#205 | Charting New Territory
The market turmoil over the last week might not be unprecedented in and of itself, but it is producing some unprecedented results – and not in a good way for fixed and indexed insurance products. While equity drawdowns are obviously a concern for the broader investment landscape, they’re not damaging in and of themselves for the core economics of fixed insurance products. Raw equities represent a small portion of insurer balance sheets. Instead, equity drawdowns are an indicator of deterioration of fundamentals that will manifest in other assets that more directly impact fixed and indexed insurance products.
That’s already starting to happen. In the past week, the 10 Year Treasury has dropped from 1.5% to just 0.92% as of this moment (4:30PM on Thursday, 3/5), which is unquestionably the lowest on record. The Moody’s Aaa Composite now sits at 2.55%, the lowest rate in history save for a few months in 1946. The Moody’s Baa Composite is similarly flirting with record lows, coming in at 3.5%. Fixed income investing is becoming incredibly tight and that’s bad news for any insurer looking to invest customer deposits in fixed insurance products. Rates on these products will fall. That much is inevitable.
Indexed insurance products have an additional linkage to the equity markets through the pricing of index options, which is represented by the implied market volatility priced into the option. Folks often use the VIX as the proxy for implied volatility and then extrapolate to potential changes for indexed insurance products, but that’s not actually accurate. Volatility has a term structure in the same way that fixed income instruments have a term structure, which is commonly called the “yield curve” (minus some technical distinctions). We all know that interest rates are different for different maturities and the same goes for volatility. VIX tracks 3-month volatility, which is irrelevant for pricing indexed insurance products, all of which trade options that extend for longer than 3 months and therefore are sensitive to longer term volatility. Because most insurance product use 1-year crediting strategies, the most relevant point on the volatility curve is 12-month volatility. The chart below shows the usual relationship between 3-month (VIX) and 12-month implied volatility, courtesy of Barclays:
Also thanks to Barclays, this chart is virtually impossible to read, so let me decode it for you. The chart shows 12M volatility minus 3M volatility. The visible horizontal line is zero, meaning that 12M and 3M are the same. You can see that, generally speaking, 12M volatility is meaningfully higher than 3M volatility. For VIX watchers, that means the implied volatility baked into indexed insurance products with 1-year crediting is meaningfully higher than what you’re seeing on the VIX. But that relationship changes occasionally, when suddenly 3M volatility spikes far beyond 12M volatility. Those spikes are not random. If you could see the dates, you’d see that they almost perfectly correspond to overall increases in volatility because of market drawdowns. See below for a comparison between the 12M-3M volatility spread and overall 12M volatility.
It’s fairly obvious that anytime overall volatility spikes, the relationship between 3M and 12M volatility suddenly changes as well. So, again, for VIX watchers – when VIX goes through the roof, that doesn’t mean that the 12M volatility feeding your indexed insurance products is necessarily spiking as much as you’re seeing in VIX. In fact, it’s usually a lot more subdued. You can actually see this playing out right now by looking at the full-term structure of volatility for the S&P 500 or, if you want to call it this, the volatility curve right now:
Right now, the market is saying that the shorter-term view of market volatility is significantly higher (a whopping 32.4% annualized) for 1-month volatility versus 24-month volatility (19% annualized). That’s a boon for indexed insurance products. It means that the damage to IUL products, for example, from higher volatility will be less pronounced than you might think. In just the past week, the market-priced participation rate that I track in the Indexed UL Benchmark Index has dropped from 55% to 35%. That’s dramatic, but not nearly as bad as it would be if 12M volatility matched 3M volatility. In that scenario, the drop would have been from 55% to just under 20%. Participation rate strategies are directly tied to implied volatility and the carnage will be readily apparent once carriers renew rates.
Cap options, as I’ve written numerous times before, are more dependent on volatility skew than straight volatility but they’re not immune. For example, the price of a 10% cap has been steadily increasing from 4.5% in the middle of January to 4.9% today. It’s a lot, but not as dramatic as it could be. If 12M volatility matched 3M volatility and volatility skew stayed where it is today, you’d be looking at somewhere north of 5.25% for a 10% cap. That would send huge tremors through the FIA and IUL markets in a way that an isolated 3M volatility spike won’t. But don’t think that 12M volatility is immune from volatility spikes. It certainly isn’t – it just moves more slowly than 3M volatility.
There’s another angle, though, that I think is worth quickly exploring. Take a look again at the chart comparing 3M volatility to 12M volatility. I’ve been highlighting the fact that in volatility spikes, you’d rather be buying 12M options than 3M options. But the opposite is also true – in times of normal volatility, you’d rather be buying 3M options than 12M options. There is a baked-in volatility premium to longer-term volatility. In layman’s terms, this means that 12M options are intrinsically more expensive than 3M options the vast majority of the time. Think of it as a volatility tax on 12M options that is the market attempting to price for the big upswings in short-term volatility that will also manifest, eventually, in 12M volatility. But for indexed insurance products, it’s an indicator that these insurance products are buying a relatively expensive option and, therefore, that additional cost will eat into long-term returns.
So what’s the bottom line? Stop watching VIX and thinking that you’re looking at an indicator of what will happen to indexed insurance products. That ain’t how it works – and you can be grateful for that when short-term volatility is spiking like it is right now. The bigger threat to fixed and indexed insurance products overall is that we’re in a fixed income yield environment that we haven’t seen since World War II. Depressed yields are going to pound their way through the doors of the insurance company portfolios and impact caps. That’s the sure and unavoidable thing.