Scott Roberts, CPA, CLU
Even for those clients familiar with Indexed Universal Life insurance policies, most don’t truly understand how they work. Sure, they understand that premiums paid into the policy are added to the cash value and then the cash value is credited based on the performance of the chosen index (or indexes). Most also understand that there is a “floor” that provides downside protection, usually 0% so the policy can’t have a negative “return” in any given period (this does not account for any fees or costs that are subtracted, of course). And there is usually an understanding that the crediting rate is often capped when the index has a positive return, limiting the policy “return” to a specified percentage, such as 10% or 12%. But that is where general knowledge often ends, and erroneous assumptions begin.
While most clients vaguely understand that hedging is used to create the floor, many assume (erroneously) that the cap is in place because the insurance company is taking any upside profit beyond the cap in exchange for this hedge/downside protection. This, of course, is a logical assumption if one believes that the cash value is actually invested in the chosen index. However, the cash value is NOT invested in the underlying index. Allow me to explain.
Let’s assume a typical scenario which has a crediting method of annual point-to-point based on the S&P 500 with a floor of 0% and a cap of 11%. So, if the S&P 500 has a negative return during the year then the policy would credit 0% (the floor), if the S&P 500 has a positive return above the cap (16%, for example) then the policy would credit 11% (the cap) and if the S&P 500 has a return between 0% and 11% then the policy would credit that actual return of the S&P 500. Simple enough. But, the question is HOW this all happens. Here’s how it works:
Let’s assume $1,000 is paid in premium. As we learned above, the $1,000 is not invested directly in the S&P 500. Rather, an appropriate amount, let’s say $950 is invested in the insurance company’s General Account which is invested conservatively with the majority in interest-rate type investments such as bonds. As an institutional investor, the insurance company can get a much higher low-risk return in their general account than an individual investor can, and can be reasonably certain that, after one year, the $950 will grow back to the $1,000 (requires an approximate 5.3% rate of return). Ta-dah! We have our floor – we are “guaranteed” to have the $1,000 back after one year.
So what happens with the other $50? That becomes part of the options budget which is used to buy one-year call options, on an Exchange Traded Fund (ETF) that mirrors the S&P 500, with a strike price equal to the current price of the underlying security. If the S&P 500 increases in value, then those options become valuable (“in the money”) and can be liquidated and credited to the cash value. If the S&P 500 decreases in value, the options become worthless and there is no credit to the cash value (but, remember, our $950 grew back to $1,000 so we did not “lose” anything).
The last piece of the puzzle is the fact that the insurance company wants to reduce the net cost of the options budget as much as possible and also buy as many call options as they can to fully capture the market increase up to the stated cap. For this reason, they also SELL “out of the money” call options with a strike price equivalent to the cap and use those proceeds to buy even more call options (with a strike price equal to the current price). This results in profit to the insurance company (which is credited to the policy) for “in the money” options up to the strike price of the call options sold. Any profit above that strike price would go to whomever bought those call options, creating the cap. For those of you using your financial dictionary at home, this is commonly referred to as a Bull Call Spread.