#260 | The Hang Seng & Indexed Account Availability
Last week, Pacific Life announced that it is “pausing” allocations to its 1-Year International Indexed Account until “further notice” due to an executive order issued last year “prohibiting transactions in securities and derivatives of certain Chinese Companies.” As a result, Pacific Life wrote, the company is “unable to purchase derivatives of the Hong Kong-based Hang Seng Index,” which is one of three indices included in the 1-Year International Indexed Account. If this strikes you as an innocuous announcement, you’re right. For the policyholders affected, they’ll simply be defaulted to the Fixed Account and, from there, the funds can be redirected to the other indexed crediting strategies in the product. It’s not the end of the world. But if you also get a funny feeling in your stomach like you’re seeing something for the first time that isn’t quite how you understood things to work, then you’re right about that, too.
Let’s start with the strange history of the Hang Seng’s outsized presence in the Indexed UL market. Back in 2006, AIG was looking for a new angle on Indexed UL and partnered with an external consultant to bring Elite Global IUL to market. The core differentiator of the product was a 5-year “hindsight” crediting strategy using 3 indices – the S&P 500, the EUROSTOXX 50 and the Hang Seng. The product sold like hotcakes and several other companies adopted the index as a part of their own crediting strategies.
I took no small pleasure in ripping apart the strategy when I reviewed Voya’s version, Global Choice with ICAR, a couple of years ago (here). The gist of the story is that the Hang Seng delivers extremely strong lookback performance based on long-term historical data that has essentially nothing to do with its nearer-term performance, which hasn’t been stellar. The index itself has shifted from being reflective of Hong Kong as an entrepreneurial global financial hub and is now reflective of Hong Kong as a Chinese province and, accordingly, a heavy dose of state owned and quasi-state owned companies. I would bet that very few, if any, life insurance producers are aware of the changes to the 50 stocks comprising the Hang Seng over the past few decades.
And it’s that connection to Mainland companies that caused the Hang Seng to run afoul of the executive order from late last year. The order specifically lists companies that are prohibited for trading and one of them is China Mobile, which is also a constituent of the Hang Seng. Therein lies the problem, it seems, although I’m sure there are other connections between state owned enterprises and various companies in the Hang Seng. Although the fact that Pacific Life had to suspend the 1-Year International Indexed Account because of an executive order seems like a one-off deal, it’s a result of a flexibility within Indexed UL contracts that has only and infrequently been used – the ability to seal off allocations to specific indexed accounts for any reason, including reasons that have nothing to do with the product itself.
Why would a company want to do that, anyway? Well, again, the seemingly innocuous announcement by Pacific Life hints at the truth when it says that it is “unable to purchase derivatives…which [are] used to support [the account].” If a company can’t affordably hedge an indexed crediting strategy, then a company probably isn’t going to offer it. That’s also the reason why Pacific Life sealed off its uncapped S&P 500 crediting strategy last year, when volatility in the market was through the roof and it was almost impossible for any company to change rates fast enough (or far enough) to reflect the evolving market conditions, meaning that there would inevitably be a disconnect between the price to hedge and the rates in the product. No matter what way you cut it, Indexed UL is always and forever an options product. And what happens in the options market dictates what will happen in the product.
If you want to think about the problem in simplistic terms, then just consider the simple relationship between supply and demand – or, in this case, hedge notional and market liquidity. If you’re trading a lot of hedge notional into a thin market, then you’re going to bump into issues when things go haywire. That’s exactly what happened in March.
Where are derivative markets relatively thin? There are a few spots. The longer the option tenor, the thinner the market. The vast majority of S&P 500 (SPX) options are traded within a few weeks of their expiration. At short (sub-6 month) tenors, the market is very, very liquid. But it starts to trail off with anything beyond 1 year and the volatility market beyond 5 years is virtually non-existent. The institutional data service I use to track option implied volatility doesn’t even offer data beyond a 2-year tenor. So if you’re looking for an immediate spot where a life insurer might want to seal off an account option in a volatile environment, look no further than long-dated crediting strategies. When the going gets tough, finding a counterparty willing to sign up to price 5-year volatility is probably going to be a bit tricky.
