#110 | Indexed UL in the Mirror – Part 2
Evidence is starting to mount that the epoch so beneficial to Indexed UL has ended. 12 Month LIBOR, a proxy for the rate embedded in the price of call spreads, has jumped from 0.75% in 2015 to a current rate of 2.75%, which in itself would cause a decrease in caps from 12% in 2015 to just 8.75% now with the same option budget. Furthermore, carrier portfolio rates have continued to decline or flatline because of a flat yield curve and low returns to credit risk. And, on top of that, volatility is finally picking up again. All of these things point to dramatically increasing prices for call spreads – as much as a 1% increase for a 12% cap in just the last year alone – and unprecedented pressure on current Indexed UL products. So where does IUL go from here? Before we answer that question, we’re going to take a look at something else that is absolutely essential to understanding the ending of the Indexed UL epoch.
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The speed at which the nearly decade-long former epoch dissolved has been, frankly, a little alarming to watch. It’s nearly binary – before the shift, everything was ripe for Indexed UL and then, after the shift, everything went wrong. In this post, I’m going to walk through some of the key metrics for pricing Indexed UL products and show how the epoch is changing.
First, the easy one – 12 Month LIBOR. That LIBOR would be a major pricing component for Indexed UL products might be a bit counterintuitive for some producers. But it is. LIBOR is a proxy for the risk-free interest rate priced into the equity call spreads that life insurers use to price and hedge the caps in Indexed UL products. All else being equal, an increase in LIBOR will generate an increase in the price for call spreads. The precise relationship between the increase in LIBOR and the increase in the price of a call spread is dependent on a variety of factors, but the effect is never zero and never negative. When the risk-free rate priced into the option goes up, the price of the option goes up. Take a look below at LIBOR in July of each of the years below. To put some meat on the bones, assuming 12% flat volatility and a 12% cap, the price of a call spread with 0.55% LIBOR would be just 3.78% but rises to 4.46% with 2.75% LIBOR. Put another way, assuming the carrier was working with a 3.8% budget in both cases, the cap would drop from 12% in 2014 to 9.25% in 2018 based solely off of movement in LIBOR.
But what about the fact that life insurers can earn higher rates when interest rates increase? This is the second metric that has suddenly moved against life insurers. Or, at least, it hasn’t become as favorable as it needs to be. We can get a feel for life insurer new money yields by looking at the Moody’s Aaa Composite, which is both a reflection of the benefits of investing long and taking some credit risk, precisely how life insurers invest. It tells us two things as relates to Indexed UL. First, it’s generally a leading indicator for whether life insurer portfolio rates are going to rise or fall. If Moody’s is below crediting rates in UL products, which take into account investment spreads and expenses, then it’s not unreasonable to assume that portfolio yields are going to fall as old money at higher yields rolls into new money at lower yields. Second, Moody’s is an indication of the inherent leverage that life insurers can create by investing long to support buying call options priced with short term rates. The tighter the gap between Moody’s and LIBOR, the less leverage there is. Right now, that gap has shrunk from an average of about 3.2% from 2009-2017 to under 1.2% right now. What this tells you, more or less, is that life insurer portfolio rates haven’t increased to offset the rising cost of the call spreads as LIBOR increased, which reduces the ability of the life insurer to deliver the high caps that have marked the last 10 years. And, not only have portfolio rates not increased, but Moody’s is actually indicating that they could continue to fall.
Third, the volatility regime has changed. This is a far more subtle – and far more important – distinction than most people realize. Most people who are conversational in options (and, frankly, a lot of actuaries) talk about “volatility” as a single number and quote VIX as a proxy for it. In looking at that measure, it’s not as easy to see a change in the epoch. VIX since 2009 has been as high as 43 (in 2011) and as low as 9.5 in 2017. Since 2009, VIX has been low, fairly volatile and punctuated by steep increases and quick declines. For example, VIX popped to over 37 on February 5th of this year but by the 15th, when most life insurers buy their options, VIX was back down to 19 – a little high but not incredibly so.
And, besides, as discussed in the previous post, volatility for call spread options doesn’t linearly increase the price of the option. For example, assuming a 1% risk free rate, the price of a 12% cap with 12.5% flat volatility is 3.96% and goes to just 4.48% at 25% volatility. What happens if volatility spikes to 37.5%? The price of the option stays flat at 4.48%. That’s what I mean when I said in the previous post that interest rates are music and volatility is static. With capped options, extreme volatility doesn’t mean extreme option prices – it just means that the price settles into a number that is little changed by other factors. For example, at 12.5% volatility, moving the risk free rate from 1% to 2% increases the price of the option to 4.26%, an 8% increase. At 25% volatility, the price of the option changes by just 3% for the same move in the risk free rate. At 37.5%, the change is just 1.5%. More volatility, in absolute terms, just means that the price of a call spread is more affixed to its price, regardless of interest rate changes.
If you want to pin the epoch for Indexed UL down to a simple story, it would be this – high portfolio rates allowed life insurers to buy cheap options and deliver extremely high caps. But that epoch has definitively ended. Portfolio rates have been eroded by 10 years of low duration and credit spreads. Options are no longer cheap thanks to increasing LIBOR and general volatility levels. If you want proof positive, just take a look at the comparison of the cost of a 12% cap since 2006. We are back to where we started – only now, carrier portfolio yields are 4.5% rather than 6.5% as they were in 2006.
It should be no surprise, then, that the evidence of the end of the epoch is mounting. There is no better example than recent rate moves by PennMutual and Minnesota Life (now called Securian), two companies that basically went from being tiny, anonymous mutuals to major players in the Life market on the backs of their respective Indexed UL offerings and, in particular, their aggressively high caps. I remember when PennMutual’s product sported a 14% cap and 2% guaranteed floor – an insanely expensive benefit that they did not directly hedge*. At around the same time, Securian’s Eclipse IUL had a 17% cap, which they also were not directly hedging until late 2009. Over the years, PennMutual and Securian have continued to set their caps at the ragged edge of pricing. Whereas other firms like Pacific Life tried to focus on the sustainability of their caps, PennMutual and Securian have gone for shock and awe. But now, the epoch has changed. PennMutual’s cap has fallen from 14% to just 9.5%. Minnesota Life still sells Eclipse IUL and the cap for that product is now just 11% (and soon to fall to 10.5%). And while these caps are actually still pretty high, the fact that two companies who basically hung their hat on being able to deliver high caps have sunk back down to earth is an indication of how the market has changed. And, for what it’s worth, recent economics show that they and peers with similar caps still have further to fall.
So where does Indexed UL go from here? Before we get to that question, I’m going to tackle another issue that came up while exploring the idea of an epoch for Indexed UL ending – the fact that volatility for call spreads used in Indexed UL is not VIX and not by a long shot. In fact, it’s something entirely different that has huge implications for the future pricing and performance for Indexed UL.
*Yes, you read that correctly. They did not hedge it – at least, not directly. Why do you care if a life insurer hedges their Indexed UL product? First, because if life insurers actually thought that options delivered 50% profits, then not hedging would mean that the life insurer would be on the hook for paying those gains out of their own pocket. Second, because not hedging means that pricing for caps can become unhinged from reality, as happened with PennMutual and Minnesota Life. Once they started hedging, they became quite sensitive to actual hedging prices. Minnesota Life dropped its cap from 16% when they started directly hedging in September of 2009 to 15% in August of 2010 to 14% in November of 2011 to 13% in August of 2012. So for all the people that purchased an Eclipse IUL product with a 16% cap and 9.5%+ illustrated rate, within the span of just a few years they had a 13% cap and a 7.5% illustrated rate.