IUL Rate Translator Methodology & Assumptions ITsimple INDEXED UL RATE TRANSLATOR KEEPING for YOU and YOUR Clients
IUL Rate Translator Methodology & Assumptions Introduction What is Indexed UL? Ask that question at an industry meeting and you will likely hear an array of passionate responses. However, consensus will probably emerge about a fundamental point: Indexed UL generally falls between current assumption UL and variable UL on the risk-return spectrum. Agreement tends to break down, however, around the question of how to present this truth in a fair and consistent manner. The IUL Rate Translator was developed to help demystify the process of selecting an Indexed UL illustrated rate assumption. The IUL Rate Translator is available at www.iultranslate.com. It provides a translated assumption by entering a hypothetical long-term equity return, which is then adjusted or translated into an assumed rate that is consistent with the risk associated with the current Indexed UL crediting strategy. This paper discusses the background that led to the IUL Rate Translator, explains the translated rate calculation and offers new insight into the value Indexed UL offers. Background Indexed UL s position on the risk-return spectrum of life insurance products is pretty clear. It generally provides more growth potential and more risk than a traditional current assumption UL policy, because Indexed UL exchanges steady interest credits (based on a declared rate) for volatile credits (based on the performance of an outside index). Indexed UL generally provides less growth potential and less risk than a variable UL policy because it has a floor that protects against market loss and a cap that limits gains. RETURN Indexed UL VUL (Equities) UL (Bonds) RISK Page 1 of 8. Not valid without all pages.
IUL Rate Translator Methodology & Assumptions This relationship between risk and return often is not reflected in the way Indexed UL is illustrated. The common method for selecting Indexed UL illustrated rates is to use a look-back rate that applies the current parameters of the index strategy against a set of historical data. Benchmark indices over the last 20 40 years have earned about 9 10%, resulting in Indexed UL look-back rates that often fall between 7 8%. Agents do not typically use look-back rates for current assumption UL or VUL; if they did, illustrated rates for those products might be 100 200 basis points higher. Indexed UL illustrations are thus often out of sync with other product types. This inconsistency can make it difficult for agents to convey the inherent value of Indexed UL. The IUL Rate Translator can help them restore the balance and tell the Indexed UL story more effectively. Calculation Ties to Modern Financial Theory Most financial theories hold that, absent any special skill or alpha, investors should not expect higher returns without also assuming a higher level of investment risk. In the context of life insurance illustrations, this means if one is comfortable running a VUL at 8%, one should consider making an appropriate adjustment for a less risky Indexed UL policy. But how should that adjustment be made? Fortunately, an answer already exists in the world of modern financial economics: The Capital Asset Pricing Model (CAPM). This model gives a prediction of the relationship between the risk of an asset and its expected return. CAPM is widely used because of the insight it offers for many important applications.* CAPM was the framework used for the IUL Rate Translator and, as demonstrated in Appendix A, was corroborated by other approaches. The Equation The translated rate is calculated as an Implied UL Rate plus an Indexed Risk Premium. The two components are described below. Implied UL Rate The Implied UL Rate (r UL ) is a proxy for a UL crediting rate derived from the current yield of a seasoned bond portfolio with a long-term investment horizon. The Implied UL Rate is determined by the recent average cost of supporting the indexed strategy (i.e. options budget). It does not represent the actual options budget of any one company, but rather provides a consistent approach for all companies based on the level of equity participation offered by their indexed strategy. The data used to calculate the Implied UL Rate is included in Appendix B. *Source: Bodie, Z., Kane, A. Marcus, A.J. (2009). Investments. Boston: McGraw Hill-Irwin. Page 2 of 8. Not valid without all pages.
