hedging strategies for indexed ul products · 2020-04-02 · indexed ul is a general account...
TRANSCRIPT
Hedging Strategies for Indexed UL Products Data, Analysis and Implications
Bobby Samuelson
SamuelsonDesign
10/18/11
Abstract
Life insurance carriers are required to record all derivative trades in Schedule DB of the annual statutory Schedule
of Investments section of their annual filings. Analysis of the options trades underlying Indexed UL contracts
reveals almost universal pricing constraints with some notable exceptions that are cause for further investigation
for producers selling Indexed UL. This white paper walks through general observations on Indexed UL return
profiles, options trading practices carriers use to offload equity risk and the mathematical implications of
including real options prices in long-term options profit models.
Outline
1. The Indexed UL Return Profile
2. Hedging Indexed UL Equity Risk
3. Carrier Hedging Data
a. Pacific Life Options Data
b. Aviva Options Data
c. Minnesota Life Options Data
4. The Exceptions – Minnesota Life & Penn Mutual
a. Minnesota Life
b. Penn Mutual
c. Summary
5. Long-Duration Account Options
6. Hindsight & Other Esoteric Options
7. Observations on Options Profit Models
8. Implications for Indexed UL Illustrated Rates
9. Recommendations for Indexed UL Illustrated Rates
10. Technical Appendix
a. Policy Charges – Current Assumption & Indexed UL
b. Policy Charges – Indexed UL vs. Indexed UL
c. Artificial Options Budget Return Leverage
d. Caveats to Assumed Universal General Account Yields
e. Mitigating Factors to Opportunity Cost of Options Purchases
Disclosure
All words herein are solely mine unless specified otherwise.
I did not receive any compensation from any party, directly or indirectly, for authoring and publishing this piece.
This white paper is for open distribution.
The Indexed UL Return Profile
Indexed UL is a general account product offering crediting rate upside based on the performance of an external
equity index and guaranteed downside protection. Upside participation is adjusted via a participation rate and an
interest cap. Most account options available inside IUL products guarantee one of the two limiting factors and
allow the other to float. The most common account option has a floating annual interest cap of between 10% and
15% in current market conditions and a guaranteed 100% participation rate.
The return profile of an Indexed UL product is, by definition, limited when compared to the underlying external
equity index. Floating caps and participation rates change the return profile of Indexed UL in different ways.
Floating participation rates below 100% mimic the general shape of returns for the equity index but with lower
returns and a cluster of returns at the guaranteed floor of 0%. Interest caps simply truncate the upside and
downside tails of the distribution and exactly mirror the external equity index for all points between the
guaranteed floor and the floating cap.
Figure 1 shows hypothetical annual returns for Indexed UL and the S&P 500 excluding dividends since 2000.
Over time, the floating cap strategy will have an exceptionally large number of observations at the floor and cap
because all observations beyond are clumped into a single return pattern. For example, all equity returns above a
12% cap are credited to the policy at 12%, meaning a very large number of observations at the 12% level. Visually,
the distribution of returns for a floating cap strategy looks like a barbell with the vast majority of observations
occurring at the floor and cap. The concentration of returns at the limits of the capped Indexed UL strategy begs
the analogy of flipping a very fat, unevenly weighted coin with one side representing the guaranteed floor and the
other representing the floating interest cap. Since 1950, 73% of years would have been either a 0% credit or a
12% credit (assuming a constant 12% cap historically). Approximately 44% of years would have returned the 12%
cap and 29% would have resulted in the guaranteed floor of 0%. Of the 27% of observations that fell within the 0-
12% bound, the average return skews towards 8%, also indicating the overall skewness of the observations
towards positive returns over negative returns – the uneven weight in the coin. Note that the size of the losses or
gains beyond the cap and floor are irrelevant for long-term returns. 73% of the time the only relevant fact is
whether the return yielded a result within the limits or beyond the limits. The actual return of the index only
matters within the floor and cap, when the product performs identically to the external index.
-40%
-30%
-20%
-10%
0%
10%
20%
30%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
An
nu
al R
etu
rn
IUL S&P 500
Figure 2 shows the distribution of S&P 500 and Indexed UL annual returns since 1950 run on each day of the
trading year. Red is the S&P 500 and blue is Indexed UL with a 12% cap and 0% guaranteed floor.
Despite its polarized annual payoff pattern, Indexed UL returns will converge to a relatively stable mean over the
long term, much like one can expect the mean of a series of coin flips to approximately equal 0.50 after sufficient
observations despite perfectly polar individual return observations. The long-term distributions of returns for
Indexed UL is also substantially tighter and converges faster to the mean than the underlying external equity
index because of the absence of negative returns. One way to measure the tangible impact of return volatility in a
distribution over the long-term is to compare its arithmetic mean return to its geometric mean return. The
arithmetic mean return is the sum of all annualized returns divided by the number of observations. The geometric
mean return is the square root of all of the observations multiplied together.
Comparing the arithmetic to the geometric mean for each distribution sheds light on what might be understood
as the “risk premium” for each asset class. The mathematical definition of an expected outcome is to multiply the
probability of occurrence by the magnitude of the outcome. It is impossible to accurately predict the true
probability of occurrence for a particular event in financial markets but historical data provides a proxy.
Arithmetic averages for historical annual returns provides an analogous figure to mathematical expected outcome
because the math is essentially the same, although the probability calculation is not based on an assumed
distribution but rather on the actual occurrence pattern in the data set. A highly volatile asset will most likely have
a high expected return in any given year. However, arithmetic averages systematically underweight large negative
outcomes by treating each annual return observation as an independent outcome. Geometric averages correctly
weight negative outcomes by calculating the average return based on the sequence of returns rather than the
returns as independent outcomes. For instance, the arithmetic average of two annual returns of +50% and -50% is
0%. However, the geometric mean and real dollar outcome is -25%. Geometric means, therefore, shed light into
the volatility of the distribution and adjust average returns for the outsized impact of negative years in each
sequence of returns. By comparing geometric to arithmetic, we capture the difference between the
mathematically expected return (arithmetic mean) and the volatility-adjusted expected return (geometric mean).
The spread between the two averages is a cut-and-dried indicator of the real volatility of returns for the asset
class.
0%
5%
10%
15%
20%
25%-5
5%
-51
%
-47
%
-43
%
-39
%
-35
%
-31
%
-27
%
-23
%
-19
%
-15
%
-11
%
-7%
-3%
1%
5%
9%
13
%
17
%
21
%
25
%
29
%
33
%
37
%
41
%
45
%
49
%
53
%
57
%
61
%
65
%
69
%
73
%
Pe
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s
Annual Return
Table 1 shows real annual CAUL, S&P 500 and Indexed UL returns since 2000. Indexed UL performance through
2009 is the reported average annual credited rates of an actual in-force IUL block at a major Indexed UL carrier.
