over 10% with the level of protection of an IVA is very similar to taking the significant risk of an all-equity investment. Additionally, the level of protection provided by an IVA to buffer losses of greater than 10% is very similar to a balanced allocation of 65% equities and 35% bonds. Perhaps most significantly, IVAs would have provided similar historical levels of returns and protection of a balanced benchmark without the risk of rising interest rates. Of course, these are historical returns, and past performance is not necessarily indicative of future performance.
How buffers work
The buffer method provides a first level of protection against losses, rather than an ultimate floor on losses. Losses up to a stated percentage are covered, and the investor participates in losses that exceed the buffer. This means that the investor is still exposed to extreme losses for negative performance in excess of the buffer, but partially protected on any loss. Annual product fees and charges may be assessed which will reduce values.
The hypothetical example shows conceptually how cap and buffer rates work in an IVA product in different market index environments, utilizing a 10% cap and 10% buffer rate. The example assumes that the declared rates do not change after the contract is issued and do not include deduction of any annual product fees and charges that may apply, or taxes that may be incurred. The example does not predict or project the actual performance of an IVA. For index returns of 10% or greater, the investor would receive a 10% credit. For positive returns of less than 10%, the investor would receive a credit equal to the performance of the index. For negative returns up to -10%, the investor is protected by the buffer and would be credited with 0%. For negative returns in excess of -10%, the investor would receive negative credit on the portion of the return in excess of the -10% buffer. For example, an index return of -12% would result in a -2% credit.