Back-testing the Bull-Call Spread Strategy used in S&P500 Indexed Universal Life Policies

The Goal behind this exercise

While engaging with HNIs for their Estate Planning needs, we’ve noticed that the Indexed Universal Life product line is growing in popularity. Our team is already responsible for hundreds of millions of dollars in Life cover from this product line alone.

We had to come up with a way to ensure that we are structuring these products correctly at inception and are bench-marking their performance appropriately. A key decision is the assumed growth rate of the policy. It’s the rate at which you expect the policy to grow Y-o-Y. At first, we encouraged going conservative with it and structured them assuming that indices will average a return almost equivalent to what a Fixed Account would pay out. It’s like owning a Tesla and assuming you would always drive 40 kmph below the speed limit on the highway.

But we had our reasons for being conservative even though it results in higher premiums. While auditing some of the wealth management products held by our clients that were sourced externally, we noticed quite a few of the cash value based insurance products were structured at the maximum available growth rates at that point of time and 9 out of 10 times, the actual performance of these products was observed to be trailing far behind what they were originally illustrated at. If you’ve had to inform clients again and again that the product they put in place all those years ago, assuming it would cover them till Age 100 is actually going to run out by Age 67, it will make you conservative (and a little bit jaded).

To be fair, when we do our annual reviews, it does feel great to tell the clients we on-boarded in 2022 that their policy is over-performing compared to what we illustrated them at but considering most of our clients for the Indexed Universal Life product line are Entrepreneurs, we are conscious about the opportunity cost of their money

So, maximum possible growth rates are a big No and Conservative growth rates are not ideal. So, there is an in-between. The goal of this exercise, therefore, is to facilitate these discussions with the clients we are responsible for.

First, a refresher to help you save a trip to ChatGPT.?

PSA: Even GPT-4 may need some time before it can be reasonably relied upon to explain financial concepts. Exercise caution.

What is a Bull-Call Spread Options Strategy?

This is one of those things that are better explained with an example.

Suppose the SPY (SPDR S&P 500 ETF) is currently trading at $500. This is an ETF that mirrors the performance of the S&P500 Index.?

Now, suppose you expect the current rally in the S&P500 will simmer down but continue for another year but are also worried about the potential downside risk. A Bull-Call Spread strategy can be used.

?It is a strategy that involves buying two options simultaneously with an identical expiry date.

The First Option – You go long (Buy) a call option with an expiry date of Feb 20, 2015 and a strike price identical to where the SPY is currently trading at. Let us assume it to be a round figure of $500. This option gives you the right to buy SPY a year from now at $500, irrespective of the market price.. Suppose the cost of buying this option today is $40. Here’s what could happen at the expiry date:

1. If the SPY has grown by 12% and is at $600, you will exercise your call option which has a strike price of $500, will then sell it at the market price of $600 and you’ve made a profit of $60 ($600 - $500 - $40).

2. If the SPY has fallen by 10% and is at $450, you will let your call option expire without exercising it and absorb the cost of $40 as a loss.

But there is a way to reduce that loss. So, that’s where the second option comes in.

The Second Option – You short (Sell) a call option with the same expiry date of Feb 20, 2015 and a strike price of $570. This option creates an obligation for you to sell SPY to the option buyer at $570. However, you receive $20 right away for getting into this contract.

1. If the SPY has grown by 12% and is at $600, this option will be “Called” by the buyer because the strike price is $570. You will end up incurring a loss of $10 ($20 + $570 - $600)

2. If the SPY has fallen by 10% and is at $450, the buyer of the call option will let it expire without exercising it and you would have pocketed the $20 from this option.

Since you paid $40 for the first option and receive $20 from the second one, your effective net outlay is now $20. You now have a floor with a maximum loss of $20 and a cap with a maximum gain of $50.

Fun fact: This strategy is probably much older than I am. Here's how it is said to have evolved. Suppose you want exposure to the stock of Booking Holdings which is currently trading at $3,700 per share but you only want to spend $370 on this stock. Today, Fractional trading allows you to utilize that $370 and buy 1/10th of the stock. But back in the mid 80s when fractional trading wasn’t as accessible and you wanted to take positions in stocks like Berkshire Hathaway A shares (Currently trading at ~$610,000 per share, was around $3,000 per share in the Mid 80s), the Bull Call strategy worked like a workaround for traders who were interested in making bets on rising prices of such stocks in a cost effective way.

What is an Indexed Universal Life Policy (IUL)?

It is a type of Permanent Life Insurance policy with a cash value where the performance of the policy is linked to the performance of chosen stock indices. S&P500 Index is justifiably popular choice. I’ve observed that certain insurance companies have also started to provide the S&P500 Shariah Index as an option.

How do Life Insurance companies utilize the Bull Call Spread in an Indexed Universal Life Policy?

Insurance companies collect your premiums in a General Fund. Think of it as a master account where everybody’s premiums are collected, as well as any investment income generated by those premiums. Typically, 80%+ of the assets in a General Fund are invested in Fixed Income Assets.

Now, let’s assume that the Insurance company knows that they can earn 5% interest this year. Then, if you’ve paid a premium of $100,000, the insurance company only needs to retain $95,238 (which will grow back to $100,000 in 1 year at 5%) to protect your premiums. So, typically, the remaining $4,762 is what they use for running the Bull Call Spread strategy as described above.

The Back-Test Methodology

The crediting rate in the policy is decided on the basis of each “segment”. Each segment has a maturity of exactly 1 year and are created continuously once a month. For example: Segment 1’s crediting rate is decided on the basis of S&P500 Index’s performance between 15-Jan-1994 to 14-Jan-1995, Segment 2’s crediting rate is decided on the basis of S&P500 Index’s performance between 15-Feb-1994 to 14-Feb-1995 and so on.??

This process is identical across most insurance companies around the world that use Indexed Universal Life Policies and is where the Bull Call Spread comes into play. The settings for the Cap rates, Floor rates and Fixed Account rate are based on those of a popular Canadian insurance company. To try and adhere to the Actuarial Guideline AG-49B, multipliers and bonuses are ignored.?

Some insurance companies do, in fact, publish this data in their product literature. Developing the back-test model ourselves allows us to keep things current, run stress tests and allow scenario analyses.

?The Results

The Conclusion

Notice how much lower the volatility (standard deviation) of the Segment crediting rate is compared to the S&P500 Index? That is the effect of the Floors and Caps in place achieved by the Bull-Call Spread strategy.

So, in structuring the Indexed Universal Life policies, do we go with the 30-year average of 6%+ or do we play it safe around 4%-5% based on the back-test results of younger policies?

As with all good things, the answer begins with an annoying “It depends…”

The conservative clients may look at this and still choose to go for a growth rate which is around the 4% to 5% range whilst the indifferent and/or aggressive clients may choose to be around the 6% range. We periodically update the above because this is a discussion to be had in the context of the client’s risk profile, their current situation, the performance of the indices leading up to the review date, the performance of their policies leading up to the review date, the outlook for the future and so on.

If you’ve made it this far and have liked reading this article as much I enjoyed writing it, do let me know. It would make my day.