Caps, Floors, Thresholds, Spreads, and Participation Rates
A cap is an upper limit on index return to the policy owner for a given period. The floor (usually zero) is the lower limit. A participation rate (usually on uncapped index strategies) represents a percentage of total index gain that would be allocated to the policy. Some participation rates may be greater than 100% and are always more than zero.
One of the newer index strategies credit all of the index gains up to a certain point, known as the threshold. The threshold is then followed by a gap known as the spread, inside which there is no index credit above the threshold. If the index performs better than the sum of the threshold and the spread, all excess gain would be credited without any cap.
For example, one carrier currently offers such a strategy in which all of the one-year performance for the S&P is credited up to 8%. There is a 4% spread, and any annual gain of the S&P above 12% is then added to the first 8% without any limit. If the S&P rises by 6%, you get 6%. If the S&P rises by 9%, you get 8%. If the S&P rises by 20%, you get 16%. If the S&P loses 15%, you get 0% (no loss).This is a very interesting strategy, since you are credited with a reasonable chunk of the first-dollar performance, and yet still have no upper limit or cap on a big up-year. Another way of stating this is to say that, for S&P annual gains in excess of 12%, the policy owner always gets the entire S&P gain less 4%. Pretty good, considering that you never suffer performance of less than zero!
How do insurance companies make good on the range of index performance they offer for indexed universal life? How does the company assure that the policyholder won't lose on the investable part of his premium, and at the same time be able to gain an amount well above what might be expected from the fixed-income returns usually associated with traditional life insurance products?
First, keep in mind that not all of the premium paid into the policy is "investable". The premium payment is reduced by the "cost of insurance" (COI) and operating expenses of the insurance company. These charges vary between companies, and it is important to choose an insurance company that is efficient in these areas and treats the policyholder fairly.
Performance also varies according to the age of the policy and the degree to which the amount paid in is above or below "target premium". Amounts paid above the target premium usually incur no COI charges and very little expense charges, if any.
Therefore, persons interested in accumulating the most cash value possible in a given policy would want to pay in as much as possible above the target premium while still qualifying to meet the definition of life insurance by the IRS. There will also be an upper limit to the premium size, assuming that the policyholder also wishes avoid having the policy be deemed a Modified Endowment Contract (MEC) for tax purposes.
Let's assume a 100 dollar investable amount, and the index strategy in use is the typical one-year point to point strategy tied to the S&P index. The policyholder is told that, if the S&P is at 1400 on day one of the yearly segment, no matter how far the index may fall during the ensuing 12 months, the segment or "bucket" of money will not lose value.
In order to put in a floor on the segment value, the insurance company places most of the funds (say, 95%) into its general account. The actual amount placed into the general account takes into consideration the overall return the general account is expected to earn over the coming year. Because the company invests predominantly in long-term bonds and mortgages, this return is not expected to change much from year to year. For a $100 investment, 95 dollars will turn into 100 dollars at the end of one year if the general account earns 5.26%. Thus, the promise that the invested segment will not lose money can be fulfilled.
In supplying an upside to the policyholder, the insurance company takes the remainder (in this case 5 dollars) and uses it to purchase a call option at a strike price of the initial S&P price on the first segment day. This has the effect of being able to "call" the same number of units of the S&P index a year from now at 1400, no matter how high the actual index has risen. The problem with such an "uncapped" option is that it usually costs more than the 5 dollars that are available.
In order to afford the call with the 5 dollars in hand, the insurance company will additionally sell a call option for an index value that is somewhere above where the index is at the segment's commencement. For instance, selling a call at 1596 effectively places a cap on the gain for the policyholder of 14%. The revenue from the sale of this call should be just enough to offset the excess cost of buying the uncapped call. Say, the uncapped call costs 7 dollars and the revenue from selling the call at 1596 makes the company 2 dollars. Thus, the policyholder is assured that he can make up to 14% on an annual segment without the risk of losing value. For uncapped strategies, such as mentioned above, the same general concept applies, but the math is a bit more complicated.
To summarize, if the index falls, the policyholder is protected by the fact that his underlying value is supported by having been mostly applied to the general account plus one year's interest on the general account. If the index rises, but not more than 14%, the call pays off and accounts for all of the gain to the policyholder. If the index rises more than 14%, the call still pays back all of the gain, but the insurance company must give back the amount above 14% to the purchaser of the call that was sold for 2 dollars.
So, what are the factors that can affect caps and participation rates? Clearly, the return anticipated on the company's general account will have a significant influence. Also, the price of options, which are in turn affected by market volatility, will impact the caps, thresholds, spreads, and participation rates. To a lesser degree, company expenses will have an effect too. (Back to IUL Table of Contents)