#178 | The Dark Art of Setting Indexed UL Caps
In theory, setting a cap in an Indexed UL product should be straightforward. The life insurer earns a yield for the portfolio of assets backing the product, scrapes off a cut and then goes to market with the remaining amount to buy options to support the affordable cap. But as Yogi Berra famously said – in theory, there is no difference between theory and practice, but in practice, there is. That’s why setting an Indexed UL cap (or participation rate or spread, for that matter) is more art than science. And because the rate-setting process and even the pricing inputs aren’t disclosed, it’s not art – it’s dark art. Very dark, indeed.
Let’s start with the basic fact that the Indexed UL market has never accepted the idea of a market-priced cap. Within a given year, the price of a particular cap could swing by more than 1% but, generally speaking, caps change once a year or less. Life insurers selling Indexed UL regularly smooth out the inherent variations in monthly cap pricing. Economically, this is bizarre behavior. Keeping an artificially steady cap means that carriers are systematically short-changing policyholders who buy in some months and systematically over-crediting policyholders who buy in other months. But the Indexed UL market is governed by illustrations, not economics, and maintaining a stable cap is essential to maintaining a steady competitive position because illustrated rates are directly tied to caps. As a result, carriers try to peg a cap that is “affordable” for the foreseeable future, whatever that means.
What’s the definition of “affordable?” That’s a very tricky question. No life insurance product turns a net profit for at least the first 7 years. As a result, profitability in life insurance is always the function of a long-term view of distributable earnings from the product over time. Companies each have their own views of future interest rates, mortality improvements, expense structures and policyholder behavior that feed their long-term profitability projections*. An affordable cap for one company might be the cap can be purchased by strictly spending their current portfolio yield because that company assumes no improvements, in the long run, to the portfolio yield in their pricing model. An affordable cap for another company might be the one that will be affordable, with a nice spread, once interest rates start to increase again. An affordable cap for still another company might be the one that allows them to hit profitability targets because other policy expenses add to overall profitability and make up for the losses from hedging the higher cap. I could go on. The fact is that there are many, many different ways of setting caps – and no carrier does it exactly the same way because carriers don’t gauge profitability exactly the same way.
Caps aren’t an abstract notion because they have both real illustrated benefits that drive flows into the carrier and real costs in terms of hedging. As a result, setting caps is always a balancing act between financial consequences and sales consequences. Carriers regularly change their opinions about which one should prevail and how best to balance between the two. For example, should the carrier shoot for an extremely high cap today with the knowledge that it will be unsustainable if the winds shift? That’s what Securian did from 2009 until earlier this year, when their cap fell to 10.5% after once sitting at 17%. Other companies shoot for caps that they deem to be “sustainable” for the long run, even if they are slightly behind the pack today. And then there’s the issue of upstart life insurers who have tiny blocks of IUL can basically eat hedge losses while they soak up new sales thanks to their high caps. And still there are other insurers, like PacLife, who have a smash-hit product that brings in so much new money that it dilutes their portfolio yield and forces them to exactly match their hedge budget to their cap prices because the sheer size of the losses from not matching it correctly would be unbearable. As if you needed more convincing that setting caps is a dark art and not science, I’m not even covering participation rate, spread and proprietary index accounts, which are even more subjectively priced and less consistent than caps because their flows are smaller and life insurers pay less attention to them.
The arbitrary and often-capricious way in which life insurers set their caps undermines the entire competitive benchmarking game being played in Indexed UL. We know that benchmarking is increasingly driving Indexed UL premium. We also know that almost all benchmarking is predicated on using the AG49 maximum rate (or some percentage of it), which itself is directly derived from the current cap. The presumption, then, in benchmarking is that all caps are created equally. As I’ve shown, that is clearly not the case. Some caps are more sustainable than others. Some caps should change more often than they do. Some caps are virtually guaranteed to drop. Some caps are already money-losers for the life insurer. But regardless of how specifically the caps differ, the fact remains that they are not comparable and should not drive benchmarking exercises.
What’s the alternative? Illustrate at the option budget. But, unfortunately, life insurers don’t feel the need to disclose their option budgets. Why not? Because they all know that they aren’t strictly adhering to them anyway. The option budget is more like an aspiration, not an actual cost incurred every month. So our alternative is not such a good one. That puts producers in a very tough position. How are you supposed to run competitive illustrations on a product where the cap isn’t reliable and the option budget isn’t disclosed? My advice is to not sell off of the illustration. Pick a product that is simple, low cost and written by a solid company. Those will be better predictors of success – much better than an illustration or a benchmark.
*Technical folks will point out that carriers all have to comply with illustration actuary testing so that any current cap is actuarially supportable. Actuaries love to use supportability testing as a catch-all for the fact that what they are doing with a particular product or rate “works.” But it is a mistake to equate illustration actuary compliance with long-term sustainability. Illustration actuary compliance is a bare-minimum that essentially represents a 0% profit hurdle with prescribed assumptions and restrictions. Companies price to much higher target returns and use different assumptions, which basically means that a cap (or product) can be actuarially supportable but not economically supportable. Some companies are skating so close to the line that actuarial supportability dictates their hand, but usually the economic and profitability considerations at the life insurer are what forces changes to caps or product pricing. As a result, it’s the more important consideration for a discussion like this one.