We are often asked by our clients, “How can the insurance company afford such generous caps and floors in their indexed universal life policies?” Many insurance producers themselves may ponder the same question.

We may even take it a step further and wonder, if the insurance company can do this in a life insurance policy, shouldn’t we be able to do this in our own investment portfolios without the insurance fees associated with the policy? Before addressing the later, we need to understand how the insurance company hedges to be able to offer their stated caps and floors.

As an example, we’ll assume XYZ insurance company offers an indexed universal life with a one year point to point crediting strategy on the S&P 500, a 0 percent floor and a 12 percent cap with a 100 percent participation rate. What this means is that if a policy begins the year with $100,000 of account value, it is guaranteed to end the year with at least $100,000 in account value and possibly up to $112,000 (less insurance charges and policy fees in both cases).

Now, let’s assume that XYZ has a general fund that they know will earn 5.5 percent interest this year (which is about the industry average). The insurance company would need to have $94,787 of your $100,000 invested in their general fund at 5.5 percent in order to guarantee your $100,000 account balance at your policy anniversary. This leaves them with $5,213 to invest in an option strategy to credit the upside potential of the market. The insurance company uses call options to credit the excess interest.

A call option is a security that gives the purchaser the right to buy a security at a specific price (strike price) within a certain time period. Since this policy is linked to the S&P 500, the insurance company will buy call options on an ETF that mirrors the S&P 500. Spiders (SPY) is one such ETF.

At the time of writing this article, SPY is trading at $200. If the S&P index rises 10 percent, shares of SPY will also rise 10 percent to $220 ($200 x 1.1). Since the insurance company will need to credit at least some interest if the S&P index rises at all, they need to buy one-year call options with a strike price equal to the current price of the underlying security. This is called an “on the money call.” As long as the index is up by year end, these options will be “in the money.” The insurance company will liquidate the options and in order to credit excess interest to the policy. If the S&P index falls, the options will be worthless, but the money that was put in the insurance company’s general account will now be worth $100,000.

Currently, the price of a one-year on the money call on SPY is $13.22. This means that for a premium of $13.22, the purchaser will have the right to purchase one share of SPY at a price of $200 until the option expires one year later. If, a year from now, SPY is trading at $250, the option would be worth $50, as it allows the purchaser a $50 discount to the current price. If the underlying stock is trading at $300, the option would be worth $100. Since there is no limit how high the price of the underlying security may go, the call option offers unlimited profit potential. If the underlying security is trading below the strike price (in this case, $200) the option would be worthless and the purchaser would have lost the premium paid.

While the profit potential of a call option is unlimited, the insurance company does not need unlimited profit potential since they are only on the hook to credit your policy up to the cap, in this case, 12 percent. At the time of the call option purchase, the insurance company will also sell an “out of the money” call option with a strike price higher than the current trading price. Option traders refer to the strategy of buying an on the money call and simultaneously selling an out of the money call with both positions having the same expiration date as a “bull call spread. The purpose of using a bull call spread is that the net cost of the option strategy is lower and more options can be purchased. It also caps the upside potential of the position.

*A bull call spread consists of one call option purchased on the money and the simultaneous sale of an out of the money call option on the same security with the same expiration date. This strategy caps the potential return of the long position but reduces the net cost of the option.*

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In our example, using a 12 percent cap, the insurance company will sell call options with a strike price 12 percent greater than the “on the money” price of $200, in this case, $224. Unfortunately, SPY calls are not available at a price of $224, so I will need to round up or round down to come close. In this case, I will use a strike price of $225.

Currently, a one-year call option on SPY with a strike price of $225 would sell for $2.80. The net cost of the spread will be the price paid for the call purchase (long position) less the price received for selling the call option (short position). In this case, $10.42.

*$13.22 (long position)*

*-$2.80 (short position)*