As a policy owner, you’re given many index allocation options that are directly tied to the upside growth of your account. These options were created to provide you with a balance between growth and protection in today’s uncertain market environment.

In this episode of Money Script Monday, Joe explains how insurance companies are able to offer index options while still delivering on their promises.

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Video transcription

Hello, and welcome back to another episode of Money Script Monday.

My name is Joe Schweiger, and today we're going to talk about life insurance companies creating different index allocation options.

Specifically, towards index products, so whether that be a fixed index universal life or a fixed index annuity.

Insurance Company

When we think about what a life insurance company is, whether that be for an annuity or a life insurance death benefit, really what it does is pool together policy owners, or insureds and annuitants.

And when we think about what that means, the insurance company has different policy owners who then pay premiums for the products that they offer.

With these premiums, they have different expenses that they need to cover, such as marketing expenses for advisers or any of their material that they send out.

They need to keep the lights on inside of their home office. They have to staff their employees.

And with that, they will have a leftover amount of money where they'll, then, put that into what's known as a general account or general portfolio.

What that means is, dependent on the interest rate environment and what the current status of our economic system is, they'll earn a certain percentage, which is a bit of a profit center for them.

Now, why this is important when we think about index products and how they actually work is we'll get into a little bit of hedging and how that works.

Hedging Options

Not every insurance company is going to have an internal team of actuaries that are able to build out different index options, but the general idea of how they're built is going to be similar.

Whether they have to outsource it and use an external expense or able to do that in-house.

Example Policy

I'm going to break this down with a pretty general example here of exactly how this would look for one policy owner.

They're going to pay $1,000 of premium into their policy, and let's just say this is a life insurance policy.

Now, the way index products work is they do have a guarantee that you won't lose money due to market volatility.

Of course, there are other expenses inside of the policy that can help drag down the accumulation value, but due to market volatility, you can't lose money.

The way they do this is, let's say, they take that $1,000 premium, they're going to put $950 into their general account, or general portfolio, and at the end of the year that will grow back up to $1,000.

Again, this is dependent on, our current market interest rates and what each insurance company is currently earning.

It would be dependent on their own general account or portfolio.

The majority of carriers, how they invest their money is going to be very high grade fixed income products, 90% to 95%, with very little risk or exposure in lower class bonds.

What they do with that other $50, and again, if the interest rates are up in the industry, you may only need $930 to grow up to $1,000.

So, you'll have a little bit more flexibility in money with that options budget.

What options are, are a derivative product, call or put options, that will either, A, expire worthless or come to fruition and be able to provide some return.

A common misperception that we see here in the industry is that when we have these index products, any excess return over a certain amount, whether that be over the spread or the cap, actually is a profit center for the insurance company when, in fact, that's false.

Again, with these options budgets that they have, their team of hedgers are actually, determining what exact return can we provide with this $50 for this policy owner or for their book of business.

Which is how different caps are created, how spreads are created, and how participation rates are created on their different index options.

Historical Returns

When we think about where we want to allocate money to, there's obviously different things we can consider.

Every insurance product, whether, again, it be an annuity product or a life insurance product, and company will have different index options.

It's always useful to kind of look back at some historical returns and to just say how did this perform during down years?

How did it perform during our greatest years? And see what type of index allocation it really is to get through those years.

It's never going to be extremely accurate on predicting the future, and I would never recommend only going off historical results.

But, it's extremely important to look through, especially with the plethora of products and index options that are out in the market today.

For instance, we have some very generic options, which are easy to understand.

An S&P annual point to point.

You take the S&P value today, 365 days from now, you take that, and what's the change?

That's what your policy is credited, up to, of course, the cap.

Again, depending on the options budget that the insurance company has, which is based on their general account yield.

Now, when we think about historical returns and when we're looking at each individual situation, everyone's going to be different.

When someone asks, "Where should I allocate my money?"

That's never a very easy question to ask or answer.

Diversification

Of course, it's always important to have some diversification inside of the policy.

When we look at these different types of products there are multiple allocations options available on a number of different carriers and products that we work with.

It's important to know your options.

With that being said, again, every individual is going to be different. They'll have a different risk tolerance level.

They'll have a different time horizon of when they'll actually want to use these funds, and many other factors can play into where they should be allocated in these products.

So, it's important that you talk with a financial professional if you have a policy where you'd like to re-allocate or if you're thinking about having a policy and where you should allocate.

Today was a brief breakdown of how insurance companies create these different index options, how they use hedging to create caps, participation rates, and spreads, and then, of course, how you should allocate your money.

I hope you found it useful. Thank you for tuning in, and we'll see you next week.