#55 | Gradients of Protection

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Equity exposure in life insurance essentially comes in two flavors – Indexed UL and Variable UL. Each option represents a position at the poles of continuum of equity risk. Indexed UL removes all downside crediting risk by offering a guaranteed 0% floor. Variable UL products have equity funds with full exposure to downside. While there are merits to both, most clients fall somewhere between the two options. They’re comfortable with some equity risk but don’t want all of it. They’re willing to give up some return to get some certainty, but most clients are also willing to take a bit of risk along the way. Indexed UL and Variable UL haven’t traditionally offered intermediate solutions, but that’s changing at a pretty rapid pace. My bet is that Variable UL will come back into vogue within the next five years because the separate account chassis delivers unparalleled flexibility in providing intermediate solutions – what might be called gradients of protection.

Equity exposure in Indexed UL is governed by the requirement that the explicit crediting floor can’t be below zero lest the product be considered a security. This forces a severe tradeoff between risks and returns because the baseline requirement is essentially that the product has no explicit market risk. All of the upside in an Indexed UL product is directly attributable to the carrier’s yield being spent to buy equity upside from a third party. There is no tradeoff between taking more equity market risk in order to get more equity market returns. The higher returns are a function of the carrier’s ability to generate yields in excess of the risk free rate. Indexed UL offers the minimum possible exposure to the equity market available in a life insurance product because it takes no equity market risk and instead relies solely on general account yields to access equity market upside.

As a result, the upside is fairly limited. The average IUL cap is around 12%. That sounds like a pretty high number given that equities have performed at less than 12% since the Great Depression, but it doesn’t reflect how equity market volatility actually translates into an IUL product. Since 1950, roughly 50% of years have been above 12%, 25% between 0-12% and 25% below 0%. This means that 50% of returns are being undervalued by the Indexed UL structure – a tradeoff required by the fact that IUL is funded solely by the carrier’s general account and can’t expose the client to direct market downside. I say direct because IUL obviously exposes indirect market risk in the form of higher policy charges or asset fees explicitly used to fund higher caps. This is a crude, inefficient and poorly disclosed tool for increasing the equityness of Indexed UL because policy charges never perfectly match the way the client funds a contract. But it’s the only method carriers can employ without crossing the line into making IUL a security.

So what if we could introduce equity downside in order to fuel more upside? That’s precisely the opportunity made available by putting indexed options in Variable UL contracts. Let’s say that a carrier can afford a 0% floor and 12% cap Indexed UL product by assuming a 5% general account yield. The upside is entirely contingent on the 5% yield, which is used to buy a call option at 0% and sell a call option at 12%. The net cost is 5%. If the carrier could allow the indexed option to have a -10% floor, then it would liberate roughly 15% of the account value to be used to purchase the two calls (the first with a strike of -10%). Some quick Black-Scholes math shows me that the affordable cap with the same budget that would provide a 0%/12% cap would provide a 30% cap if the downside was -10%. Whereas 75% of the returns fall outside of a 0%/12% structure, only about 25% fall outside of a -10%/30% structure and the distribution is actually more favorable than on a 0%/12% structure. A -10% downside still protects against 16% of years but only gives up on 8% of years over 30%. In my opinion, this is a wholesale improvement over the Indexed UL model. The additional risk is marginal but the upside is meaningful. I’d argue that any rational consumer would choose a negative floor in exchange for a significantly higher cap. Clients are buying IUL to protect against a 50% loss, not a 10% loss.

Supercharging the carrier’s option budget with downside risk exposure still suffers from one of the unavoidable problems with any indexing structure – lack of direct dividend payouts. As I’ve written previously, dividends reduce the price of hedging which in turn increases the affordable cap, essentially allowing the policyholder the opportunity to recapture some of the dividends over time via the increased cap. But the recapture is limited by how often the cap is triggered, so only about half of the dividend is reflected in policy performance. Given that dividends constitute the majority of equity market returns over the long run, this is no small issue. So indexing can only go so far. It is still fundamentally a fixed income play that can be amplified with a measure of market risk.

If you want real market exposure, you have to leave the safe-and-sound world of the carrier’s general account and step out onto the equity risk spectrum. This is much less scary than it sounds. The same financial tools that allow life insurers to manage equity risk in Indexed UL are available in greater breadth, liquidity, variation and efficiency by hedging within the separate account assets rather than on the carrier’s balance sheet. The future of separate account assets is equity exposure coupled with derivative structures to manage downside risk. Think of it as buying insurance on your equity risk. Yes, insurance costs something, but it delivers more stability in the long run and can remove tail risk. Some of these structures will be built by the carriers, but most of them will be managed in the separate account funds themselves. You’ll see funds that are offered in both standard and protected formats with a flexible menu of protection options that can be fitted to a client’s stated desires. The possibilities are limitless. At the moment, using the carrier’s general account to fund an indexing strategy looks appealing simply because the carrier’s general account is beating market interest rates. When that spread no longer exists or inverts, protected separate account funds will become relatively more attractive because they better represent true market pricing for protection.

The product of the future doesn’t force the hard tradeoffs that we find in current offerings. Today, you have to choose between no-risk IUL and full-risk VUL with few alternatives*. Tomorrow, you’ll be able to buy a VUL product that offers funds running the full risk spectrum from the fixed account to full equity exposure. Choice without distinction isn’t choice. Current VUL products offer a paralyzing array of fund options that fundamentally tell the same kind of stories. Future VUL products will have fewer funds that tell different stories. And that, I believe, is a compelling proposition.

*The alternatives are: PacLife’s Select VUL (offers indexed bucket and downside protection rider), AXA’s Incentive Life VUL Legacy and Optimizer (offers Market Stabilizer Option), New York Life VUL’s downside protection rider, ValMark’s TOPS Protected portfolio (downside protection in separate account ETF funds) and a couple of others that I’ve momentarily forgotten.

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