#361 | Cap Price Pressure

Quick Take

When AG 49 was adopted in 2015, it established the supremacy of a single crediting methodology – an S&P 500 annual point-to-point with a 0% Floor, 100% participation rate and non-guaranteed Cap. This Benchmark Index Account is what governs illustrated rates for all Indexed UL products. At the time, the cost to hedge a 10% Cap was at an all-time low, but since then the price has steadily crept upwards and is now at all-time highs. Why? Not because of market volatility, which washes through both sides of the Cap trade. Instead, two factors are at play – volatility skew and interest rates. As of last week, skew was adding nearly 1.5% to the base price of the option and interest rates were adding another 1%, bringing the grand total to 5.5%, nearly 2% higher than the lows of 2014. There is no sign that the pressure is going to relent. Volatility skew has been steadily increasing since 2013 and a drop in interest rates from the current 5% to 3% would only shave 30bps off of the price of the option. This is the new normal. The response from life insurers has been to paper over the problem with monthly hedge losses, subsidization from artificially low fixed account rates and by pushing policyholders into engineered indices with lower hedge costs. None of these strategies are good for long-term policyholder value. Instead, what needs to happen is an industry-wide adjustment to take the current hedge prices into account and a re-focus on what fundamentally matters in Indexed UL regardless of how it’s illustrated – downside protection with upside potential.

Full Article

It’s hard to overstate the importance of the Cap to indexed insurance products. Historically, crediting strategies with Caps have dominated sales for both indexed life and annuity products. Given that the guaranteed minimum index-linked credit in indexed policies is universally referred to as a Floor, the fact that a Cap is not called a Ceiling is one of the great unsolved mysteries of our generation. But regardless of what it’s called, the concept of a Cap is an integral piece of the indexed crediting story. What do indexed products do? Downside protection with upside potential, up to a point. And that point is what we call a Cap.

Life insurers like Caps for one very specific reason – price stability. Caps are hedged by buying an at-the-money (ATM) call option and selling an out-of-the-money (OTM) call option, a strategy referred to as a call spread. The fact that the two option positions offset each other naturally means that the effect of volatility on the overall price of the call spread is muted because volatility is priced into both legs of the trade. As a result, the price of the Cap is quite stable, at least compared to the price volatility of either leg in isolation.

Below is a chart of one-year, European (point-to-point) ATM, 10% OTM and 10% Cap option prices since 1999. I got the underlying volatility data and S&P 500 dividend yield from an institutional data source. I used 1-year Treasuries for the interest rate. The dark blue line is the price of the purchased at-the-money call option. The light blue line is the price of the sold out-of-the-money call option. Subtracting the OTM from ATM yields the net price of the 10% Cap, which is the middle blue line.

As expected, the price of the call spread is very stable relative to the price of the ATM and OTM legs. The most profound visual example is in 2008 when volatility rapidly flew to all-time highs and the price of a 10% Cap actually fell. The usual adage that volatility drives Cap prices simply isn’t true. Volatility is an input, certainly, but it’s not the only input. Clearly, there is much more going on when it comes to Cap prices that makes them move in ways that seem pretty counterintuitive. Take a closer look at the price of a 10% Cap, this time with the graph scaled to 6% rather than 18%. There’s quite a bit more price movement at this scale.

In my view, you can more or less divide the history of Cap prices into two segments – declining and increasing. From 1999 until 2013, the price of a 10% Cap steadily declined from over 5% all the way down to a low of 3.6% in 2013. Since then, 10% Cap prices have persistently increased. Below is a table of average 10% Cap prices in each of the years, the cumulative change in prices and the estimated total cumulative Indexed UL premium from 2013 onwards (using both public Wink and LIMRA data).

I would argue that what Caps provide in stability, they take away in exposure to other, more obscure pricing elements. In order to understand why Cap prices are increasing, we have to figure out what is driving those price increases. In general, the price of a call option is equal to its expected future value at expiry. The expected future value is comprised of two elements. The first is an assumed growth of the asset, which is equal to the risk-free rate of return until expiry. The second is the degree of uncertainty around the future value, the volatility of the asset. Higher volatility always results in a higher call option price, all else being equal.

Because the date of expiry and risk-free rate are known, the level of volatility is also the “price” of the option. Imagine you have 3 options on an index at different strike prices of 100, 105 and 110. If the spot price is 100, then clearly the pure dollar price of the call option at 100 will be higher than the pure dollar price of the 110 because the likelihood of the option expiring in the money is higher.

But from an options standpoint, the pure dollar price is not the metric. The “price” of the option is level of volatility built into the dollar price. If the 100 strike is trading at 15% implied volatility and the 110 strike is trading at 17% volatility, then the 110 strike is more expensive than the 100. Volatility is the pricing metric because the common denominator that cuts across all tenors and strikes.

