#307 | The New Indexed UL Narratives – Part 2

The first two narratives dealt with the narrative for the product generically, but these next two narratives deal with specific product features that could potentially become more common.

Attractive Guaranteed Participation Limits

A few years ago, Penn Mutual famously offered a Survivorship IUL product with an annual S&P 500 point-to-point account offering a 2% guaranteed floor and 10% minimum guaranteed cap, far higher than the 2-3% guaranteed minimum caps found in most other comparable products. Certain firms absolutely sold the daylights out of that product – and why not? The current price to hedge a 2% floor / 10% cap account is about 5.5%, which means that Penn Mutual product very likely has the richest guarantee of any Universal Life product for the past 30 years or, hell, maybe ever. Little wonder why the later generations of that product sported only a 4% cap guarantee.

The story going around these days, however, is products that have accounts with the holy trinity of guarantees – no spread, no cap and 100% participation rate. How is this trifecta of perfection possible? By using a proprietary index. Nationwide New Heights IUL serves as the prime example. Both its JP Morgan Mozaic II and NYSE Zebra Edge strategies offer 100% guaranteed participation. The story is compelling – who wouldn’t want guaranteed 100% participation, especially in a world of falling caps and illustrated rates?

The question, though, is the actual economic value of the guarantee. Mozaic II has a volatility target of 4.2% and Zebra Edge has a volatility target of 5%. Both are Excess Return indices. That makes modeling their option prices pretty easy. In general, proprietary indices trade with a 1% premium to their stated volatility target. Using that setup, a 100% Par Rate costs about 2% for Mozaic and 2.3% for Zebra Edge. That’s certainly richer than a 1% guaranteed interest rate in a fixed account, but it’s hardly anything that should sway the placement of business. The fact that some agents are selling New Heights IUL just because of the 100% Par Rate guarantees is baffling, to put it mildly. It’s a classic example of where optics trump economics.

But you have to dig a bit deeper to see the real problem with portraying the 100% Participation Rate as a guarantee. If you actually read the contract for New Heights IUL, you’ll find this language:

Indexed Interest Strategy Availability

From time to time, Nationwide may offer new Indexed Interest Strategies…Nationwide may also close one or more of the Indexed Interest Strategies to allocations of Net Premium, reallocations of Index Segment Maturity Value, and transfers from the Fixed Interest Strategy at any time. Any existing Index Segments in a closed Indexed Interest Strategy will be permitted to continue until the end of the applicable Index Segment Term. Before an Indexed Interest Strategy is closed, Nationwide will provide written notification to you and any assignee.

Although there is a 100% Par Rate guarantee on the Mozaic II and Zebra Edge Indexed Interest Strategies, Nationwide has the right to close off any allocation or reallocation to the strategy. In other words, it isn’t a guarantee at all and shouldn’t be portrayed as one.

Penn Mutual’s old Survivorship Plus product with its 10% guaranteed S&P 500 cap, however, is trickier. Here’s how the language reads:

Indexed Accounts

The Company may add additional Indexed Accounts or remove Indexed Accounts for future allocation.

Read it one way and it looks like Penn Mutual reserves the right to add or remove Indexed Accounts. Given that the S&P 500 Point to Point strategy with the 10% guaranteed cap is the only one available in the product and it’s included in the base contract without brackets, then Penn Mutual should arguably have to get state approval to remove the policy because doing so would constitute a material change to the contract itself. I spoke with someone at Penn Mutual who confirmed that they view removing this account as requiring state approval. And that makes sense. If ever they were going to remove the account, it would be now because of the exorbitant cost to hedge the cap on that product.

However, the language doesn’t exactly read this way – it reads that they can remove Indexed Accounts for future allocation. What does that mean? The simplest explanation is that it means that Penn Mutual can remove the account as an allocation option without removing the account itself, which wouldn’t require state approval. And what does it mean by “future” allocations? On one hand, it could mean client-directed allocations but, on the other hand, it could mean any allocation, even an automatic allocation from one policy anniversary to another. Read this way, the Penn Mutual language looks a lot like the Nationwide language.

Why are we getting into the weeds on this? Because it matters. A lot. If you were out there promoting the Penn Mutual product or you’re currently promoting the Nationwide product as having attractive guaranteed rates without reading the contract then you’re doing your clients a disservice. This stuff is complicated. You can’t tell the client that something is guaranteed unless you’ve actually read the contract language and gotten verification from the life insurer.

My guess is that the proliferation of proprietary indices in the marketplace will bring more pseudo-guarantees into the picture. Do your due diligence. Read the fine print. Ask the tough questions. Chances are good that if it sounds too good to be true, it probably is.