The second spot the derivative market is thin is specialized crediting strategies – think Monthly Point-to-Point, Monthly Sum, lookback options and other “exotic” structures. All of these options have to be shoe-horned into existing derivative pricing models. I’ve asked for option pricing runs from investment banks for these types of strategies and I’ve noticed that the numbers usually come back, shall we say, rounded off. They are very complex instruments and pricing them appropriately is somewhere between art and science. That works fine in normal environments because enough firms will step up to make a market for these types of trades. But in non-normal environments, it’s entirely possible that a life insurer won’t be able to find a counterparty at a reasonable price (or at all) to execute a trade for some of these types of strategies.
The third spot is similar in concept – proprietary indices. Most of these indices have volatility control mechanisms and deduct the risk-free rate from the pricing (referred to as an Excess Return) index that, theoretically, means the index should be very easy to hedge even if volatility in the broader market is going haywire. But there are other problems with executing these trades. Too often, these proprietary index options rely on highly complex algorithms to dictate the asset allocations and volatility control. In order to simplify the story, some banks price their hedges using proxies for the allocation. This is referred to, intuitively, as basis risk. If you’re basing your hedges on instruments that actually aren’t identical to the asset you’re trying to hedge, then you’re taking basis risk. Again, it’s usually not a problem. But in a wild market, basis risk could lock up the derivatives market for a particular specialty index, particularly if that index is only hedged by one or two counterparties.
All of these spots could cause problems on one side of the equation – a thin options market. But what about the other side, where notional volume is so big that it can overwhelm even a relatively liquid market? I wrote over the summer about how, at the height of the COVID crisis in March and April, companies clearing their vanilla S&P 500 call spread options were having trouble finding counterparties to even take the trade. When a counterparty was willing to play ball, the insurers paid huge premiums over fair-market to close the trades. Had that market persisted for a longer period of time, it’s entirely possible that companies would have started rapidly reducing rates or temporarily sealing off their vanilla S&P 500 index accounts. Imagine the chaos – the pure havoc – that sealing off vanilla S&P 500 accounts would have unleashed on the Indexed UL market. Little wonder why insurers were willing to pay through the nose to keep those accounts active.
Increasingly, life insurers are likely to bump into option market constraints for their indexed crediting products. From what I can gather in talking to derivative counterparties, life insurers already dominate the market for options with a tenor of 1 year or more. As more Indexed UL and FIA gets sold, the more likely it is that carriers will occasionally seal off certain indexed accounts in certain economic environments because of option market constraints. Why hasn’t that happened yet? Think about it – indexed products exploded in popularity in the wake of the last financial crisis. Virtually every exotic crediting strategy and proprietary index was created in a world of historically low interest rates and equity market volatility. Just take a look at the VIX since 2007.
The only serious disruption to the volatility market happened in March and April of last year. Not coincidentally, that was the only time we’ve seen insurers seal off indexed account options, have trouble finding counterparties and pay exorbitant prices over fair-market to execute trades. For those counting, that’s a 1-to-1 hit ratio. What happens the next time volatility spikes? Probably exactly the same thing. The result will likely be some truly bizarre moves by life insurers trying to manage their hedge costs at exactly the moment when clients will be looking for the safety, upside potential and consistency of indexed crediting strategies. Yikes.
Thanks to AG 49 and AG 49-A, everyone is now fully aware of the absurdity of Indexed UL illustrations. I gave a webinar recently where a bunch of questions came in that basically asked me what producers should do now that Indexed UL illustrations under AG 49-A don’t reflect the “real” performance of the product. This idea is understandable because producers too often mistake illustrated performance for real performance, but it’s completely inexcusable. Illustrations are not reality. They’re not even a semblance of reality. They’re not even correlated to reality. The best illustrating product is no more likely to be the best performing product as the best-looking steak in a glossy magazine is likely to be the best-tasting steak.
But even if you buy into what I just said, consider this – the availability of a certain indexed crediting option is also a non-guaranteed element that causes further disconnect between the illustration and reality. Producers selling clients on certain crediting strategies and how they may or may not perform over the next 50 years are taking for granted that the strategies will be available. That may or may not be true. I wrote earlier that the PacLife announcement is innocuous because it just forces the client to reallocate to the other strategies. But what if that client bought the product because of the 1-Year International Indexed Account? For those clients, if they exist, this announcement is anything but innocuous. It’s terminal. It’s a huge problem. Now, of course, the chance that a client bought this product for this account option is vanishingly small. But what about if the traditional S&P 500 capped account goes away because of adverse volatility skew, which has been marching steadily upward for a decade without an end in sight? That would be a problem for a lot of clients, not just a handful.