You may have seen some pretty large industry movement in decreasing cap rates at carriers, especially in regards to Indexed Universal Life insurance (IUL). It seems like this is an industry wide issue and “carrier chatter” is really heating up across the board.
Caused by Option Costs
These decreasing cap rates are 100% due to option costs. However, it isn’t because of volatility. There are three main factors in the price of traditional index options:
- Volatility (higher volatility = higher option costs)
- Short term interest rates (higher interest rates = higher option costs)
- Dividend yields (lower dividend yields = higher option costs)
Today, short term interest rates are increasing and dividend yields on the S&P 500 are decreasing, since the prices of the S&P stocks have appreciated so much and companies have not yet increased dividends. Both of these factors are increasing option costs and therefore putting pressures on cap rates.
Impact on IUL vs. FIA
The impact is more prevalent in IUL than Fixed Indexed Annuities (FIAs). Typically when higher interest rates increase option costs, option budgets are expected to increase as well due to the higher rates. For a FIA, this makes sense because they use new money rates in pricing their products (interest rates for new assets at the time of issue). However, IUL typically uses portfolio rates (interest rates for the entire block of assets backing the product line). Since portfolio rates are still higher than new money rates (even though new money rates have increased) and new money assets are such a small portion of the total portfolio of assets, it takes time for portfolio yields to increase in an increasing interest rate environment. That is why FIAs haven’t been hit has hard as IULs on cap rates.
Bottom line, if interest rates continue to increase and/or the dividend yields on the S&P 500 continue to decrease, we will continue to see this pressure on IULs.
