#159 | How Big Can ICMs Get?

With Lincoln’s introduction of a 6% asset charge to fund an Index Credit Multiplier (ICM), which was then followed by PacLife’s 7.5% charge-funded ICM and soon by John Hancock’s 5% charge-funded ICM, folks began to speculate on a logical question – how big can charge-funded ICMs get?

The stock answer provided by most carriers, and seemingly acknowledged by regulators, is that a charge-funded ICM can’t increase the risk profile of a leveraged Indexed UL product beyond that of Variable UL. Or, put differently, the risk profile of the product can’t exceed the risk profile of the index being used as the basis for indexed crediting – which, for AG49, is the S&P 500. This seems like a very reasonable conclusion. Variable UL’s enhanced risk profile has led it to be classified as a securities product with more scrutiny, disclosure and an entirely different illustration regulation. In order for leveraged Indexed UL to credibly remain an insurance product and not a security, it can’t deliver more risk than a Variable UL. Voila. There’s the boundary.

Except this is where things get tricky. What’s the definition of “risk”? I wrote an entire series built on this concept in order to try to pull out the risk/return profile of Indexed UL, but the question here is a more pointed one – what gauge of risk works best for setting the boundary line between Variable UL and leveraged Indexed UL?

Let’s start with volatility. As I wrote about in the previous series, the only way to gauge volatility in Indexed UL – even leveraged Indexed UL – is by drawing out the returns over a longer period of time. This immediately disqualifies volatility as the measure for the boundary. Volatility in the S&P 500 can be measured to the second over any period of time and the measurements will have self-similarity. The same tools for measuring daily volatility can be used for measuring annual volatility and the distributions of returns across any time period will be visually similar, even if not completely identical. This is not true for Indexed UL. Looking at returns over one year in Indexed UL produces fully 75% of the returns at either the cap or the floor. Looking at returns over 10 years in Indexed UL produces something that looks like a standard normal distribution, which is the traditional basis for calculating volatility. So, to cut the chase, volatility in the S&P 500 means the same thing regardless of the time over which volatility is measured, but volatility means very different things for Indexed UL depending on the period of measurement. So volatility, in the traditional sense, is out.

The only other real option for setting the boundary between the two products is by measuring downside risk. This measurement can be applied over any time period greater than a year with consistency between the index and Indexed UL. You know the maximum loss, at any period of time, for a leveraged Indexed UL product and you have a historical record of maximum losses in the S&P 500. If you map the hypothetical historical performance of various leveraged Indexed UL products over historical S&P 500 performance every year, you get this:

What this graph shows, more or less, is that even a 20% asset charge to fund an ICM would result in less annual downside risk than the S&P 500 itself. But what about over a longer time horizon say, 20 years? Take a look:

Even here, a 20% asset charge would produce the same or similar tail risk to the S&P 500 in this hypothetical historical analysis, which follows the same methodology generally accepted in the market of freezing both option prices and the current cap. Based on these results, I think it would be rather difficult for anyone using the AG49 methodology to draw the line in the sand below a 20% asset charge. And if that’s the boundary, then there’s another issue that arises – why would anyone choose investing in the S&P 500 over a leveraged Indexed UL product? The average return for the S&P 500 over these 1,000 scenarios is 7.8%. The average net return for the leveraged Indexed UL with a 20% charge-funded ICM is 13.5%. Same risk, double the return.

How is that possible? Simple: the AG49 methodology produces massive assumed and illustrated option profits. Allocating more of the account value to options, which is exactly what a charge-funded ICM does, generates huge assumed returns. Even though 80% of the Account Value is essentially dead weight from a return standpoint, the remaining 20% is producing such spectacular results that the overall package produces risk-adjusted returns that are significantly better than the base index. Based on this analysis, investors would be vastly better off in a leveraged Indexed UL product than in traditional equity funds or Variable UL.

When asked how to spot a fraud, one investigative journalist gave a counterintuitive answer – if the idea doesn’t make sense in its simplest form, then it’s suspect. The quote was particularly pointed at the story of the downfall of Theranos, which was a company that claimed to have developed breakthrough blood testing technology created by a CEO without any medical experience. Hmm. Saying it like that, without all of the hype surrounding the forceful personality of Elizabeth Holmes, does make the story seem a little bit suspect. Let’s try it out on Indexed UL – the sleepy arm of the insurance industry creates a way to deliver vastly superior risk-adjusted returns than traditional asset-management. Hmm. Really?

AG49 says that yes, that’s really true, and gives life insurers the leash to show up to 50% option profits on illustrations. Really. Leveraged Indexed UL products simply put more money to work at the assumed option profit. The only way to right-size leveraged IUL is to right-size illustrated option profits. And it’s going to take quite a herculean effort to get regulators to reopen that can of worms, so buckle up.