How (and why) indexed universal life really works

$10.42 Net cost of bull call spread

As stated earlier, in our example the insurance company has $5,213 available to "play" the option strategy. At a net cost of $10.42, the insurance company will be able to buy approximately 500 spreads. Let's assume that over the next 12 months, the index earns 10 percent. The insurance company will need to credit your policy with $10,000 of indexed interest. At 10 percent growth, SPY will be trading at $220 and each 200 call will have an intrinsic value of $20. Since the insurer owns 500 of these call options, their long position is worth $10,000. Since SPY is trading below the short position, the short position will simply expire. In this case, the insurer is perfectly hedged for the caps and floors they are offering. 

It is nearly an impossible coincidence that these numbers worked out so perfectly, as I arbitrarily picked the cap, floor and general account interest rate. In reality, option prices change daily and if we ran this same analysis a week or a month from now, we would likely get different results. But as long as the strategy comes close, we should have a degree of comfort that the insurance company is not over-promising. 

Since all insurers purchase their options at the same exchange and at the same price, how can caps and floors be different amongst different carriers? For instance, suppose ABC is offering a similar policy with a 13 percent cap. Is that insurer over-promising? It may be that the ABC is earning a higher rate in its general account. Suppose ABC has a general account that is earning 6 percent instead of the 5.5 percent we assumed with XYZ. ABC would need to have $94,340 of the client's account in the general account, leaving $5,660 available to play the option strategy versus XYZ's $5,213. With more money available for the option strategy, ABC could offer a higher cap or a higher floor, or perhaps a combination of both. It is also possible that one company's internal fees and expenses are greater and the increased fees could also allow more generous rate caps.

Now that we have an understanding of how the insurance companies invest, let's see if we can achieve similar results in our own investment portfolio … 

We need to start by finding a safe place to deposit enough of our money so that it one year later it will be worth what we started with. In the previous example, the insurance company did this by putting $94,787 in their general account, earning 5.5%. Unfortunately, we as individual investors do not have access to such high rates for "safe money." As individual investors, we would probably look for a one-year certificate of deposit or an investment grade zero coupon bond. 

At the time of this writing, the highest yield to maturity zero coupon bond with a one year maturity yields about 2 percent. Unlike an insurance company, as an individual investor, I will have to pay income tax on the 2 percent. Assuming a tax rate of 40 percent (federal and state), my net after tax yield on this 2 percent bond will be 1.2 percent. This means that I will need to have $98,814 invested in this bond in order to have my initial $100,000 one year later. This, of course, leaves me with just under $1,200 to invest in my call spread strategy in order to participate in the upside of the market. 

Assuming I purchased the same bull call spread as the insurance company did in our previous example, I would only be able to afford to purchase 115 options versus the 500 options the insurance company was able to buy. Since my option holdings are approximately one-fifth of that of the insurance company, my return on the option strategy will be one-fifth of that of the insurer. In a year when the insurance policy would have credited 12 percent interest, my portfolio would have only credited about 2.5 percent. In a year when the policy would have credited 5 percent, my portfolio would have only earned about 1 percent. 

Adding insult to injury, my option gains would also be taxable as a short-term gain. Again, assuming a 40 percent tax rate, my 2.5 percent and 1 percent return would be chopped to 1.5 percent and 0.6 percent respectively.

An astute student of options might suggest an alternate strategy called a collar. A collar strategy is one where the investor buys a security and then buys an equal number of put options with a strike price equal to the price he paid for the underlying stock. The put will then guarantee no loss of principal if the underlying security declines in value. The investor would then sell call options on the underlying security to offset the price of the put. 

Let's see if such a strategy would work with SPY. If I started with $100,000, I would be able to purchase 500 shares of SPY at $200/share. In order to fully protect my $100,000 investment, I would need to purchase 500 one year put options at a current price of $15.82. If I were to pay for the puts by selling calls, I would need to find the strike price of a call option approximating the price I paid for the put. Scanning the call option prices, I see that I could sell 195 calls at $16.08/share. Selling 500 call options would not only pay for the puts, I would come out about $130 ahead. But my 500 shares of SPY would be immediately called away at a $5/share loss, making my net return of the strategy -2.5 percent. 

The bottom line is that after taxes, an individual investor would not even come close to matching the guarantees and caps of an indexed universal life policy on a gross basis. Keep in mind that gross returns on any life insurance policy will be reduced by the insurance charges and fees charged against it. These fees can vary dramatically from issuer to issuer and are also affected by policy design. Consumers will need to judge for themselves if these fees are justified by the higher gross crediting rates.