CAUL Returns S&P 500 Returns IUL Returns
2000 6.08% -9.10% 5.88%
2001 5.93% -11.89% 0.00%
2002 5.78% -22.10% 0.06%
2003 5.23% 28.69% 6.11%
2004 4.95% 10.88% 9.86%
2005 4.85% 4.91% 6.61%
2006 4.83% 15.79% 8.13%
2007 4.80% 5.49% 9.33%
2008 4.80% -37.00% 0.02%
2009 4.78% 26.46% 2.99%
2010 4.75% 15.06% 12.00% (Assumed) Arithmetic 5.16% 2.47% 5.54% Geometric 5.16% 0.41% 5.47%
Spread 0% 2.06% 0.14%
A spread of 0% implies that Current Assumption UL returns are roughly equivalent to a fixed rate or, in other
words, there should be only a minimal (if any) risk premium in accepting the floating CAUL rate instead of a fixed
rate. This is intuitive. One does not know at onset whether the rates are going to go up or down, but the volatility
is exceptionally low on an annual basis and subject to a floor of 2-4%. Were we to include carrier defaults and
policy charges in the analysis, the numbers may have been more volatile and almost certainly increased the
spread from 0% to some marginally higher number. S&P 500 returns are assumed to be more volatile than CAUL
and the spread between arithmetic and geometric returns corroborates this assumption. The most interesting
outcome, however, is that the spread for Indexed UL is a mere 14 basis points. Based on this data set, one can
make the assumption that the volatility in Indexed UL isn’t worth much in terms of risk premium for long-term
returns. The return profile for Indexed UL appears to be much more like CAUL than the S&P 500.
Table 2 shows arithmetic and geometric averages for 10 Year Treasuries, S&P 500 and hypothetical Indexed UL
returns since 1950.
10 Year Treasuries S&P 500 Returns Indexed UL Returns
Arithmetic Average 6.29% 12.51% 7.25%
Geometric Average 6.26% 11.05% 7.11%
Spread 0.03% 1.50% 0.14%
Like Current Assumption UL, the miniscule 3bps spread for 10 year Treasuries implies a relatively riskless asset.
The spread for Indexed UL since 1950 is identical to the spread from 2000-2010 despite the fact that the risk
premium (and average return) for the S&P 500 increased. This result is highly intuitive. The return profile of an
Indexed UL product remains that of a fat, unevenly weighted coin toss regardless of the level of returns for the
S&P 500. The level of Indexed UL returns floats somewhat in accordance with the S&P 500 but in a
counterintuitive way. Indexed UL returns could stay flat even if the S&P 500 increased dramatically if the S&P 500
grew in a highly volatile fashion, with infrequent, extremely large gains. What matters to Indexed UL returns is not
the size of S&P 500 returns but instead the frequency of occurrence. Indexed UL looks best compared to the raw
index when the S&P 500 grows at a consistent, conservative rate. Ironically, that is precisely the scenario where
Indexed UL would be the least valuable as a hedge against downside risk.
Note also that Indexed UL returns are going to be systematically skewed to the positive in an analysis that does
not capture the effect of policy charges. Years when the policy credits 0% to the cash value will actually show a
decline in return because of policy charges. Comparing the arithmetic and geometric means for real cash-on-cash
yield in Indexed UL products would yield different risk adjusted returns across Indexed UL products with identical
caps and floors due to differing charge structures. As discussed in other publications, policy charges should be of
paramount concern for producers selling Indexed UL because they represent the real downside risk of each
product. Policy charges, in effect, inject substantially more risk into the product than we can see by just looking at
hypothetical historical crediting rates. This effect is well documented in Variable UL actual policy performance.
Hedging Indexed UL Equity Risk
The return profile of Indexed UL is fundamentally mismatched to the returns of the fixed income assets
comprising the vast majority of a carrier’s general account. Generally, returns on fixed income assets only change
if the asset is sold prior to maturity or if the issuer defaults. Indexed UL returns are polarized at the guaranteed
interest rate and floating cap, virtually never matching exactly with the fixed income asset yields of the carrier’s
general account.
The issuing carrier is, in effect, placing an equity based liability on its fixed asset balance sheet when it writes an
Indexed UL product. The carrier has a few options to deal with the liability. The simplest is to retain the risk by
simply writing the liability and gambling that fixed income assets will cover the equity liability over the long term.
This strategy has several negative implications. First, it exposes the carriers to swings in product profitability
based on swings in the equity markets. A long stretch of consistent growth in the S&P 500 would cause a major
mismatch between the crediting rate on the Indexed UL product and the earned rate on the fixed income assets
in the general account. Second, it builds perverse incentives for the carrier to lower the cap rate at the moment
when it believes that equities are going to rise. Finally, it lends itself to periods of historically overstated and
understated performance depending on the pricing assumptions used for illustrative purposes.
The vast majority of carriers choose to offload the equity risk in Indexed UL products to a third-party financial
services entity, most commonly investment banks. The mechanics of the transaction are deceptively simple. The
carrier uses the earned rate on its fixed income assets as the budget to purchase protection against the Indexed
UL equity risk liability. The carrier effectively transforms the equity risk of an Indexed UL product into fixed
income risk. Equity returns are irrelevant to long-term carrier profitability because any payoff from the equity
hedge will be immediately transferred, dollar for dollar, to policy cash values. The only risk the carrier takes is that
it can’t earn enough to cover the budget of the purchased equity hedges. Options profits go to the policyholder.
Over time, the product risk profile of a fully hedged Indexed UL product looks very much like CAUL to the carrier.
If crediting rates on CAUL are unsustainable based on fixed income yields, the carrier lowers crediting rates. If
hedging costs for Indexed UL are unsustainable at the current participation limits based on fixed income yields,
the carrier lowers participation limits and thereby reduces the cost of protection against equity risk. Regulators
have confirmed the similarity between fully hedged IUL and CAUL by giving them effectively the same reserving
treatment, tacitly equating the risk profiles (more reserve would imply more risk, vice versa). Actuarial Guideline
36 sets out 3 methods for reserving for Indexed UL contracts. One method applies only for fully hedged IUL
polices, the other two methods apply to partially or dynamically hedged IUL policies. The key parameter for
determining reserves for fully hedged IUL policies is the statutory equality of historical hedging (options) costs to a
guaranteed crediting rate for future returns in accordance with the Cash Value Reserve Methodology reserving
regime used for CAUL. Note that projections of future strategy returns are irrelevant for reserving. Only the cost
of hedging the policy is important.
Carrier Hedging Data
Every carrier must file a statutory annual report containing, amongst a variety of other things, a schedule of
investments that contains details on every asset held, terminated or acquired during the year. Schedule DB
contains details for all derivative transactions. Hedges on Indexed UL policies are derivative instruments and are
listed in Section 1 of Schedule DB under the caps and floors section. Analyzing the hedging trades underlying the
Indexed UL contracts provides insight into how carriers actually participate in the market and what it may mean
for policyholders in the long run.
Reading the Schedule DB to look for Indexed UL trades can be exceptionally difficult for two reasons. First, a
carrier writing Equity Indexed Annuities and Indexed UL will most likely execute multiple options trades a day that
have nothing to do with Indexed UL policies. The process of sifting through thousands of trades to look for the
ones specifically linked to Indexed UL can be arduous. Second, some carriers provide sparse information in
Schedule DB as to the exact parameters for each trade. For instance, they will only list one strike of a packaged
two-strike cap trade. If both factors are present, the data is virtually worthless for analysis because one will not be
able to reliably differentiate between Indexed UL and Indexed Annuity trades.
