In our first post on EIUL policy, we talked about the popularity of the policy and it’s characteristics. In this post, we will outline the mechanics of the policy.
EIUL Policy Cash Value
The policy cash value is tied to an index such as the S&P 500. The gain in the index does not include dividends in the index that underlying companies pay. 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. Suppose the index 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. 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, but most operate in this general manner.
How the Policy Works
A common misconception is that the carrier invests in the index and keeps all the returns over the cap. 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.
CAUL Policy and EUIL Policy Similarities
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.
EIUL Policy Rate of Return
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. Along with the credited return, it satisfies the floor return of 0%, since the account value would increase to the original $10,000.
So, where does the remaining $476 left over go? That is used to purchase options that generate the credited returns on the policy – the “upside”. Typically, if there is a positive amount in the index, the carrier enters into an agreement with an investment bank to purchase options that will pay up to a capped percentage amount.
The Role of Market Volatility and Carrier General Accounts
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 is, 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.
Carrier Details for EIUL Policy
The cost of the options contracts 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 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.
Upcoming EIUL Policy Info
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.
Next week, we will be covering EIUL policy illustration.