Have you ever wondered how Indexed Universal Life could offer higher caps than a Fixed Indexed Annuity? To grow life insurance premiums, that question has probably been asked up and down the executive suite.
The actual construction of a life insurance policy is very complicated. First of all, the insurance company must be able to pay a death claim, when and if it occurs. As an example, Mrs. Jones could make a single premium payment of $20, and the insurance company would have a liability of $100,000 (or more). In addition to guaranteeing the death benefit of the policy, the insurance company must also provide guarantees required by state law, guarantees such as a minimum interest rate, annuitization benefits and any riders attached to the policy. These riders can be as simple as a small disability rider that will pay the premiums needed should the insured not be able to pay due to a sickness or illness.
Now add to that the need for the insurance company to make a profit for its investors, a profit that is demanded and will reflect on the valuation of the company’s stock. To add more, how about reserves needed to pay any policy claims which may become due at any time?
Guarantees, performance, reserves, and yields that can be a tall order for many companies. How do they do it? One secret not many people know is this; insurance risk is never shouldered by any one company, no matter how significant or how small the promised benefit may be. The ads you see on TV showing a healthy male can pay just $40 a month to protect his family with a $500,000 death benefit is a group of companies banded together to help each other spread out any claim liability. This is known in the insurance trade as reinsurance.
How about the actual investing of the premiums paid to the insurance company? The net investments (premium minus expenses) are typically invested in bonds, both US Treasury bonds as well as corporate bonds. Corporate bonds can pay a higher rate of interest based on their actual ratings; the lower rated bond offerings would have a higher rate of interest, just as the opposite would be true. Once a satisfactory portfolio is built, some companies invest a small portion of the available funds in real estate, mortgages and even some common stock.
So how do insurance companies offer a higher cap rate for Indexed Universal Life Insurance than what may be available in a Fixed Indexed Annuity?
Part of the answer lies in fees; fees charged a policy every month. These fees can be for the cost of the actual insurance (once again outsourcing via re-insurance), fees for administration and fees to cover the real cap returns. These fees are known in the investment world as “puts and call.” Surprised that your money in your life insurance policy is not invested in any stock index? No, your premium dollars are invested in the general portfolio of the insurance company, a portfolio set aside for paying future contractual benefits.
How can a company offer a cap of 10% or even higher? Then on top of that, offer a guarantee that your funds will never be less than zero? Suppose a value of $100,000 in an IUL with a guarantee of no loss and a possible return of $110,000, would you be interested? Yes, but how do they do it?
Remember, the general portfolio returns in a life insurance company might only be 5% or at best 6% just because the portfolio must contain a certain percentage of very highly rated bone, bond such as are issued by the US Treasury. If the net guarantee is zero, then the insurance company (based on its portfolio return would need about $95,000 to net the guarantee of no loss ($100,000). The difference is about $5,000 which the company has available to protect themselves in the event the market moves up, and the actual amount owed to the policy is (as an example) 10%. That is 10% on the guaranteed floor of $100,000 or in other words, $110,000.
The insurance company buys a “call” option with a portion of the $5,000 left over to cover the possibility of the market increasing. It buys the “call” option form a Wall Street trader, one who specializes in this category. If the index increases, the “call” option is executed, and the funds are transferred to the insurance company to credit the guarantees offered in the life insurance contract. If the market index does not increase, the funds paid to the Wall Street firm are banked as income for them.
Can anyone buy a call option from Wall Street? Yes, they are known as “puts and calls” and are based on any one of numerous indexes, such as the S&P 500 Stock Index. One secret about an insurance company using “calls” is common sense; the insurance company doesn’t need to make a huge profit, all it needs to do is cover the cost of the exposure in the policy should the market increase. It boils down to simple math.
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