The ideal carrier for analyzing Indexed UL trades only has Indexed UL contracts and provides complete detail for
each trade. Pacific Life qualifies. Aviva writes Indexed Annuities but executes its IUL trades near or on the 10th and
25th of each month and provides a high level of detail, making their books relatively easy to read as well. Pacific
Life and Aviva also serve as excellent proxies for other reasons. They are ranked number 1 and number 2 in
Indexed UL sales, respectively. Pacific Life has held its cap constant at 12% since the inception of the product in
2005 through 2010. Aviva has several in-force products on the books with different pricing methodologies and
different caps. Both carriers serve as de facto benchmarks for pricing for the rest of the industry.
Pacific Life Options Trades
Most of the analysis will focus on Pacific Life primarily because the product pricing hasn’t changed since inception
and many carriers still have approximately a 12% cap, making the historical performance of the product
particularly applicable to current market conditions. Options prices are quoted as a percentage of the notional
covered. For instance, a 5% option means that it costs $50,000 to cover the equity index liability on $1,000,000 of
Indexed UL cash value.
Theoretically, a carrier could hedge its capped index liability by purchasing a call option at a strike of 0% gain and
writing a call option with a strike of a 12% gain. From 0% to 12%, the carrier receives a return in lock-step with the
index. From 12% and beyond, the carrier receives money from the purchased call and owes exactly the same
amount on the call option written at 12%, producing a net-zero payoff above 12%. The net cost of the option is
the paid premium of the 0% option less the received premium of the 0% option. Carriers usually simplify the
process by simply purchasing a packaged call spread from an investment bank. The option provides coverage from
exactly 0% to 12%, mimicking the payoff of a call spread, for a single price and with a single counterparty. The
advantage to the carrier is that it involves less trading and less complications with individual options. The cost of a
call spread package is simply the premium divided by the notional covered.
Table 3 shows Pacific Life’s 1 year Point-to-Point capped account options trading activity in each month from 2006
through 2010. The stated cap in all years was 12%. Average cost across all years was 5.45%.
2006 2007 2008 2009 2010
January 5.50% 5.62% 5.68% 5.52% 4.84%
February 5.38% 5.50% 5.53% 5.46% 4.94%
March 5.35% 5.63% 5.55% 5.25% 4.82%
April 5.46% 5.59% 5.41% 5.14% 4.74%
May 5.44% 5.65% 5.36% 4.98% 5.37%
June 5.91% 5.72% 5.57% 5.28% 5.45%
July 5.95% 5.78% 5.50% 5.22% 5.47%
August 5.82% 5.93% 5.35% 5.17% 5.40%
September 5.71% 6.07% 5.61% 5.10% 5.31%
October 5.58% 5.94% 5.55% 5.03% 5.24%
November 5.50% 5.96% 5.70% 5.04% 5.04%
December 5.57% 5.86% 5.53% 5.07%
Average 5.60% 5.77% 5.53% 5.19% 5.15%
This data points to several observations. First, that PacLife determined a 12% cap to be sustainable on the same
policy charge structure even as the options cost fluctuated from between 6.07% and 4.75% and their general
account rate stayed relatively constant at approximately 5.15% (including in-force). Second, that options costs
haven’t fluctuated to the degree that one might expect based on the exceptional market turmoil over the data
period. Third, that options cost are not correlated to the normal market bellwethers of the CBOE market implied
volatility index (VIX) and short term rates in accordance with Black-Scholes options pricing theory.
Figures 3 & 4 show options prices in relationship with external benchmarks.
The external benchmark most closely related to costs of Pacific Life’s packaged call spreads appeared to be the
AAA composite yield as recorded by the Federal Reserve. While somewhat counterintuitive, the fact that
packaged call spread options are closely correlated to the AAA composite signals support for the idea that
Indexed UL returns are relatively stable compared to equities with very little premium for riskiness. It follows that
options pricing should be largely based on opportunity cost of capital for which the AAA composite serves as a
proxy. We could construct detailed narratives for why options prices move with AAA bonds but, ultimately, those
would fall short. The most pertinent metric is that the average differential between the AAA composite and 0-12%
options since 2006 is 1 basis point. Despite short term volatility, the two appear to be highly related at least over
the short time period in question.
Figure 5 shows the AAA composite and Pacific Life’s call spread option costs
Aviva Options Data
Aviva’s options trades bear a striking resemblance to Pacific Life’s. The primary trading difference between Aviva
and PacLife is that PacLife purchases options once in the middle of the month and Aviva trades near the 10th and
25th of every month. Some of the difference in options prices can be attributed to timing.
Table 4 compares options purchases for 12% caps on Aviva and PacLife products throughout 2009.
2009 Data Aviva PacLife Differential
Cap Rate 12% 12%
January 5.46% 5.52% -0.05%
February 5.41% 5.46% -0.06%
March 5.25% 5.25% -0.01%
April 5.15% 5.14% 0.01%
May 5.12% 4.98% 0.14%
June 5.22% 5.28% -0.06%
July 5.08% 5.22% -0.14%
August 5.11% 5.17% -0.06%
September 5.06% 5.10% -0.04%
October 5.02% 5.03% -0.01%
November 5.03% 5.04% -0.01%
December 5.01% 5.07% -0.06%
Average 5.16% 5.19% -0.03%
Aviva’s notional for its 12% capped block of business was just over $200 million and Pacific Life’s was
approximately $266 million. However, Aviva also has older Indexed UL lines with caps at 11% and 10% with
notional totaling more than $1.1 billion. Aviva’s primary counterparties were Bank of NY Mellon, SunTrust, BNP
Paribas, Societe Generale and Barclays. Pacific Life traded mostly with Credit Suisse, BNP Paribas and Barclays as a
distant third. Since 2006, BNP Paribas has traded with Pacific Life by far more than any other financial institution.
4.50%
5.00%
5.50%
6.00%
6.50%
1/13/2006 1/13/2007 1/13/2008 1/13/2009 1/13/2010
Options Cost AAA
The similarity in trading costs for Aviva and Pacific Life signals that options pricing places carriers at the mercy of
the market. Aviva trades substantially more options than Pacific Life yet does not appear to receive any financial
benefit for doing so. Furthermore, BNP Paribas and Credit Suisse accounted for virtually all of Pacific Life’s options
trades in 2009 but the costs were in line with Aviva’s pricing after bidding out a larger group of competitors. This
may corroborate the conclusion that options prices are the best guess at actual Indexed UL yields.
Minnesota Life Options Data
To hedge its Eclipse Indexed UL product, Minnesota Life purchases at-the-money call options with unlimited
upside and writes a call option at the cap, currently set at 15%. The data allows for a comparison between the
pricing for Minnesota Life’s unlimited upside options and Pacific Life’s cap options written on the same days and
at the same strikes.
Table 5 shows Minnesota Life’s unlimited cap options prices in comparison to Pacific Life’s 12% cap call packages.