As previously stated, hedging a Cap involves buying an ATM call option and selling an OTM call option at the level of the Cap, a strategy referred to as a call spread. The advantage of the strategy is that it mutes the effect of volatility because volatility impacts both legs of the trade and theoretically washes out. However, that isn’t what happens in the real world. The volatility only washes out if the two options are priced with the same implied volatility. The essentially never happens. There is always a difference between the implied volatility priced into the ATM leg and the OTM leg. The difference between the two implied volatilities is called volatility skew. As volatility skew increases, so does the price of a call spread.

So we have three things to consider for Cap pricing – overall volatility levels, volatility skew and the risk free rate. In order to figure out which of these three things is contributing to the price of 10% Cap options, I built a Black-Scholes based option price model with four variations. First, the pure model itself, which produced the graphs that are in the beginning of this article. Second, a model that eliminates volatility skew by forcing implied volatility for the 10% OTM call to equal the ATM call. Third, a model that eliminates the risk free rate component by dropping the rate to 0% while retaining volatility skew. And fourth, a model that eliminates both the risk-free rate and volatility skew, which isolates the effect of overall volatility levels.

Each one of these models compared to the full model gives us the component price of each one of the pricing inputs, all of which add up to be within 3bps (on average) and 10bps at the extreme ends of the full model itself. In other words, I think it’s reasonable to break up the price of the option into individual parts and see them all individually, as if the investment bank was selling a call option on volatility, a call option on risk free rates and a call option on volatility skew separately. Here’s what that componentized model produces:

There is so much to unpack in this graph. First, the base volatility price of a call spread is relatively stable except for two instances – 2008 and 2020. In both examples, implied volatility increased dramatically and subsequently pumped up the price of the call spread, but not by as much as you’d think. On average, the price of pure volatility for a 10% Cap option has been 3.25% with a range of about 25bps in either direction. Even in 2008 and 2020, the jump in the price of the call spread tied on overall market volatility was less than 50bps. The base price of a 10% Cap option is, in fact, quite stable due to the offsetting nature of the two legs of the trade.

Volatility skew, however, is not nearly so tame. On average, volatility skew adds a whopping 1% to the price of a 10% Cap call spread, but the range is wider – from 0.5% to 1.5%. These days, it’s closer to 1.5%. Interest rates are similarly variable but with a lower bound. Back in 2013 and 2014, interest rates had essentially zero impact on the price of call options. But now, the risk free rate is adding nearly 1% to the price of a 10% Cap call spread. Below is the same chart as above, but this time with the base volatility pricing removed so that we can isolate the impact of just interest rates and volatility skew.

Why, then, is the price of 10% Cap currently sitting at the redline? The answer is not that market volatility is high. Right now, the contribution of base volatility to the price of the option is 3.31%, which is just 6bps above the long-term average of 3.25%. The problem is volatility skew and interest rates. Skew is currently adding about 1.45% to the price of a 10% Cap, 50bps higher than the long-term average. Interest rates are adding 0.96% to the price, which is 62bps higher than the long-term average and 90bps higher than from 2009 to 2015. Add all of these up and it’s little wonder why the price of a 10% Cap is higher than it’s ever been.

The impact of rising option costs on Indexed UL rates is palpable. Back when AG 49 was being written, Indexed UL writers scoffed at the idea of Caps falling below 10%. I distinctly remember being on a call with a bunch of life insurers and one of them piping up to dismiss the idea of a 10% Cap as “unimaginably low.” How times have changed. Some of the companies with the highest Caps in 2013 – looking at you, Securian – now sport Caps well below 10%. That’s not because these companies are evil or nefarious or scraping excess profits. It’s primarily because option prices went up and secondarily because portfolio yields went down.

The math is unambiguous. In April of 2013, the price of a 10% Cap was hovering around 3.7%. Using a 4.5% hedge budget, which is the average price of a 10% Cap since 1999, a company could offer a whopping 13.5% Cap. But last week, with the price of a 10% Cap sitting at 5.5%, that same 4.5% hedge budget would only buy a 7.8% Cap. Translating these numbers to AG 49/A/B maximum illustrated rates – which is really what carriers and agents care about – shows a decline of 2.78% from 7.87% for the 13.5% Cap to 5.09% for a 7.8% Cap, nearly double the increase in the cost of a 10% Cap. Life insurers wanted to leverage their illustrated rates by using a hypothetical lookback, but leverage cuts both ways.

When AG 49 was written, the guardrail of 45% in illustrated “option profits” was implemented because it was just a hair above what life insurers were actually illustrating based on option prices at the time. But now, 45% is lightyears away and nowhere near being in play – except, of course, in the fantasy land of hypothetical Benchmark Index Accounts, as I wrote a couple of weeks ago in #359 | The New Weapons of AG 49-B. If a 10% Cap costs 5.5% and it illustrates at 6.27% using the hypothetical historical lookback, then it is currently showing a mere 14% in illustrated lookback-based “option profits.” The margin has gotten much, much thinner.

Put another way, there’s theoretically never been a better time to be in a fixed crediting strategy compared to a Capped indexed crediting strategy. The fixed account rate in an Indexed UL product should be roughly equal to the cost to hedge the currently declared Cap. If a 10% Cap currently costs 5.5% to hedge, then life insurers should offer a 5.5% fixed account rate. That sort of setup would give clients two alternatives of equal fair-market value within the same product chassis.

