#109 | Indexed UL in the Mirror – Part 1

Executive Summary

Legendary asset manager Bill Gross once wrote “is it the man who made the epoch or the epoch who made the man?” The same could be asked about Indexed UL. Did it grow because of its intrinsic value, or did it grow because it was the right fit for the time? The last 10 years could not have been a more perfect incubator for Indexed UL. The crisis created a new hunger for products that preserve capital and the combination of low rates and low volatility coupled with relatively high portfolio yields made Indexed UL economics appear to be extremely attractive. But a new epoch is beginning. Will Indexed UL adapt or fall victim? As it turns out, the cracks are already starting to show.

One of the most impactful articles I’ve ever read was from the legendary PIMCO asset manager Bill Gross entitled “A Man in the Mirror.” For a man like Gross – his billions earned by leading one of the largest actively managed funds on Earth to such consistent out performance that it earned him the celebrity moniker of the Bond King – to look at himself in the mirror and see anything other than a successful investor would be unthinkable. And yet, that’s exactly what he did in the article, writing “let me admit something. There is not a Bond King or a Stock King or an Investor Sovereign alive that can claim title to the throne. All of us…have cut our teeth during the most advantageous period of time, the most attractive epoch, that an investor could experience…Perhaps it was the epoch that made the man as opposed to the man that made the epoch.”

Like Gross, it’s time for us to take a look in the mirror when it comes to Indexed UL. Undoubtedly, Indexed UL has been wildly successful since the financial crisis, growing from something like $500M in premium in 2009 to over $2 billion in 2017. It is now the dominant Universal Life product by every metric. This begs the question – did the epoch make the product or did the product make the epoch?

Let’s start by looking at the last 10 years from the standpoint of the factors at play in both pricing and positioning Indexed UL. In terms of positioning, the Crisis clearly shifted the common view of risk as it relates to financial markets. Capital preservation hasn’t traditionally been a selling point of financial products but, after the crisis, it suddenly became a hot topic. Indexed UL delivers the goods on capital preservation while still offering upside potential. The story was the perfect fit for the times. But that’s just the gateway to the bigger story.

The post-2009 economic environment proved to be quite conducive to all accumulation life insurance products but particularly Indexed UL. First, although falling interest rates were bemoaned by life insurers and blamed for all sorts of calamities in the annuity market and in long-duration products like Guaranteed UL, they were a boon for accumulation life insurance products. The earned rates on portfolios of fixed income assets already backing in-force life insurance products fell far slower than market rates, which created a massive gap between the rates being used to price life insurance policies and market rates. To put it in blunt terms, the entirety of the gap was the result of diluting older, higher-yielding investments funded by in-force policyholders with funds from new policyholders. Portfolio crediting is a necessary* feature of recurring premium life insurance policies, but this is one of its side effects that only becomes obvious when interest rates move a lot in a very short period of time.

I think it’s fair to chalk up a fairly large portion of the increase in accumulation Whole Life sales to the gap between market interest rates and portfolio crediting rates, but there’s more to the story when it comes to Indexed UL. In IUL, the portfolio rate buys equity call options, the vast majority of which are structured in pairs as call spreads – one call option at the money (the 0% leg) and the other call option out of the money (at the level of the currently stated interest cap). The pricing for call spreads doesn’t follow the usual logic about the pricing of options because there are two, offsetting positions rather than a single, directional position. The best way to think about the price of a call spread is like a radio tuner. The static, if you will, is volatility and the music is interest rates. When the static is low, you can hear the music. But when the static is high, all you hear is static and it all sounds the same. Same deal for call spreads. As volatility increases, the price of the option becomes almost completely affixed to a single number, no matter what else. To take an extreme example, at 50% implied volatility, changing the interest rate assumption from 1% to 5% changes the price of a 10% cap by just 15 basis points. In other words, the price of the option is when volatility is high is all volatility, all static.

But when volatility is low, as it has been for years since 2009, the music of interest rates comes through loud and clear. And what sweet music it has been. Unlike life insurer portfolio yields, which buy mostly mid-duration corporate-credit type fixed income instruments, the best proxy for the interest rate component of option prices is LIBOR. In this case, 12 Month LIBOR pairs to a 1 year call spread option. In July of 2007, 12 Mo LIBOR was 5.5%. Just 18 months later, it was 2.2%. From there, it consistently fell to a low of just 0.5% in 2014. Combine dramatically falling rates with low volatility and you get historically cheap call spreads. Don’t take my word for it –in June of 2014, Minnesota Life paid just 4.25% for a 13% Cap. Today, that same cap would cost about 6%. But I’m getting ahead of myself.

From a sales standpoint, the beauty of IUL was that it could illustrate the benefit of those extremely high caps for the life of the policy through the illustrated rate. On the illustration, a 13% cap purchased with a 4.25% budget and generating a look-back illustrated rate of 8% was supportable forever. There was not, and still is not, any provision for in the illustrated rate calculation for the fact that the cap will change. Many life insurance producers were more than willing to use the maximum illustrated rate to sell the story of a conservative, no-downside product that “historically” performs at 8%, despite the fact that there was actually no real historical data to back up the illustrated rate. As the old adage goes, these producers didn’t let the facts get in the way of a good story.

And, as it turns out, Indexed UL actually has delivered extremely strong performance since 2009. Equity markets played their part brilliantly by delivering a nearly unbroken chain of price increases, growing from a low of 675 in March of 2009 to recent highs above 2,700. There have been a few hiccups, but the hiccups have happened to be quick losses followed by steady gains – in other words, the perfect pattern for strong performance in Indexed UL. Little wonder, then, that life insurers have been crowing about the “real-world” performance of their in-force Indexed UL products. Their portfolio rates could purchase huge caps thanks to extremely cheap options on an asset class that basically only went up. If that’s not a perfect storm, then I don’t know what is.

Indexed UL was undoubtedly the right story and financial structure for the times. For Indexed UL, 2009 to 2017 was, to put it in Bill Gross’s terms, the most attractive period of time, the most advantageous epoch possible. But the article doesn’t end there. Towards the end, Gross poses this question: “What if an epoch changes? Ah, now that would be the test of greatness: the ability to adapt to a new epoch.” For Indexed UL, this is the question at hand – will it adapt, or will it fall victim to the new epoch? As it turns out, the epoch is already changing and Indexed UL is already showing cracks.

*This is a point that I’ll probably write more about in a future post, but all life insurance products except for single premium products have portfolio crediting. The distinction between “new money” and portfolio crediting is not as clear-cut as one might think. In order to do a true “new money” product, each recurring premium payment would have to create its own portfolio. This is virtually impossible to administer and no company (that I know of) actually does it. Instead, “new money” in our vernacular just refers to the fact that all policyholders of a certain series are a part of the same portfolio that is distinct from the portfolios for other products. Portfolio crediting products lump multiple products and series into a single portfolio. That’s the distinction for life insurance, which stands in stark contrast to annuities, virtually all of which are sold as single premium products and therefore entail a much closer match of specific fixed income instruments and yields to specific products.

References:

Bill Gross “A Man in the Mirror” – https://www.pimco.com/en-us/insights/economic-and-market-commentary/investment-outlook/a-man-in-the-mirror

12 Month LIBOR – https://fred.stlouisfed.org/series/USD12MD156N

SPY Option Chain – https://www.nasdaq.com/symbol/spy/option-chain