Purchased Premium Minn Life Pacific Life Additional Date Notional Strike Paid Call Cost 12% Call Cost Cost
10/15/2009 6,000,000 1,097 514,200 8.57% 5.03% 3.54%
11/19/2009 10,000,000 1,095 897,596 8.98% 5.04% 3.94%
12/17/2009 10,000,000 1,096 863,000 8.63% 5.07% 3.56%
1/14/2010 10,000,000 1,148 711,000 7.11% 4.84% 2.27%
2/18/2010 10,000,000 1,107 755,000 7.55% 4.94% 2.61%
3/18/2010 5,500,000 1,166 378,400 6.88% 4.82% 2.06%
4/15/2010 7,000,000 1,212 486,500 6.95% 4.74% 2.21%
5/20/2010 5,000,000 1,072 571,000 11.42% 5.37% 6.05%
6/17/2010 8,000,000 1,116 721,600 9.02% 5.45% 3.57%
7/15/2010 10,000,000 1,096 977,000 9.77% 5.47% 4.30%
8/19/2010 10,000,000 1,076 996,000 9.96% 5.40% 4.56%
9/16/2010 9,000,000 1,125 787,950 8.76% 5.31% 3.45%
10/16/2010 12,000,000 1,174 1,049,400 8.75% 5.24% 3.51%
11/18/2010 25,000,000 1,197 1,980,000 7.92% 5.04% 2.88%
12/16/2010 15,000,000 1,243 1,063,560 7.09% 5.00% 2.09%
Totals 152,500,000 12,752,206 8.49% 5.12% 3.37%
Figure 6 shows Minnesota Life’s unlimited cap options costs against PacLife’s options cost and the S&P 500
950
1,000
1,050
1,100
1,150
1,200
1,250
1,300
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
10.00%
11.00%
12.00%
10/1/2009 1/1/2010 4/1/2010 7/1/2010 10/1/2010
ML Unlimited Cap PL 12% Cap S&P 500
Minnesota Life’s data brings forth three interesting observations. First, that the expected return for purchasing
unlimited cap options is 8.49% on average. Since 1950, the average one year return for every day the S&P 500
traded is 8.51%. This appears to corroborate the notion that options prices are accurate reflections of expected
returns over the option duration and fundamentally profit-neutral to purchasers in the aggregate. Second, that
unlimited cap options appear to be highly inversely correlated to the S&P 500 and, consequently, much more
volatile than Pacific Life’s 12% cap options.
The logic behind the inverse correlation between options prices and the S&P 500 will be the subject of a separate
piece. In short, the options appear to be adjusting prices to match long-term pricing expectations (or average
annual return expectations) with temporary movements in the stock market. This idea flies in the face of the
Black-Scholes options pricing theory, which posits that stock prices have implicit return expectations based on a
replicating portfolio of borrowed capital at the risk-free money market rate and purchased stocks and that
volatility in options prices, ceteris paribus, comes from changes in expectations of volatility in the underlying
stock. A Black-Scholes theorist would claim that expected volatility increased as stocks fell and options prices
increased to reflect new volatility expectations. We generally downplay the notion that volatility is itself volatile
and posit that options prices are constantly attempting to match market expected returns with current price
movements under mostly static volatility assumptions. Again, this is a topic for another paper. For a more
technical dismantling of Black-Scholes, see Taleb and Haug, 2009.
The question that arises from comparing Pacific Life’s 12% packaged call spread options to Minnesota Life’s
unlimited cap options is one of accurate return expectations. We can safely say that Minnesota Life’s options do
not behave like the fat, unevenly weighted coin of packaged call spreads and that an average 8.49% cost appears
to accurately reflect the historical annual returns of the S&P 500. What is less clear, however, is the applicability
of packaged cap options prices to the actual returns for those options. Packaged cap options benefit from the
“volatility smile” phenomenon that appeared after the stock market crash on Black Monday in 1987 and has
persisted since. Simply put, the volatility smile means that, holding all else constant, at-the-money options are
cheaper than out-of-the-money options on a risk-neutral pricing basis. Practically, it means that packaged call
spread options benefit from buying a “cheap” at-the-money option and writing an “expensive” out-of-the-money
option at the cap. This may allow some, uncertain degree of additional profitability to accrue to a consistent
purchaser of call spread options. Conversely, insurance carriers purchase packaged call spread options from
investment banks and there is some anecdotal evidence that investment banks price a profit margin into the cost
of the options over and above the real expected payoff, potentially negating the impact of the volatility smile on
long-term profitability. Also, the volatility smile isn’t necessarily symmetrical around the strike and may evolve
into a “smirk” that could wipe out the long-term profitability of call spread options under a smile assumption.
The Exceptions – Minnesota Life and PennMutual
We have reason to believe that the vast majority of carriers with Indexed UL products employ replicative hedging
akin to Aviva and Pacific Life at least for their most popular account options, typically a capped 1 year Point-to-
Point as referenced above. Some carriers may not fully hedge using external options for less popular, more
esoteric account options that would more expensive to hedge than to hold on the books due to the illiquidity of
the market or quirkiness of the risk profile. We also have evidence that at least two carriers, Minnesota Life and
PennMutual, are employing different pricing and/or hedging strategies that allow them to provide account
options with participation limits in excess of the market norms.
Minnesota Life Hedging
Minnesota Life’s Eclipse Indexed UL product has had elevated caps since its inception, falling from 17% to 15% in
recent years. The market benchmark for an annual point-to-point cap is between 11% and 13%. The annual floor
for Eclipse IUL is the standard of 0%. Two factors partially account for Eclipse’s ability to have a higher cap have
nothing to do with hedging. First, Eclipse IUL is designed to be profitable through the charge structure rather than
retained earnings on the yields of invested assets. As such, its charge structure is higher than many of its peers,
especially in the years at and beyond LE. The effect is that Minnesota Life theoretically has a higher budget to
spend on options.
Second, and more importantly, Eclipse IUL credits indexed interest to the account based on the account value at
the end of the segment rather than the mid-point account value. The effect is that indexed interest is credited to a
smaller amount than it would be if the product used the mid-point account value. Using the end-of-year value
instead of the mid-point value allows Minnesota Life to provide a higher cap than its competitors without
necessarily incurring a higher cost to hedge or actually crediting more to the policy. In effect, Minnesota Life has
to purchase a wider call spread (0% to 15% vs. 0% to 13%) but less notional value. The cost of the hedge, then,
could be lower than a product using the mid-point method (therefore buying more notional) with a lower cap.
Table 6 illustrates the functional difference between using the mid-point and the end-of-year methods.
Pacific Life
Minn Life
Pacific Life
Minn Life
Pacific Life
Minn Life
Year 1 Year 1
Year 1 Year 1
Yr 20 (AV) Yr 20 (AV) Premium 20,000 20,000 65,000 65,000 1,000,000 1,000,000
Premium Load (1,320) (1,100) (4,290) (3,575) - - Policy Charges (9,099) (8,364) (9,099) (8,364) (1,083) (1,641)
End-Of-Year AV 9,581 10,536 51,611 53,061 998,917 998,359 Mid-Point AV 13,751 14,370 55,781 56,895 999,413 998,551
Marketed Current Cap 13% 15% 13% 15% 13% 15% Maximum Equity
Exposure (Notional x Cap) 1,788 1,580
7,252 7,959
129,924 149,754
Effective Mid-Point Cap 13.00% 11.00% 13.00% 13.99% 13.00% 15.00%
Effective End-of-Year Cap 18.66% 15.00% 14.05% 15.00% 13.01% 15.00%
The last two rows translate the marketed caps into their equivalent using the other method. For instance, in the
first set of columns, Pacific Life’s 13% mid-point cap is equivalent to an 18.66% using the end-of-year method. The
truism for comparing the two methods is that as policy charges become a smaller percentage of the total account
value, the difference between the two methods will shrink. Therefore, Minnesota Life can market a higher cap
using the end-of-year AV method than it would be able to under the mid-point method only in the early years of
the policy or in the event that the net amount at risk for the contracts stays high. In an overfunded scenario, as is
outlined in the right two columns, the effect of using the end-of-year method is virtually nothing. Minnesota Life’s
hedging costs will more or less match the equivalent cap on a mid-point product.