Unfortunately, that’s not what the vast majority of life insurers do. Instead, they artificially suppress the fixed account rate in order to subsidize the Caps. Below is a list of Indexed UL products ranked by the difference between their declared fixed account rate and the cost to hedge the current cap as of last week.

The problem with this approach is that it turns Indexed UL into a single-use product and it really shouldn’t be. Mechanically, Indexed UL isn’t a separate product – it’s a Universal Life contract with an index-linked crediting strategy endorsement. But given what life insurers are doing to the fixed accounts in their products, producers are forced to use traditional Universal Life or Whole Life in order to get competitive fixed crediting rates. More than ever before, the fundamental value proposition of Indexed UL is under pressure. Is the upside potential of Indexed UL really worth it if a policyholder can get 88% of the illustrated return in the Indexed UL just by using a fixed crediting rate?

This question is made more acute by the fact that each succession of AG 49, AG 49-A and now AG 49-B has continued to put more and more emphasis on the Benchmark Index Account, which is an S&P 500 crediting strategy with a Cap. In making the original AG 49 grand bargain, life insurers effectively tied the fate of illustrated performance in Indexed UL to a particular – and very peculiar – option trade. For the past decade, that trade has been turning hard against them and is now putting the entire franchise, which has been built on promises to deliver systematically outsized returns relative to traditional fixed products, at risk. I don’t think it’s a stretch to say that this is the most challenging moment for Indexed UL in its short history.

Where do Cap prices go from here? The picture is murky. If interest rates were to drop back down to effectively 0%, then the price of a 10% Cap, all else being equal, would fall to around the long-term historical average of 4.5%. That seems to be unlikely in the near-term given current Fed policy and, of course, long-term low interest rates would put pressure on portfolio yields and eventually pull hedge budgets downward. Falling interest rates are a short-term fix for Cap levels that create long-term problems for all fixed insurance products, including Indexed UL.

A more moderate approach with rates falling to maybe 3% would also not solve the problem. At 3%, the price of a 10% Cap falls from 5.5% to 5.2%. My guess is that most insurers are already sort of baking that pricing into their Caps. In order to keep Caps artificially stable, life insurers have to run monthly hedge gains and losses. There’s a certain tolerance for what might be termed “soft” hedge losses that can be recovered later with hedge gains, at least theoretically. My guess is that a lot of life insurers are seeing red on their hedge reports for the last few months but are biting the bullet because they think option prices will revert.

Instead, things have only gotten worse and the reason is clear – volatility skew. Skew has been generally on the rise since 2003 and consistently on the rise since 2013, but it’s really picked back up in the past 6 months. See the graph below, which isolates just volatility skew component of the option prices and runs a linear trendline through them.

The reason why volatility skew has been increasing is not entirely clear. I’ve spoken with the folks on the desks of the banks who write these options and the answer I get about volatility skew is that, like any market price, there are supply and demand dynamics at work. Beyond that, volatility skew is a bit of a mystery. It just is what it is. As a result, I don’t think there’s any reason to think that volatility skew is going to revert to some sort of long-term average. If anything, it’s probably going to get worse as demand for options continues to increase.

Short of a dramatic drop in interest rates and volatility skew, neither of which seem likely to happen, the default assumption should be that Cap prices will remain elevated for some time. Life insurers will have to scrap to keep their Caps high any way they can, primarily by using new portfolios, subsidies from the fixed account and engineered index accounts and taking on trading losses. None of these are good options and all of them have negative long-term value implications for policyholders, but insurers feel like they have no choice. AG 49/A/B revolves entirely around illustrated rates for Caps. That seemed like a good idea in 2014, when interest rates were effectively 0% and volatility skew was at historical lows. It’s not anymore. Life insurers tied the fate of illustrated performance in Indexed UL to the wrong option trade, at least in today’s environment. And now they’re paying for it.

However, it would be wrong to assume that the pressure on Caps extends into other crediting strategies. Virtually every other crediting strategy in the Indexed UL market is a single-option trade*. Only the Cap combines a long and short position, which exposes the pricing to volatility skew. The fact that current volatility levels are actually within historical norms means that participation rate strategies are actually a much better bargain than Caps. You’re basically buying 60% of an ATM option priced with 18.6% implied volatility (as of 5/18/23) rather than buying 100% of an ATM option at 18.6% vol and selling 100% of a 10% OTM option at 14.8% vol. The same applies to engineered indices with volatility controls because they too have no volatility skew effect either. Spreads, which use only OTM options, actually benefit from increased volatility skew. There’s still plenty of opportunity in index-linked crediting strategies – just not the one that Indexed UL illustrations depend on.

*The other 2+ leg option strategies are in RILA and IVUL products. Floor strategies generally look worse with more volatility skew because, as with Caps, the life insurer is on the wrong side of the trade by selling an ATM put option and buying an OTM put option at the Floor level. Buffer strategies involve selling an OTM put and, as a result, benefit hugely from volatility skew.