IUL Rate Translator Methodology & Assumptions Indexed Risk Premium The Indexed Risk Premium is the yield above the Implied UL Rate consistent with the Indexed crediting strategy. It is composed of an Equity Risk Percentage, a and a Risk-Free Rate. The Equity Risk Percentage (Δi) This percentage is derived using the same option price data as the Implied UL Rate. It can be loosely interpreted as the percentage of the underlying index that, if held directly in equities, would match the level of equity risk in the indexed crediting strategy. The ( r m) This is the client s long-term equity market expectation entered into the IUL Rate Translator. This should represent the growth rate assumption for the underlying index, including the dividend yield. While the Indexed UL crediting strategy is based on the point-to-point change in the price index, excluding dividends, it is appropriate to include the dividend yield here because the underlying framework assumes direct investment in the index. The Risk-Free Rate ( r f ) This is the cost to borrow the direct equity investment on a risk-free basis, as described under equity risk percentage. It is important to base the risk-free rate on a long-term view of the 1-year risk-free rate because the translated rate is a long-term rate assumption. The IUL Rate Translator sets the risk-free rate to be consistent with the implied UL Rate by making an adjustment to reflect the historical term structure of interest rates: r f = rul xstrate Adj STRate Adj This is the average of the historical ratio of 1-year to 10-year treasury yields. Historical daily yield curve data was taken from the U.S. Treasury website for the period from January 1, 1962 to December 31, 2015 resulting in a short-term adjustment factor of 35.45%. This adjustment is necessary for the risk-free rate to reflect short-term yields, consistent with the historical shape of the yield curve. Putting It All Together The final equation reflects the CAPM formula adapted to the unique characteristics of an Indexed UL policy. The translated rate, denoted r IUL, is equal to the Implied UL Rate, plus the Indexed Risk Premium: r IUL = r UL + Δ i [r m r f ] The Indexed Risk Premium, Δ i [ r m r f] consists of the market return ( r m), minus the risk-free rate ( r f), times the crediting strategy s equity risk percentage (Δ i ). Page 3 of 8. Not valid without all pages.
Assumed Average Policy Credit IUL Rate Translator Methodology & Assumptions Results Here are the results when applying the IUL Rate Translator to the most common index strategybased on the S&P 500 Index 1-year point-to-point strategy, at various caps and a 0% floor. Cap Level 6% 8% 10% 12% 9% 4.78% 5.17% 5.55% 5.94% 10% 5.17% 5.60% 6.03% 6.46% 11% 5.52% 5.99% 6.46% 6.92% 12% 5.85% 6.35% 6.86% 7.36% 13% 6.15% 6.69% 7.23% 7.78% If an agent entered an 8% hypothetical equity return for a product with a 11.5% cap, the translated rate would be 6.17%. This, however, is just the beginning of the story. When applying this approach to a variety of scenarios, an interesting pattern emerges. The chart below compares two different crediting strategies at different hypothetical long-term equity returns. The solid diagonal line represents VUL, which would have full participation in the market, and thus the average return equals the average credit. The dashed line represents the IUL translated rates for a policy with a 11.5% cap and a 0% floor. Unlike VUL, the Indexed UL credits in this scenario are not equal to the hypothetical long-term equity returns. Instead, the Indexed UL line is considerably flatter than the VUL line. The two lines intersect at 6.1%, this suggests that the index strategy could outperform a VUL strategy if long-term equity returns were moderate or low, and that it would likely underperform a VUL strategy if long-term equity returns were higher. 0.1 0.09 0.08 0.07 Capped IUL Translated Rates - 11.5% Cap, 0% Floor VUL 0.06 0.05 0.04 0.03 0.02 0.01 0 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 Page 4 of 8. Not valid without all pages.
Assumed Average Policy Credit IUL Rate Translator Methodology & Assumptions Here is that same chart again but with an additional line for an uncapped account 1 with a 6% threshold rate. The uncapped line is steeper than the capped line, meaning it offers more return potential, but also more risk. For example, an 8% hypothetical long-term equity return results in an uncapped translated assumption that is higher than the capped account. However, each year the uncapped account is more likely to return 0%, with a few years of high returns supporting the average. This may lead to higher volatility in a policy s cash value. The value of using translated rates for different Indexed UL strategies is that one can assume that the higher the illustrated rate for a given equity assumption, the higher the risk. 0.1 0.09 0.08 0.07 0.06 Capped IUL Translated Rates - 11.5% Cap, 0% Floor VUL Uncapped IUL Translated Rate - 6% Threshold, 0% Floor 0.05 0.04 0.03 0.02 0.01 0 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 1. The uncapped account line assumes a crediting strategy based on the S&P 500 Index, 1-year point-to-point crediting, a 0% floor, a 6% threshold rate and a 100% participation rate. The credit for a given segment would equal the greater of zero and the price change of the S&P 500 less 6%. Page 5 of 8. Not valid without all pages.