The potential effect on the client is twofold. First, underperformance will negatively affect Minnesota Life’s
product more than a competing mid-point product. Any unanticipated increase in NAR will not only cause more
drag simply from higher charges but it will also have an outsized effect on the interest credited to the policy.
Second, Minnesota Life is clearly offering a higher cap predicated, to some unknown degree, on the idea that it
can save costs by reducing the hedged notional using the end-of-year method. It only can cut costs compared to
its competitors if the block of business has a relatively high NAR, as noted in the table above. If we assume that
clients pay premiums on time and the products perform as illustrated, virtually all of the major sales designs will
have a thin NAR and Minnesota Life’s costs to hedge will equate its mid-point competitors currently offering much
lower caps. The result is somewhat paradoxical. If the block performs as illustrated, the cap may have to fall back
to market norms because the savings from the end-of-year method will vanish. If the block does not perform as
illustrated, the cap can stay higher than competing products. High performance is clearly better for clients than
underperformance, but the cap would fall in the former and potentially even rise in the latter. Using the end-of-
year AV method presents a somewhat perverse set of outcomes without any real benefit to the client. The end-of-
year method exacerbates underperformance without commensurate upside, except illustrated rate at sale.
Penn Mutual
Penn Mutual’s Accumulation Builder IUL product seems to offer the best of all worlds. It has an annual floor of
2%, a percentage point or less below Current Assumption UL products, and a current upside cap set at 13%. Like
Minnesota Life, Penn Mutual built exceptionally high policy charges into the product in later years to offset some
of the cost of additional upside. Also like Minnesota Life, Penn Mutual appears to be taking shortcuts in hedging
equity risk although in far more egregious ways. Schedule DBs for both the Penn Mutual Life Insurance Company
and the Penn Insurance and Annuity Company (where the Accumulation Builder IUL is written) did not contain any
call options prior to April of 2011. Penn Mutual representatives have confirmed that the company was internally
hedging its Indexed UL product against its Variable Annuity block of business until April of 2011. After that time,
PennMutual began to offload an unspecified amount of the risk to third parties via packaged call spreads.
According to its 2nd Quarter of 2011 statutory filing, Penn Mutual started buying call spreads in April and, on June
3rd, bought call spreads to cover equity exposure through January of 2012. The notional value of the options was
approximately $112 million, less than its sales through the quarter and far less than its total block of business. The
call spreads were structured as a 2% floor and a 13% cap and the cost averaged 4.15% for the three months (April,
May and June) of one year options. The 2% guaranteed product floor is covered by the bond yield. The total cost
to hedge is the cost to option plus the guaranteed floor (which could have been spent on options), yielding an
average total cost of 6.15%. Over the same period, Minnesota Life’s 0%/15% options cost 5.64% and AXA’s
0%/12% options cost 4.92%. Penn Mutual does not appear to use the end-of-year AV method to cut hedging
costs. Penn Mutual is clearly still retaining a substantial amount of equity risk in order to reduce its reported
hedging costs because the cost of full, replicative hedging using options would be prohibitively high. Assuming a
general account yield of 5%, we can speculate that Penn Mutual could provide a 2% floor guarantee with a fully
hedged cap between 7% and 9%. The hypothetical look-back illustrated rate would be approximately 6.5% with a
9% cap and 2% guaranteed floor, meaningfully below the current illustrated rate of 8.36%.
Summary – Minnesota Life & Penn Mutual
By and large, Indexed UL products are constrained by crediting methodologies and market hedging prices that do
not change across carriers. Two carriers, Minnesota Life and PennMutual, have appeared to circumvent these
restraints and offer exceptionally competitive products with participation limits well above market benchmarks.
They both use high policy charges to subsidize high participation limits and both engage in potentially risky
hedging strategies, especially Penn Mutual, that could push the products rapidly back to or below their
competitors if they turn sour. Minnesota Life’s end-of-year AV crediting methodology is almost universally a
disadvantage for clients and only provides a benefit to Minnesota Life if the products do not perform as
illustrated, creating a perverse set of incentives. Producers should not sell PennMutual or Minnesota Life products
on the assumption that either carrier can actually support elevated participation limits over the long term that are
not predicated only on their relatively expensive product charges. Both products should be illustrated at rates
more in line with their closest competitors and producers writing Minnesota Life should be wary of the future
impact of the end-of-year AV method on underperforming contracts.
Long-Duration Account Options
Many carriers are starting to offer accounts with durations in excess of 1 year but not longer than 5 years. Long-
duration accounts are hedged identically to one year accounts.
Table 9 shows the cost of 5 year 100% participation rate options purchased by Pacific Life since 2008 as a
percentage of notional.
Month 2008 2009 2010
January 24.89% 15.80%
February 24.69% 15.97%
March 21.94% 23.54% 14.90%
April 18.95% 24.00% 15.42%
May 18.87% 20.29% 18.58%
June 20.45% 22.83% 18.86%
July 19.56% 19.29% 19.44%
August 19.25% 19.80% 17.55%
September 19.29% 19.15% 16.08%
October 22.77% 18.70% 15.72%
November 26.18% 18.76% 13.90%
December 27.41% 19.05% 14.20%
Average 21.47% 21.25% 16.37%
Figure 7 shows the value of the S&P 500 index versus Pacific Life’s 1 year options cost. Options costs are graphed
on the primary axis, S&P 500 on the secondary axis.
600
700
800
900
1000
1100
1200
1300
1400
1500
4.70%
4.90%
5.10%
5.30%
5.50%
5.70%
5.90%
3/14/2008 3/14/2009 3/14/2010
1 Year Option Cost S&P 500
Figure 8 shows the value of the S&P 500 index versus Pacific Life’s 5 year options cost.
Despite the superficial similarities, 5 year option costs differ from 1 year option costs in dramatic ways. The
analogy of a fat, unevenly weighted coin toss does not apply in this situation because the cap is unlimited.
Instead, 5 year options are theoretically tied more to the movements of the S&P 500 and the market’s
expectations about the yield of the index over the next 5 years. Long-duration, uncapped options prices should
move conversely to S&P 500. 1 year capped options should remain relatively steady due to limited upside. The
graphs below corroborate the theory. 5 year options appear to have almost perfect inverse correlation to the S&P
500 and 1 year options do not appear to be systematically correlated to the S&P 500.
