#183 | Picking an Indexed Crediting Strategy
I’m often asked which indexed crediting strategy is the “best” one. The answer, of course, depends on your perspective. If you believe that hypothetical historical backtesting (such as the AG49 maximum rate methodology) is a reliable indicator of the intrinsic value of a particular strategy then you’ll come to a very different conclusion than if you generally believe that option prices reflect the intrinsic value of the strategy and, therefore, all indexed account have the same theoretical returns over time. Much of the conversation in the Indexed UL space revolves around these two points of view – both of which have their flaws.
The folks who advocate backtesting as a reasonable baseline expectation for the returns of a strategy must make the completely absurd assumption that the specific, currently-declared rates across the strategies available are all equally indicative of what the rates would have been historically. For example, if a company offers a current cap of 10% and a current participation rate of 70%, then this view assumes that the current 10% cap is equally as indicative of actual historical caps as the current 70% participation rate is indicative of actual historical participation rates. This is, of course, not true. Caps react very differently to interest rates, volatility and volatility skew than participation rates. Folks often miss this distinction. I’ve heard even very credible people make impassioned arguments in favor of a particular indexed crediting strategy without realizing that each strategy’s rates will change in different ways. If we had perfect and deep historical data on option pricing, then we could start to draw some conclusions using historical backtesting. But we don’t. We’re actually woefully short on real data. And the hypothetical historical methodology embedded in AG49 is certainly not real historical data. Consequently, this view of how to evaluate different indexed crediting strategies isn’t particularly helpful.
The alternative view that all indexed accounts have identical expected payoffs suffers from a different affliction – it’s true in theory, but not in practice. The theory of option pricing is, more or less, than options are priced to reflect their expected payoffs. Under that concept, the price of an option is constantly adjusting in response to interest rates and asset volatility to effectively wash out arbitrage conditions. Therefore, all options should have the same profit profiles. But that’s not actually what happens. Options are market priced instruments. The future is uncertain. That means that some options will certainly and absolutely outperform others, even if they all have the same theoretical value. Sometimes certain options will outperform others over extended periods of time. But most importantly, some people will believe that certain options will outperform others because of other beliefs that they hold. If a client has a certain philosophy about equity returns, then that client might also believe that certain indexed strategies will deliver outsized profits relative to others. Even if theory states that they should all be the same, the reality of the market is that they won’t – and clients should choose accordingly.
But there’s a third way, which is to think about indexed accounts like an option trader would. An option trader doesn’t have any opinion about long-term equity returns. An option trader doesn’t do hypothetical historical backtesting. The only thing an option trader cares about is how options are priced and where he can pick up a relative value trade. That means our trader friend is primarily watching implied volatility. For option traders, that’s the “price” of the option in terms of relative value. The actual cash price is simply a residual fall-out function of interest rates, time left to expiry and moneyness.
From that standpoint, the hierarchy of indexed crediting strategies is fairly clear. Let’s take a one-year, point-to-point account on the S&P 500 and let’s assume that at-the-money volatility is 15% and out-of-the-money volatility at a 110% strike price is 12%, which is pretty in-line with recent history. The best trade from a relative value standpoint would be to buy an option with a strike higher than 100%, because those options have lower priced implied volatility than the at-the-money option. Put differently, as the strike price increases, the relative price of the option decreases, but the relative value increases. Actual realized volatility for the S&P 500 will be identical across all strike prices. So the fact that the 110% strike option has just 80% of the implied volatility as the ATM option means that buying the 110% strike is a solid intrinsic value trade. The next best trade would be to buy the ATM option, which has a 15% implied volatility and is “market priced,” if you will, without a volatility penalty. The worst trade, by a long shot, would be to buy the ATM option at a 15% implied volatility and then sell the 110% OTM option at 12% implied volatility. That strategy, in effect, would be buying something expensive and offsetting it by selling something cheap. It would be like trying to dump your C5 Corvette Z06 (the car with the widest gap between owner perceived value and actual sales price) in order to get on the wait list for the glorious new mid-engine C8 Corvette, which is already sold out and commanding huge dealer markups. I mean, who would do that?
Everyone, apparently, because buying an ATM option and selling an OTM option is exactly the hedging strategy for a capped strategy, the most popular crediting strategy in Indexed UL by a country mile. It’s a terrible trade in terms of intrinsic value. So why do carriers do it? Certainly not because it has the highest expected returns for policyholders. Instead, caps are very stable relative to other crediting strategies. Stability is a benefit in Indexed UL because it means your illustrated rates (and, therefore, competitive positioning) doesn’t change often. Caps are a good choice for carriers. From an intrinsic value standpoint, they’re an acutely poor choice for policyholders.
A better option is a straight participation rate with no declared cap. That’s at least priced to the center of the market. Why don’t life insurers use them more often? Because a properly calibrated participation rate can swing by 20% in a single rate-setting cycle. Carriers don’t like to eat hedge cost gains and losses on a regular basis, but that’s exactly what keeping a consistent participation rate would require.
But the best option is the spread, which provides exposure above a certain percentage return. This option is a cheap relative value trade because it only buys the cheap option. And the higher the spread, the cheaper the option. A 5% spread with a 100% participation rate is not as good of a value trade as a 10% spread with a 200% participation rate because the implied volatility of a 105% strike option is higher than a 110% strike option. But the flip side is that spreads should change even more often, and even more violently, than participation rates. Why? Because even a slight uptick in implied volatility can cause a disproportionately huge spike in the price of an OTM option. To give you an example, if the price of an ATM option jumps by 45% if volatility goes up by 50%, then the price of a 110% OTM option jumps by a whopping 119% for the same increase in volatility. As a result, spreads can have enormous swings in the space of just a few days, and that’s precisely why some carriers avoid them.
Spreads have kind of come into vogue recently for another reason – carriers have them set very low, sometimes as low as 4%, in current Indexed UL products. If what I said is true, then why are spreads so low and why do they seem to never change? The simple answer is that the reason is because no one allocates to them so the hedge gains/losses by keeping the spread constant are trivial. But if enough people allocate to them, then mark my words, spreads will start dancing like the bachelor groomsman at his best friend’s wedding. And it’ll be every bit as uncomfortable and cringeworthy.
In short, you should care about which indexed option your client chooses. Each one tells a story. Want consistency and are willing to make a bad value trade to get it? Go with a cap. Want some variability of rates but potentially better returns? Go with a participation rate. Don’t mind variability and want to knock it out of the park? Take the spread. Or, maybe better yet, spread the exposure across all 3. But no matter what you do, don’t fall into the trap of using hypothetical historical lookbacks to inform your choice. That never ends well.