Index Lock

One of the biggest new twists to the indexed crediting narrative to hit the market in the last few years comes courtesy of Allianz and its Index Lock feature, which was released in May of 2019. The idea is incredibly simple – it allows a policyholder to lock the index value at any point between the start and end date of the indexed crediting segment for the purposes of calculating the final index credit. A policyholder could, for example, decide that a jump in the tracked index value from 100 (for example) to 108 was plenty of interest and could pull the trigger to lock the 108 for the purposes of calculating the credit at the end of the year, even if the index subsequently declined.

There’s no question about the psychological power of the story. Index Lock provides a level of flexibility and certainty to policyholders that simply hasn’t been present in other Indexed UL products. Theoretically, policyholders could strategically trigger Locks once they’ve crossed certain thresholds, which could be particularly applicable for premium financing and heavily loaned contracts. And Allianz makes it incredibly easy to use. Producers can get daily reports of the gains in their policies that can be Locked and even the ability to automatically perform an Index Lock once the gain in a particular policy hits a certain level.

But does Index Lock actually have any economic value? For an option to be worth something, you need time and you need volatility. The more time and volatility there is, the more valuable the option is. Or, to put it another way, if there is any volatility or any time left, then there is value remaining in the option above and beyond what it would be worth if it were actually exercised at that moment.

As time passes, the market value of the option above the exercise value naturally decreases, which is referred to as time decay. Time decay is incredibly important for option valuation. In one sense, it is option valuation. Exercising early means leaving the value of time on the table. And in the context of Index Lock, exercising the option is actually performing an Index Lock. Therefore, in blunt terms, it is never purely economically optimal to do an Index Lock. If you do, you’re leaving option value on the table. Take a look at the value of an option for a 50% Par Rate on an index that’s increasing by 1% per month with 20% volatility and an initial cost of 4%, roughly what you’d see these days in an IUL:

The gap between the two lines is the difference between the Index Lock value and the fair market value of the option. Performing an Index Lock halfway through the year with a 3% index credit leaves more than 1.5% in residual option value on the table. You can think of that residual option value in two ways. One is to view it from the carrier’s standpoint as pure profit. They can liquidate the option for more money than they’re paying out from the Index Lock. From a client’s standpoint, the residual option value is the fair market expectation of the forefeited earnings from the time remaining in the strategy. In other words, it’s what you’re giving up, on average, by doing an Index Lock rather than holding the option to term.

From an economic perspective, Index Lock is inefficient. It systematically leaves money on the table, which means profit for Allianz and forfeited returns for policyholders. But that doesn’t mean it isn’t valuable. Index Lock provides certainty – and certainty costs something. It’s an insurance policy for the returns for the rest of the term. It would stand to reason, therefore, that you have to pay for the insurance. Therefore, for simplicity’s sake, I’m going to refer to the difference between the fair market value of the option and the Index Lock value as the index lock cost. Because that’s what it is.

So how much does Index Lock cost? In an S&P 500 option, the fair market value is highly volatile based on volatility and market interest rates. But Allianz restricts Index Lock only to two indices – Bloomberg US Dynamic Balance II ER (BUDBI) and the PIMCO Tactical Balanced ER. Why? Because these indices are volatility controlled and Excess Return, which means that their two key pricing elements – volatility and interest rates – are locked down. That makes the price of the option very predictable relative to the performance of the underlying index.

Using volatility controlled Excess Return indices means that for any given period of time and any given level of index performance, we can know with a high level of certainty how much exercising a Lock is going to cost. The chart below shows the cost of Index Lock for index return scenarios ranging from 5-10% at each month end date throughout the year. The returns are immediate, meaning that the policy is issued and then the index jumps by the specified amount and remains constant through the year. This allows us to see the cost for any given month at any given index return, regardless of how the index return came to be or what it’s going to do next. Take a look:

It’s important to note that these results quote the cost of Index Lock in proportion to the gain in the index. That makes sense from an analytical standpoint because it allows for generalized results without getting into specific participation rates offered by specific accounts. But from a client’s standpoint, Index Lock isn’t about the gain in the index itself – it’s about the final index credit, which does involve the current participation rate. They’re determining when to pull the trigger on an Index Lock when the total index credit crosses a certain threshold. The table below shows the average cost of Index Lock from months 2-11* at Locked indexed credited rates from 8-12% using current participation rates in the 4 different account types offered by Allianz:

Generally speaking, if a client has asked for an automatic Index Lock at an 8% indexed credit, the cost would be 25-40bps, on average. Each account has a slightly different cost because the index gain required to hit the specified Locked credit is different depending on the participation rate. But remember, the cost ranges quite a bit within the year. An earlier Lock costs more than a later lock. For a 2^nd month Lock, the cost would range from 91bps for the Standard Account to 65bps for the Classic account at an 8% Locked credit. Pull the trigger in month 9 and the cost drops to below 10bps for every account. Why?