The correlation between 5 year options prices and the level of the S&P 500 may be a temporary phenomenon
spurred by recent market volatility. The sentiment in the 5 year options prices appears to be that the S&P 500 is
going to remain flat as it was over the past decade. In order to maintain make options prices match the flat yield
assumption, options prices must be inversely correlated to the S&P 500. But it is irrational to think that options
prices would continue to fall indefinitely as stocks rise. In fact, it is reasonable to believe that a strong market
sentiment about future equity returns could actually create positive correlation between 5 year options prices
and the S&P 500. The point is not that long-duration options prices are correlated to the S&P 500 in a particular
way. Rather, it is that long-duration options prices are estimates of future S&P 500 returns and that it is unlikely
for an options purchaser to consistently beat the options writer due to the linkage with market expectations for
S&P 500 returns. Furthermore, we may also conclude that 5 year options are substantially more volatile than 1
year caps and that policyholders may see drastically different caps or participation rates (whichever floats) in the
future than today.
Long-duration accounts make sense is when a client is extremely bullish about future equity returns. Whether the
client is right or wrong is irrelevant. The 5 year bucket accommodates those who think that the next 5 years holds
substantially more promise than the options writers (and, by extension, the market) have priced. It is also the
riskiest option because the long-duration nature of the bucket means fewer flips of the coin. Some clients will
profit madly (on a risk adjusted basis) from 5 year accounts. Some will merely receive protection of principal. The
average return, however, is unlikely to deviate far from the market expected return for the bucket adjusted by
any future decreased participation limits. The 5 year bucket simply allows for the traditional understanding of
options as a leveraged bet on the market. The 1 year capped bucket is less about leverage and more about
opportunity cost of capital.
600
700
800
900
1000
1100
1200
1300
1400
1500
10.00%
12.00%
14.00%
16.00%
18.00%
20.00%
22.00%
24.00%
26.00%
28.00%
30.00%
3/14/2008 3/14/2009 3/14/2010
5 Year Option Cost S&P 500
Hindsight & Other Esoteric Options
International, “hindsight rainbow” options used for products such as ING Global Index UL and AIG Elite Global IUL
follow the same general logic as the above. Prices are logically most correlated to the expected return of the
strategy. The strategies may themselves have higher yields but the price of the options balances against the
higher return of the strategy. Evidence of this is that participation rates are substantially below 100% for
hindsight, multi-index accounts whereas current S&P 500 5 year accounts are at 100% or above. The hindsight
strategy has higher expected yields than point-to-point but the cost of the options forces the participation rate
well below 100%.
Hindsight products are often illustrated at the highest rates in the industry. ING has released a Monte Carlo based
calculator that uses historical data to build simulations for product performance over thousands of historical
blocks of time. Monte Carlo suffers from the same problems as traditional historical analysis by making the same
poor assumptions about the similarity in size and shape of previous equity returns and the stability of
participation limits over time. Nonetheless, ING proactively uses the percentile simulator to substantiate
illustrated rates in excess of 9%. The real source of the elevated returns is the discrepancy between the
immediate past performance of the product and its historical estimated performance. There is little reason to
believe that hindsight rainbow options are structurally priced to deliver a higher yield than American options over
the same duration. The ING and AIG products can illustrate elevated performance by applying pricing based on
today’s “low” options prices to historical periods of extreme returns, especially in the Hang Seng. This analysis is
useless for projecting future returns unless ING and AIG can provide empirical analysis for the reason behind
these options being loss-leaders for the writers over the long term.
Carriers have created a litany of one year indexed account options that do not conform to the typical capped
annual point-to-point account used for the vast majority of the analysis in this paper. Most carriers admit that
non-standard account options receive a sliver of the premium that standard account options do. Accordingly,
many carriers choose to retain the risk of low-volume account options on their balance sheets or to loosely hedge
with futures and other non-replicative methods. It is difficult to trace third-party hedging activities for these
accounts because carriers often do not include sufficient detail in the options trades.
Observations on Options Profit Models
Since 2006, options have been a relatively profit-neutral proposition for Pacific Life policyholders. The past 4 years
have certainly been abnormal for the market as a whole but, for the Indexed UL strategy, the magnitude of the
volatility of the index is irrelevant. The past 4 years have simply contained two increases and two decreases. Total
and annualized returns are skewed towards the later years due to increasing amounts of premium. The arithmetic
mean shows the average of the yields in each individual year and points more towards the expected return in any
given year for this strategy. The geometric mean for the options is 0 due to the occurrence of a total loss in the
data. In short, this strategy has an exceptionally high level of risk and volatility and an uncertain arithmetic
average outcome. This data set is too short to glean meaningful answers about long term performance. Note also
that Pacific Life’s profitability is not directly affected by the profitability of the options in the short or long term.
The purpose of replicative hedging is that the options exactly replicate the liability, allowing PacLife to offload risk.
Table 10 shows the options premium and consideration at maturity from 2006 to 2009. Pacific Life began the
Indexed UL line in mid-2005 but the data was not available for this analysis. It would have almost certainly been a
yield on the order of 2006 but with a substantially smaller premium number, perhaps even under $1.5 million.
Pacific Life Options P/L
Pur. Year Premium Consideration Return
2006 2,117,482 3,616,603 70.80%
2007 5,717,383 - -100.00%
2008 11,060,565 5,061,683 -54.24%
2009 13,912,306 28,225,291 102.88%
Total 32,807,736 36,903,577 12.48%
Annualized
2.38%
Arith. Mean
4.86%
The other piece to the options pricing puzzle is opportunity cost of capital. Assuming Pacific Life pays premium at
the beginning of the year and the investment bank can invest it at will over the period, the bank earns the yield
that Pacific Life would have earned had it internally hedged. Pacific Life likely considers its opportunity cost to be
its general account yield or earned rate for specific product block assets (see Appendix). Opportunity cost for the
bank is a little bit stickier. Strictly speaking, opportunity cost is the yield on a 1 year Treasury note. The reality,
however, is that the bank most likely pushes the money into theoretically higher yielding assets or hedges its own
exposure. If one assumes the AAA composite is a fair proxy for opportunity cost for both Pacific Life and the
investment bank, the cost of the options to Pacific Life (and the return for the investment bank) gets markedly
higher. Average raw options costs for Pacific Life since 2006 was 5.45%. Accounting for opportunity cost at the
AAA composite rate, the average cost was 5.75%. Carriers paying more for options to support higher cap rates will
be affected more by opportunity cost losses than carriers with lower caps.
Accounting for opportunity cost drastically changes long-term options profitability models for options purchases.
Assuming that annual profits are a coin toss of either 0% or 12%, Pacific Life’s options purchases would have had
an average expected yield of 20.82%. Accounting for opportunity cost at the AAA composite rate drops the
average expected yield to 9.45%. Changing the generic coin toss assumption to the fat, unevenly weighted coin
toss analogy espoused in this paper, profit models would change dramatically depending on the assumed metrics
of the coin. Further complicating the problem is the reality that, in the real world, the coin constantly changes
shape and weight.
Table 11 shows options premiums with and without opportunity cost and the expected profit under a coin toss
assumption of 0% and 12% sides. Expected profit is calculated as the difference between maximum gain (12%-
Options Premium/Options Premium) and maximum loss of 100%. Opportunity cost is calculated as the AAA
composite index at each data point.