Assumed Average Policy Credit APPENDIX APPENDIX A: Validating the Translated Rate The translated rate was validated using two methods. A) The principle based approach based on the CAPM formula outlined previously B) Stochastic modeling techniques These two methods, which were derived separately, produce very similar results. This chart builds on the first chart in the Results section by adding an IUL trend line derived using the stochastic models. A stochastic model is a tool that helps estimate the probability of future outcomes. Stochastic models are calibrated so that the average return across thousands of separate paths matches historical market performance and volatility, but each individual independent scenario is able to deviate randomly from the average. Notice how the slope of the stochastic line is nearly identical to the translated rate. This validates the relationship between the change in hypothetical long-term equity returns and the change in the average policy credit. 10% 9% 8% IUL Translated Rates - 13% Cap, 0% Floor IUL Trend Line - 13% Cap, 0% Floor 7% 6% 5% 4% 3% 2% 1% 0% 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Note: The stochastic trend line is over a 25-year time horizon. Page 6 of 8. Not valid without all pages.
Assumed Average Policy Credit APPENDIX There is still a discrepancy in the overall position of the stochastic line, which can be attributed to the short-term borrowing rate. The stochastic model does not reflect the impact that reversion to the historical shape of the yield curve would have on the average credit to an IUL policy. Removing this adjustment from the translated rate provides an empirical validation of the translated rate. This is demonstrated in the following chart where the stochastic trendline sits on top of the translated rate with no significant statistical error. 10% 9% 8% IUL Translated Rates - 13% Cap, 0% Floor IUL Trend Line - 13% Cap, 0% Floor 7% 6% 5% 4% 3% 2% 1% 0% 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Note: The stochastic trend line is over a 25-year time horizon. Details of the Stochastic Process 5,000 stochastic scenarios representing 25 years of monthly returns were randomly generated using a regime switching log-normal model. The average geometric return for each scenario was calculated both with and without an adjustment for the 13% cap/0% floor. A scatter plot was developed for these 5,000 data points and a trendline was fitted using standard regression techniques. Page 7 of 8. Not valid without all pages.
APPENDIX APPENDIX B: Data Sources The Implied UL Rate is based on observed market prices for the previous calendar year from commercial sources, interpolated using the Black-Scholes option pricing formula. Average Implied Volatility Strike Price Strike Price 100.0% 102.5% 105.0% 110.0% 120.0% Implied Volatility 19.65% 19.0% 18.40% 17.27% 15.59% The average forecasted dividend yield for the S&P 500 in 2016 was 2.13%. 1-Year U.S. Treasury rates were used as the short-term risk-free rate when interpolating option price data. The average 1-year U.S. CMT yield for 2016 was 0.61%. The interest credits linked to the performance of the S&P 500 Index exclude dividends. Standard & Poor s, S&P, S&P 500, Standard & Poor s 500 and 500 are trademarks of Standard & Poor s Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc. and have been licensed for use by John Hancock. The Product is not sponsored, sold, endorsed or promoted by Standard & Poor s, and Standard & Poor s makes no representation regarding the advisability of purchasing the Product. The S&P 500 Index is an index of 500 stocks that are generally representative of the performance of leading companies in leading industries within the U.S. You cannot invest directly in the S&P 500 Index. The translated rate is not a predictor of actual Indexed UL performance, nor is it in any way indicative of how the Indexed UL policy will perform relative to the performance of the S&P 500 Index. Insurance policies and/or associated riders and features may not be available in all states. Some riders may have additional fees and expenses associated with them. For agent use only.not for use with the public. Guaranteed product features are dependent upon minimum premium requirements and the claims-paying ability of the issuer. Insurance products are issued by John Hancock Life Insurance Company (U.S.A.), Boston, MA 02116 (not licensed in New York) and John Hancock Life Insurance Company of New York, Valhalla, NY 10595. LIFE-1842 5/17 MLINY08101217203 Page 8 of 8. Not valid without all pages.