#138 | Indexed UL on the Risk Spectrum – Part 3

The intuition for why a higher fee to buy more index exposure delivers better returns is pretty straightforward. The higher the fee, the more downside risk but also the more leverage on upside returns. For example, let’s just assume that the fee is 4.85% annually and that purchases a 2 multiplier on index returns for a product with a 10% cap. If the index returns are 10% or greater, then the net policy credit is 15.15%, which is 10% x 2 – 4.85%. That’s quite an upside. Running that product through the same analysis generates a standard deviation about half as much as pure equities or, in this analysis, a VUL product. The gap between the arithmetic and geometric means also widens to 33% of VUL because now we’ve introduced negative returns to the structure. No surprise, but dramatically increasing the fee to, say, 25% also dramatically increases the measures of risk. Now, both measures of risk are about twice as much as in VUL. By just this simple modification of using a fee to buy index return exposure, we’ve transformed a product that is spitting distance from Universal Life in terms of risk into something riskier than pure equities.

This leads us to another interesting angle on options. In effect, the fee is simply buying more options than could otherwise be afforded by just spending the yield. The fee changes the composition of the account value away from fixed income and towards more options. In doing so, the product itself starts to take on more of the characteristics of the underlying option strategy and less of the characteristics of fixed income. Eventually, with a large enough fee, the product would look exactly like the underlying option strategy because it would be entirely invested in options. So what are the risk/return characteristics of the option strategy itself?

That’s an interesting question. Options are obviously very risky. In this case, the company spends (let’s say) 4.85% to buy a 10% cap. That option trade has a payoff matrix that ranges from -100% (a 0% credit to the policyholder) or 106% (a 10% credit to the policyholder). As discussed in the last post, fully 75% of the time the payoff will be either 0% or 106% – that’s quite a lot of volatility. As a result, you’d expect quite a profit, right? But options aren’t investments. Options are derivatives. They derive their value from being tied to other assets. They themselves do not have a risk/return tradeoff. More risk in an option trade doesn’t necessarily mean more expectation of a profit. Take, for example, a simple swap trade. Party A pays a fixed 3% rate to Party B, who pays a rate of LIBOR + 1% to Party A. Both sides have the chance for significant loss and gain. Consequently, the value of the swap at inception and the price for each party to enter the swap at inception is zero. That’s how swaps work. Over time, of course, the trade will swing in one party’s favor or the other, in which case that party will have to post collateral to the other party, and eventually the swap will pay off to one of the parties. There is no structural profit embedded in the swap. There is no compensation for risk because both parties are on the hook. There is no return expectation built into the derivative – because that’s how derivatives work. The fundamental premise of every derivative is that the price paid for the derivative is its expected value. In the swap example, the expected value is zero based on the market clearing trade. In the case of options bought to hedge Indexed UL products, the expected value of the option is the price paid for it.

So why would anyone enter into a swap trade and take a ton of risk if they aren’t going to be compensated for that risk? Because options are not investments. Options are used to either hedge or speculate. Party B, for example, might have liabilities on its balance sheet that decrease in value if interest rates go down. Lucky for them, that’s exactly when Party A has to pony up. Party A, on the other hand, might want to bet that interest rates are going to rise. By paying a fixed rate in exchange for a floating rate, rising interest rates will cause Party B to pony up for Party A. See how this works?

Options are the same except that the value of the trade is determined at issue and the buyer is only on the hook for the price of the trade. It limits the potential loss and defines the payoffs. In fact, you could argue that the option seller is taking more risk in the trade because their upside is limited to the option premium and the downside is infinite. Regardless, the point for the insurance company in buying options is not to profit or to create a profit for the policyholder. It’s to hedge the equity exposure at market prices. That’s what options do. As a result, the idea of structural profits or risk premium transfer is foreign to anyone familiar with options. It just doesn’t compute. The only place people talk about structural profits from options is in the bizarre little world of Indexed UL illustrations.

Just to give you a little bit of perspective on this, I was recently meeting with the Chief Investment Officer of one of the largest insurance companies in the US. His team manages a general account portfolio of more than $200 billion and he’s done several stints at other insurers with similarly sized or larger portfolios. We were chatting about various other things and my last question to him was – do you know what an Indexed UL product is? He said that no, he didn’t. I described for him in basic terms how it worked and he immediately understood it because there are analogous products in the investment world. And then I asked him the real question – what do you think is a reasonable expectation for long-term profit from buying rolling call spreads? He held up his hand with his forefinger and thumb touching to make a zero. Really? Yes, he said, really.

I bring up this story to continue to the make the point, as I always make, that any discussion about illustrated performance in Indexed UL always and necessarily comes back to a discussion about option profits. If you believe that Indexed UL sits smack-dab on the risk spectrum between UL and VUL, then you believe that options are actually investments that deliver returns commensurate with their risks – returns, by the way, that average 50% annually over the long run. If you believe that different indexed account options within an Indexed UL product deliver materially different risk/return profiles, then you believe that not all derivatives are priced according to their fair market value. You think that swaps are for suckers (because they always clear with a price of zero) and that each option has its own expected profit over the long run. And if you believe that multipliers generate higher returns in the long run, then you believe that more exposure to an asset class that delivers 50% annual profits over the long run is always better. See? It always goes back to option profits. There’s no escaping it.

This makes a lot of people in our industry really uncomfortable. They just want to talk about caps, floors, participation rates and, most importantly, illustrated rates. Particularly, they want to talk about how illustrated rates in Indexed UL are indicators of a sustainable performance advantage without a commensurate level of risk. Sorry folks, that’s bad math. Not only is Indexed UL not much riskier than Universal Life, but it can’t deliver a higher return unless you believe in systemic option profits. And if you believe in systemic option profits, then why are you selling life insurance? Why do you work at a life insurer? Why don’t you go out and start the first and only hedge fund dedicated to systematically buying call options and reaping huge profits forever?

Instead, what these two articles show is that we should return to our roots. Indexed UL is life insurance. In fact, from a risk standpoint, it’s Universal Life insurance with a dash of pepper. Illustrate accordingly – regardless of what the maximum AG49 rate says.