Pacific Life PL Premium Coin Toss Coin Toss
Date Option Premium Plus Opp. Cost Profit Profit w/ Opp. Cost
1/14/2006 5.50% 5.79% 18.182% 7.338%
3/15/2006 5.35% 5.65% 24.299% 12.505%
7/14/2006 5.95% 6.30% 1.707% -9.405%
9/14/2006 5.71% 6.03% 10.158% -0.949%
11/14/2006 5.50% 5.79% 18.182% 7.200%
1/14/2007 5.62% 5.92% 13.531% 2.571%
3/15/2007 5.63% 5.93% 13.144% 2.454%
7/14/2007 5.78% 6.12% 7.612% -3.806%
9/14/2007 6.07% 6.42% -2.468% -13.103%
11/14/2007 5.96% 6.29% 1.342% -9.190%
1/14/2008 5.68% 5.98% 11.268% 0.520%
3/15/2008 5.55% 5.85% 16.216% 4.983%
7/14/2008 5.50% 5.80% 18.182% 6.729%
9/14/2008 5.61% 5.92% 13.904% 2.637%
11/14/2008 5.70% 6.06% 10.526% -2.044%
1/14/2009 5.52% 5.79% 17.403% 7.367%
3/15/2009 5.25% 5.55% 28.567% 16.241%
7/14/2009 5.22% 5.50% 29.885% 18.045%
9/14/2009 5.10% 5.36% 35.288% 23.806%
11/14/2009 5.04% 5.30% 38.095% 26.240%
1/14/2010 4.84% 5.09% 47.934% 35.746%
3/15/2010 4.82% 5.07% 48.963% 36.544%
7/14/2010 5.47% 5.73% 19.378% 9.410%
9/14/2010 5.31% 5.55% 25.989% 16.236%
11/14/2010 5.04% 5.30% 38.095% 26.606%
Average 5.47% 5.76% 20.22% 8.99%
Implications for Indexed UL Illustrated Rates
Profit model sensitivity raises the larger question about long-term assumed profitability of options trading.
Typically, this question isn’t relevant to options buyers for two reasons. First, options buyers who are hedging only
care about offloading the risk at a reasonable cost. Second, options buyers who are speculating are taking a short
to medium-term position on market movements and only care about being in-the-money during the duration of
the option. Long-term estimates of options profitability are relevant to the life insurance market for the simple
reason that life insurance contracts are shown to clients with assumed rates of return that stretch up to 120 years
into the future. Current industry practice is to illustrate Indexed UL at rates between 200 and 550bps above
comparable Current Assumption UL crediting rates. Carriers support illustrated spreads between Indexed UL and
Current Assumption UL with spurious “hypothetical historical” analysis. However, given that options are the only
differentiator between IUL and CAUL assets, we believe that long-term beliefs about options profitability verses
general account assets is more indicative of real future performance spreads between the two lines.
The math is straightforward. The net premium is discounted by the general account rate (assumed, in this
example, to be 6%) to obtain the options budget. The remainder of the net premium is placed in the general
account and will equal the full net premium at the end of the period. The options return will depend on the
performance of the external equity index. For the policy to yield 8% in a 6% general account rate environment,
the options would have to return 41.33% over the year. An illustration at 8% shown in a 6% environment implies a
constant options profit of 41.33% for the duration of the illustration. An 8% illustration in a 5% general account
rate environment implies a 68% annual rate of return. Options yield in any given year may be high, but over the
long term that options purchases will be profit-neutral to the buyer. The importance in this situation, given the
long-term nature of the illustration, is the long-term options profit model. The possibility of earning a high yield in
any given year is largely irrelevant to long term nature of the profit projection shown in the illustration. Note that
the importance of long-term yields is a function of the long-term illustration used in the sales process.
As a rule of thumb, Current Assumption UL and Indexed UL should be illustrated at the same long-term rate after
adjusting for differentials in policy charges if one is comfortable with the assumption that options purchases will
not be profitable to the buyer in the aggregate. If options have a 10-20% expected average return, Indexed UL
should be illustrated at 25-50 basis points over Current Assumption UL. Conversely, if Indexed UL is shown at a
rate far in excess of Current Assumption UL, the reasoning should be that historical CAUL yields are substantially
higher than current CAUL yields and Indexed UL will hold some predetermined spread over historical CAUL yields.
Recommendation for Indexed UL Illustrated Rates
The essential point is that long-term options profit models are largely irrelevant to all market participants except
for life insurance companies yet not a single life insurance carrier has laid out a mathematical model to support
the assumed annual options yields in excess of 40% commonly shown in Indexed UL illustrations. Hypothetical
historical analysis falls woefully short for more than the obvious reasons that interest rate environments clearly
affect options prices and that assuming a constant cap since the beginning of time ignores the natural bias that
makes options prices increase at precisely the moment they are expected to be most profitable. The more
problematic assumption is that equity returns will not only match historical aggregate returns but also that the
shape of returns will be identical. Options prices are the best immediate guess at any given year’s return
regardless of historical long-term performance. Until life insurance companies can come up with a reliable,
mathematical model for consistently beating options writers at their own game, Indexed UL should be illustrated
at the same rate as Current Assumption UL after adjusting for the caveats addressed in the Technical Appendix.
Technical Appendix
Policy Charges – Current Assumption UL & Indexed UL
Direct comparisons between Current Assumption UL and Indexed UL are complicated by the fact that the charge
structures for the two product lines can be wildly different in shape and size. Policy charges play a role in
determining the assumed asset yield for policy crediting rates and, by extension, options budgets. Contracts with
high policy charges may allow a carrier to pass more investment earnings to policyholders and vice versa. On
average, Indexed UL contracts are substantially more expensive in every metric than Current Assumption UL
policies.
Table A1 summarizes the graphical data using cumulative charges and, more relevantly, Internal Rate of Return as
a calculation for the time value of money. IRR is a net present value calculation that solves for the rate of return
needed to get the net present value to zero.
CAUL IUL Differential
Cumulative Charges 1,449,446 2,212,455 763,008
Year 10 IRR 54.11% 46.91% -7.20%
Year 20 IRR 18.60% 15.88% -2.72%
A90 IRR 4.42% 1.76% -2.65%
A100 IRR -4.01% -10.13% -6.12%
Cumulative charges measure the total charges over the life of the contract without giving any indication to when
those charges occur. Obviously, the client would prefer to have more expensive charges at the end of the contract
for two reasons. First, the client may not be alive at the point. Second, lower policy charges in the early years
mean maximum opportunity to accumulate cash value at interest, thereby shrinking NAR and decreasing the
impact of high per $1,000 NAR charges in the later years. IRR captures the shape of the curve. High early IRR
figures indicate low charges and vice versa. Policies with high early IRR figures and low later IRR figures are best
for overfunding, narrow death benefit designs. Policies with lower early IRR and high late IRR are generally best
for level pay scenarios. There are exceptions to these rules of thumb, but the basic point for this paper is that high
IRR figures are better than low.
