#74 | AG 49 – Part 6 – The Main Thing
The greatest irony of AG49 is that the most publicly-discussed outcome of the rule, lower and more standardized illustrated rates, was actually one of the least controversial elements and that the least publicly-discussed outcome of the rule, the 1.45 option budget multiplier for illustration actuary testing, was by far the most controversial. Why? Because it became readily apparent to everyone on all sides of the debate that the question of IUL illustrated rates is really just a proxy for the question of long-term, sustainable profits for option buyers. To put it differently, you can’t believe that IUL illustrated rates should be greater than UL illustrated rates, all else being equal, unless you are also willing to believe that systematically buying equity call options is profitable. Once that argument hit the table, the entire discussion at the ACLI and then the NAIC changed. The battle raged over options profits, not illustrated rates.
Before I get into the meat of the discussion, I think it’s worth explaining exactly what I mean by option profits in this context, because otherwise the arguments put forth by both sides are going to sound bizarre. Take a baseline IUL policy that, we assume, has a 4% option budget. The carrier spends the 4% option budget to buy equity call options on an index, let’s say the S&P 500, and the size of the budget will determine the cap at any given time. Let’s say that the 4% budget can currently afford a 10% cap, which equates to a roughly 6% AG49 max illustrated rate. The illustration, therefore, makes the assumption that every year a 4% option budget is transformed into a 6% illustrated rate. This translates to a 50% annual profit from buying the options.
I’m not sure how I can be clearer, so I’ll just say this again – if you are illustrating a 6% rate on an IUL with a 4% option budget, you are making the assumption that equity call options yield 50% annual profits on average over the life of the illustration.
The implications of this math are huge, to put it mildly. For whatever reason, a lot of advisors have resorted to using flat crediting rates at 5% or 6% or even 7% (pre-AG49) across products to be “conservative.” But the option profit assumption actually more important and cuts across all products. Rather than asking what a conservative rate might be in the abstract, look at the illustrated rate relative to the option budget. A 50% annual option profit assumption equates to a 4.5% illustrated rate in a product with a 3% option budget and a 7.5% illustrated rate in a product with a 5% option budget. Again, this is the third time but it’s so important that I have to say it again, the illustrated rate is only an outflow of the option profit assumption. You cannot illustrate IUL at a single basis point higher than the option budget without having a fundamental belief that systematically buying equity call options is profitable. And if you don’t have an opinion on option profitability, you shouldn’t be illustrating IUL at a rate higher than the option budget. That’s 373 words to try to correct the misperception that AG49 is about illustrated rates – it’s not. It’s all about option profits.
So what’s the answer to the option profit question? Surely, there has to some consensus? I mean, the regulators put 45% in the regulation so that must be the answer, right? No, in fact, there was no consensus and I don’t even think it’s worthwhile for me to hash through all of the economic arguments.
In the end, AG49 instituted a 45% assumed option profit for the purposes of illustration actuary testing. Recall that the 45% was a compromise between some IUL companies insisting on 90-100% and the Coalition asking for 0-10%. The 45% was also roughly what companies would need to support the negotiated illustrated rates based on their current option budgets. So far from AG49 providing actual guidance on what an option profit expectation might be, it punted the issue over to illustrated rates, which got the most press. But in my mind, the question we’re wrestling with post-AG49 has little to do with illustrated rates and everything to do with long-term expected options profits. PacLife PDX is the prime example of this, as you’ll see when I release my review of the product in a couple of weeks. The spectacular magic of 50% illustrated option profits was too salacious for companies to ignore.
In the years since AG49 passed, I’ve spent a lot of time ruminating on this option profit question. I’ve seen some new pieces of evidence that bolster both sides of the argument. But there’s one thing, one big thing, that has really cemented my mindset.
Whenever I ask someone who is not in our little nook of the financial services world but is involved in banking, trading or structured products about long-term option profits accruing to buyers, they look at me funny and sometimes laugh. To them, it’s a patently ridiculous question. Of course, they say, buying options is net neutral over the long run. That’s how options work. The point of buying an option is to make a bet over a finite period of time, not to systematically invest in them every year over the long run. That would be ridiculous. That’s what literally everyone says, even people who are involved with FIAs and structured products, which are close cousins to IUL. I’ve met plenty of people who love structured products but scoff at the idea that systematically buying them will deliver long-term profits. Again, they see these products as finite bets, not systematic profit printing machines. And this makes a lot of intuitive sense. When was the last time you saw anyone, ever, promoting buying equity call spreads as a way to generate consistent 50% profits? Never. Except with IUL.
So here’s the question you need to wrestle with if you’re manufacturing, distributing or selling Indexed UL products illustrated at rates higher than their option budgets – either you think life insurers have figured out something that the entire financial services industry has not, or you’re wrong. That’s it. End of story. If you want to illustrate IUL at a rate higher than the option budget, you’re making an implicit assumption and set of beliefs about long-term equity call option profits. Actually, because the data is fairly clear about the fact that buying at-the-money call options does not produce significant long-term profits, you need to have a set of beliefs as to why equity call spread options are not just profitable in general, but more profitable than ATM call options. You’ll need to have an opinion about how the volatility surface contributes to call spread volatility because the OTM leg has a higher implied volatility than the ATM leg. You’ll also need to have a belief about why the vol surface generates consistent profits for call spreads across a variety of interest rate and volatility regimes. And, while you’re at it, why some cap levels and structures should generate more options profits versus other cap levels and structures due to all of the factors above. You should also have a belief about why this strategy is not employed by other parts of the financial services world. If you can nail down all of those beliefs and back them up empirically, then you can confidently illustrate IUL at a higher rate than the underlying option budget.
Uncomfortable with all of that? Illustrate accordingly.