In the first posting in this series on the equity index universal life (EIUL) policy, we talked about the popularity of the policy and the general characteristics of the policy. In this post, we will outline the mechanics of the policy.
As we mentioned in the first post, the policy cash value is tied to an index, for example, the S&P 500. The gain in the index does not include dividends paid by the underlying companies in the index; it is a strictly mathematical computation based on the increase in the index itself. Here is a simple example based on an annual point-to-point calculation: If the index being tracked stood at 2,000 when the premium went into the policy and one year later stood at 2,200, the 200-point gain over the original starting number of 2,000 would generate a 10% return (200/2,000 = 10%). Remember, the return credited is subject to a cap. In this case, if the cap were 10%, the entire amount would be credited 10%. If the return in the index were 15%, the amount credited would still be 10% – the cap. There are variations on this general methodology, and the policy contract should be reviewed, but most operate in this general manner.
How the Policy Works
One of the misconceptions about this product we hear is the carrier invests in the index and keeps all the returns over the cap as profit while absorbing loses. The policy does not work that way. Insurance carriers do not like to take those risks. Policy mechanics do not risk any money for the carrier; their risks are hedged. Moreover, the return on the policy – positive or negative – does not impact the carrier’s profitability in the policy.
The policy is a general account product, like a current assumption universal life (CAUL) policy. When premium comes in, the carrier invests in its general account, as it would in a CAUL policy. In fact, the policyholder can often allocate their premium into a fixed account, as in a CAUL policy, where it earns only the general account returns, but most do not – attempting to receive higher, equity-like returns.
The vast majority of the premium stays in the general account where it, along with interest earned, provides the policy with its floor. For example, assuming a floor of 0%, a general account return of 5% and a net premium of $10,000, $9,524 is placed in the general account where it, along with the credited return, satisfies the floor return of 0%, since the account value would increase to the original $10,000.
So, where does the rest go – the $476 that is left over? That is used to purchase options that generate the credited returns on the policy – the “upside” (if the index has a positive return). Typically, the carrier enters into an agreement with an investment bank to purchase options that will pay up to a capped percentage amount if there is a positive return in the index.
While it would seem the greatest driver of policy performance is the return in the specified index, market volatility and carrier general account returns play a significant role. The more volatile the equity market, the costlier it is for the carrier to purchase the options. The lower the interest rate credited to the policy, the more the carrier must set aside to satisfy the floor, leaving less to buy options. It is easy to see how low interest rates and/or market volatility can negatively affect actual policy performance.
The cost of the options contracts, though they will fluctuate in the marketplace, remain similar for all carriers. In other words, no carrier can get a real advantage in the market since they are all working with the same players – the counterparties to the hedging options. While some carriers may have a marginally higher rate of return in their general account, it is typically not enough to change policy competitiveness. However, some carriers will include additional charges in their policies to increase the option budget, hoping to generate potentially higher returns. In down years these additional charges tend to put a drag on policy performance.
Compared to a CAUL policy, the EIUL policy has many more moving parts, and consequently, in general, it has a higher cost structure than a CAUL policy. This may not be an issue in overfunded policies or during “good times,” but it can be a factor in more thinly funded TOLI policies used for death benefit protection, especially in “down” markets.
For the TOLI trustee bringing an EIUL policy into their trust, having an understanding of the policy is essential. What is just as important – in fact, crucial – is prudent reasoning behind the crediting assumptions used in policy projections. Our last post will focus on this and talk about regulations that have grown up around policy projections used by agents selling this product.
See you next week.