The data in Table A1 points to a structural difference between Indexed UL and CAUL that may account for
illustrated rate discrepancies. If Indexed UL products are more expensive than CAUL, illustrated rates may be
higher for Indexed UL simply by virtue of amplified policy charges. If this is the case, then using CAUL as a proxy
for Indexed UL returns misses part of the illustrated performance story. A CAUL with relatively inexpensive
charges should be run at a lower rate than an Indexed UL with higher policy charges. A fully educated consumer
would request that the IUL be run at the rate implied by the options purchases instead of the CAUL rate to
account for discrepancies in charge structures. Note that the actual cash-on-cash yield differential may be
negligible depending on the funding pattern and annual charge differences. The difference in crediting rates
simply impacts the illustration parameters, not the actual policy performance.
Even so, carriers have been less than forthcoming about why policy charges for different lines are so different.
Aviva has stated that its expected earned spread on assets is identical for its CAUL product, LifeStage UL, and its
Indexed UL lines, Accumulation Builder and Lifetime Builder. However, the policy charges for its IUL products are
substantially more expensive than LifeStage UL.
Figure A1 shows annual policy charges for the two Aviva Indexed UL products and the UL product.
AXA and Hartford products show the same phenomenon, as do several other carriers with Indexed UL and CAUL
products. One can speculate as to forthright reasons, such as expected funding patterns, and also reasons that
may be less honorable, such as the fact that higher illustrated rates effectively cloak higher policy charges.
Nonetheless, producers should be aware that using CAUL rates as a proxy for Indexed UL rates presents some
nuanced pitfalls due to policy charge differentials. We can reasonably expect the differences between CAUL and
IUL rates simply based on policy charges to be between 25 and 75bps.
Policy Charges – Indexed UL vs. Indexed UL
The phenomenon of discrepancies between charge structures in CAUL and IUL products and the implications for
crediting rates also exists within the Indexed UL universe. Some IUL products have exceptionally expensive
charges and, not surprisingly, high charge products also typically have the highest participation rates and/or caps.
Table A2 shows a representative sample of major IUL carriers sorted in descending order of highest participation
limits to lowest. Average rank calculated as average IRR rank.
Carrier Cap/Floor Year 10
IRR Rank
Year 20 IRR
Rank Age 90
IRR Rank
Age 100 IRR
Rank Av.
Rank
Minnesota Life 15.00% / 0% 41.97% 5 13.75% 6 0.81% 5 -9.74% 4 6
PennMutual 13.00% / 2% 46.70% 4 15.25% 4 0.20% 6 -14.68% 6 5
Pacific Life 13.00% / 0% 50.88% 2 17.31% 2 3.77% 1 -2.97% 1 2
Aviva 12.25% / 0% 41.14% 6 13.78% 5 2.02% 4 -7.96% 3 4
AXA 12.00% / 0% 49.79% 3 16.15% 3 2.72% 3 -7.79% 2 3
Lincoln Benefit 10.50% / 0% 61.37% 1 20.31% 1 2.74% 2 -11.34% 5 1
While this is not an exhaustive sample, there is evidence that the relationship between participation limits and
policy charges appears to exist. Policies with high charges have high participation limits. As such, producers should
be wary of illustrating all Indexed UL products at identical rates because some products are structurally designed
-
20,000
40,000
60,000
80,000
100,000
120,000
140,000
160,000
180,000
200,000
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45
Aviva LifeStage UL Lifetime Builder III Advantage Builder III
to provide a higher rate of return due to higher policy charges. Note again that the cash-on-cash yield inside the
products may be identical despite differences in crediting rates due to the difference in charge structures.
My experience with Indexed UL pricing tells me that carriers will, on the whole, readily accept the proposition of a
higher options budget if they know it is possible to increase policy charges to cover the cost. Market caps have
been trending upwards while, as this paper has shown, options prices have remained relatively steady. The
increase in the value proposition for clients is questionable. High cap products are more appealing to more bullish
investors, low cap products appeal to more conservative investors who will perform better over the long term if
Indexed UL returns more closely mirror Current Assumption UL than the broader equity market.
Artificial Options Budget Return Leverage
Another important note is that policy charges allow immediate subsidization of crediting rates that far exceeds
the costs of options to support the hedging strategy. The core concept is that there is a material difference
between the marginal performance increase, in real dollars over time, between 5% and 6% and 7% and 8%.
Carriers using higher policy charges can afford larger options budgets that increase illustrated rates by at least as
much as the increase in the options budget. For example, if carrier A is purchasing options at 5% and illustrating
7%, carrier B could show many more dollars on its illustration by purchasing options at 6% and illustrating 8%
despite building higher policy charges that wholly offset the increase in options budget. This artificial leverage is
calculated as the difference between the dollars growing at 5% and 6% and 7% and 8% [(6%-5%) - (8%-7%)]. On a
$100,000 single premium, the artificial leverage created by this strategy over 25 years is $51,553 on $684,848
(7.5%) of cash value. Over 50 years, a common illustration length for younger Indexed UL buyers, the artificial
leverage increases to $1,049,183 on $4,690,161 (22.4%) of cash value. In short, subsidizing options budgets with
higher policy charges creates artificial value that is a function of the faulty illustrated rate calculation methods
employed today rather than real return potential. Compounding the problem is that fact that the higher policy
charges used to subsidize the options budget are cloaked excessively by higher crediting rates, serving to further
obfuscate the relationship between higher policy charges and higher participation limits. A fully informed agent
would illustrate products using the options budget to eliminate the artificial return bias of higher hypothetical,
historical look-back rates. This method would allow for meaningful comparison between products.
Caveats to Assumed Universal General Account Yields
The assumption in this paper is that the general account yield is known and universal across all product lines
within a carrier. However, in practice, many carriers will segregate general account assets to support different
types of product lines. For example, the general account assets backing a carrier’s CAUL product may be
fundamentally different than the assets backing its Indexed UL. Furthermore, the mixture of assets can change
over time as the block of business matures and grows or shrinks in the process. Profitability in Indexed UL and
CAUL products is determined not just by the cost of the liability of options budget or crediting rate, respectively,
but by how well that liability matches the supporting assets. One cannot assume that falling options costs for
Indexed UL products enhances profitability in the product line because the carrier does not specifically state the
performance of the particular general account assets backing the Indexed UL product.
Mitigating Factors to Opportunity Cost of Options Purchases
This paper makes an assumption that options premium is paid in advance and from premium dollars received to
most closely approximate the hedging strategy to what would be required on the open market. However, carriers
can avoid opportunity cost of capital for options purchases in at least two ways. First, carriers with outstanding
collateral balances with the same counterparties can simply use released collateral (opportunity cost of zero) to
purchase options for Indexed UL exposure. Variable Annuities often require large amounts of collateral often
posted at the same counterparties from which the carrier is purchasing call spread packages to support Indexed
UL products. As markets improve and collateral decreases, carriers can reposition newly released capital to
purchase options, effectively moving money with zero opportunity cost (posted collateral) to another instrument
with zero opportunity cost (options). The effect is to at least mute the opportunity cost argument, although
collateral fluctuates with market conditions and could be called back to the counterparty at any time. The second
way to reduce opportunity costs of options purchases is for carriers with significant clout to push counterparties
to accept options premium in arrears. This amounts to an effective discount on the options cost by the
opportunity cost of capital. Pacific Life has confirmed that it purchases options in arrears. One could also suspect
that other large options purchasers such as Aviva, Allianz and AXA have negotiated payment in arrears.