The Determinants of Annuity Prices


Annuity prices are affected by several factors. Some of them are the rate of return the annuity company receives on its investment portfolio, its overhead costs, and the expected mortality of its annuitants. Prices also depend on the insurer's profits, which are determined by the structure and performance of the annuities’ market.

• Annuity issuing companies invest the premiums they receive from annuitants. The future flow of income from the investment combined with the principal is the source of income for the annuity payments. Depending on the insurer's expectations about the return on its investment portfolios, the company converts the premium into future payments. The annuity insurer can charge a lower premium for an annuity if it expects higher future returns on the investment portfolio.
  
  
• The insurance company also incurs overhead costs: it sets up accounts for the individual annuitants and keeps track of the amounts paid out; it also manages the assets of the company, hires people with the appropriate experience (or pays an outside firm), and pays taxes on profits.
  
  
• Mortality is also a determinant of annuity price. In order to assess its expected future liabilities, the annuity company must evaluate how many annuitants will be alive at each future year. Over the life of an annuity contract, the chance that the annuitant will die increases, which decreases the expected liability for the insurance company. In calculating the expected future obligations from an annuity contract, the insurer puts a higher weight on payments in the near future than on those in the distant future. Those weights are determined by the estimated probability that the annuitant survives to that particular point in time.
• Separating the annuities market into risk classes may be more difficult than in the life insurance market because the incentives of the insurer and the insured work in opposite directions here. In the life insurance market, both the insurance company and the insured individual want the insured to live a long and healthy life. In contrast, an annuity insurer would like the insured to die early because the liability of the company will be limited accordingly.