Think about the basic intuition – the cost of the lock is the fair market value of the foregone future return between now and the end of the crediting period, which is reflected in the difference between the fair market value of the option and the value of the Index Lock (which is exercising the option early). The earlier in the year you do the Lock, the more value you’re leaving on the table. The more it costs you. The same logic applies to the relationship between the cost of the lock and the gains in the index – the more gains you have so far, the less likely it is that there will be substantial future gains.

What’s certainty worth? That’s the question for Index Lock. Think about Index Lock in the context of a life insurance illustration. The current maximum illustrated rate for Allianz is 6.2%. If every client puts in an 8% automatic Index Lock, then we would expect the cost of all of those Locks to run in the range of 30bps. That means the actual long-term expected performance, all else being equal, isn’t 6.2% – it’s 5.9%. That’s a pretty massive swing in real cash results over 30 or 40 years. What Index Lock gives in short-term certainty, it takes in long-term performance. Even more so if you buy into the carrier argument that the fair-market value needs to be grossed up by 45%+ assumed option profits. That puts the illustrated drag on long term performance at closer to 45bps (30bps * 1.45).

But there are ways to minimize the cost of Index Lock. Based on the analysis in this article, there are two rules of thumb. First, exercise it later in the year, sometime after month 6. Second, exercise it when there have been substantial gains – and I’m not talking about 8%. I’m talking about 10%. If you follow these two rules then you’ll minimize the cost of the Lock to less than 10bps while still giving yourself the chance to lock in substantial gains prior to the end of the term.

But not all policyholders are efficient. From my conversations with distributors who use Index Lock and from chatting a bit with Allianz, it seems as though the conventional wisdom is that advisors seem to like the idea of doing an Index Lock when the credit gets above 8%. Allianz pegs the average Index Lock at quite a bit higher crediting rates, closer to 11%. But even at that level, the average cost of the lock from months 2-11 is around 20bps across all of the accounts. If we assume that every client is efficient and locks at month 6 and beyond, the cost drops to around 6bps. Take out transaction costs and maybe it’s more like 5bps. It’s not a lot, but it’s not nothing either.

That raises a final and very interesting question – what happens to the profits that come to Allianz from Index Lock? So far, my guess is that Allianz is still trying to figure that part out. Assuming the proceeds from exercised Index Locks are reinvested in the product, that could mean that rates would increase across the board for all policyholders, paid for by policyholders who prioritized certainty over economic value.

Lots of assumptions go into setting rates for IUL and FIA products – is it possible that the utilization of a feature like Index Lock could now play into the ratesetting process at a life insurer? Is it possible that an insurer could heavily promote Index Lock as a benefit to consumers in part because they’re using the proceeds to make their overall rates more competitive? It’s not possible, but probable. It’s found money, paid for by clients who prize certainty over efficiency.

Given the economics of Index Lock, the broad enthusiasm for and excitement about the feature has come as a surprise to me, certainly, but to other life insurers and probably even to Allianz itself. In my view, its popularity speaks to the mindset of both consumers and their advisors. On paper, this is a zero-cost feature that provides certainty and gives advisors a new angle to discuss and “add value” through Lock management.

Index Lock-type features have already started to proliferate in the annuity space and will come for the life space as well. Allianz has some strategic and structural advantages when it comes to Index Lock in large part because it is the only major life insurer that dynamically hedges its option positions, which means that Allianz already has the daily data flows to manage Index Lock and can sweep the Lock trades in with the rest of the book to minimize transaction costs. Allianz has a leg up on everyone else. But if the feature sells and can potentially subsidize overall rates, then other life insurers will figure out how to get close enough to at least try to tell the story as well.

In reality, however, Index Lock has a cost and exercising it often and inefficiently will have a real drag on long-term performance. Nothing in life is free. Neither is Index Lock – and it shouldn’t be positioned with clients as if it is.

*The logic for choosing months 2-11 rather than 1-12 is that it’s highly unlikely that the index will grow by 5%, for example, over just the first month and it’s also unlikely that a client would exercise an Index Lock in the last 30 days of the year.