Hedge Costs are Rising for IUL and FIA Issuers
Indexed Universal Life (IUL) and Fixed Indexed Annuity (FIA) products have risen in popularity since the global financial crisis. Policyholders are attracted to these products because they enable them to participate in the upside of equity markets while simultaneously protecting against market downturns. Meanwhile, insurance companies favor these products; the equity market risk they are exposed to is easier to manage when compared to variable products because the risk is easier to quantify and cheaper to hedge. As an example, an IUL policy has a minimum return of 1% each year, with the potential for up to 11% if the index it is tracking (typically the S&P 500 Index) equals or exceeds that amount. A basic FIA policy may have a 0% minimum up to a 5% max.
A quick options refresher: A call option pays out the underlying index’s return in excess of the strike to the option purchaser. Should the underlying index’s performance fall short of the option’s strike, the loss to the purchaser is only the initial cost of the option. To offset – or hedge – the exposure to the underlying index from selling IUL or FIA, an insurance company will use a percentage of the policyholder’s account value and buy a 1-year call option on the underlying index struck at the minimum return (i.e. 1% in our IUL example) and sell a similar option struck at the maximum return (i.e. 11%). Fixed income assets (bonds) are typically purchased with the remainder of the account value.
This week’s chart shows an upwards trend in hedging costs for insurance companies selling indexed products over the past three years. Many believe the cause for this trend is volatility in markets normalizing after several years of historically low levels. Since hedging indexed products requires buying an option position (in this case, going long a call spread), and options cost more when volatility is higher (since the purchaser’s max loss is limited and the potential for a higher payout is greater), this reasoning makes sense. However, there are two other factors contributing to the increasing costs.
First, the relative cost between the option being bought and the option being sold is increasing. In technical terms, the skew between the lower strike and the upper strike is increasing. This can occur when there is higher demand for certain options relative to others. The second factor is rising interest rates. One component driving the cost of a call option is the cost of financing the purchase of the index exposure. Similar to how a higher mortgage rate increases the cost of financing a house, a higher financing rate will increase the cost of an option. Since an insurance company is a net buyer of index exposure when it hedges indexed products, higher interest rates will increase the cost of hedging.
Insurance companies can differ in how they approach rising hedge costs. Sometimes, the increase is transitory and insurers can wait it out. Other times, there is a fundamental shift in markets that leads to a prolonged period of higher costs. In this case, insurers will take action to protect profit margins. Change in skew is typically a transitory effect; however, I question if IUL and FIA hedgers will have a permanent effect on the supply and demand for specific options. With the Fed on pace for more rate hikes this year and next, rising hedge costs may continue to pose a challenge for insurers.
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