Charlie Gipple, CFP, CLU, ChFC

Yield Compression

It’s not breaking news that life insurance carriers (and everybody else) have seen 37 years of dropping yields on bonds. At the time of this writing, the Moody’s Baa Corporate Bond Yield sits right at 3.91 percent, which is more than 100 basis points lower than at the beginning of the year! I believe that the Baa yield is the best proxy for insurance company investments because insurance carriers predominantly invest in investment grade corporate bonds versus treasury bonds. After all, if you can buy a bond from a strong investment grade company that yields 50—150 basis points over a treasury bond, why wouldn’t you? Furthermore, carriers generally invest more prominently in Baa type bonds than Aaa type bonds.

Because of these persistent low interest rates, insurance carriers have been forced to reprice their annuity and life insurance products many times over. This is because of the resulting decreases in general account yields. To put numbers to it: At the end of 2007 the aggregate yield that U.S. life insurance companies were getting on their fixed income assets – which is usually what backs life and annuity products – was 6.1 percent. Well, based off the 2018 ACLI Life Insurers Fact Book, that yield in 2017 (10 years later) had dropped to 4.43 percent. Thus, it is no mystery why caps on IUL have decreased. Furthermore, I don’t believe the pain is over yet for two primary reasons.

1. As the bonds that the carriers bought, say, 15 years ago mature and are replaced by new lower yielding bonds, the companies’ general account yields will continue to get watered down. Here is a simplified example of what I am talking about: If an insurance company’s general account has a “blended yield” of 4.43 percent and this year has $20 million in bonds from 15 years ago that are maturing, they must reinvest that $20 million in today’s low rate environment. The yield on the bonds that are maturing could very easily have been seven percent. It does not take a mathematician to understand that unless you replace those seven percent bonds with seven percent or greater bonds, the general account yield is going to continue to be watered down. So, interest rates could actually rise from here and it still would not stop the yield compression for insurance carriers.
2. There are 17 trillion reasons why I don’t believe rates will increase soon. When there is $17 trillion in sovereign debt globally that is yielding negative, that means that here in the United States we are actually in a “relatively” high interest rate environment. That creates demand for our U.S. bonds which increases the prices. That price increase on bonds, in turn, suppresses the yields. As a result, my opinion is that U.S. interest rates cannot change course unless interest rates around the globe change course, which can take a significant amount of time! However, if a crisis happens it could be that “risk premiums” on corporate bonds increase—but I am not hoping for a crisis.

By the way, the federal reserve does not control long-term rates with the fed funds rate! The federal funds rate only controls the short end of the yield curve. Market forces control the 10-year, 20-year, 30-year treasuries, etc. Now, the federal reserve could (and has) affect the long end of the yield curve by their quantitative easing or tightening, but that is different than the federal funds rate.

Yield Compression=Lower Caps, Higher Term/GUL Rates, Lower Dividends
For the fun of it, let’s do some IUL pricing based off the 2007 general account yield of 6.1 percent and compare that to today.

Let’s assume our General Account is yielding the 6.1 percent. As we discussed previously, this was the case in 2007.

Let’s also assume we are pricing a cap on an annual reset S&P 500 strategy within an IUL. Assuming a $10,000 net premium going into the IUL, how much money would need to be invested in those general account bonds so the $10,000 grows back to the original $10,000, based off the yield of 6.1 percent? The answer is $9,425. In other words, when the $9,425 grows by 6.1 percent over the next year, the insurance company will have the client’s premium back which is the goal! This means we have $575 ($10,000 minus $9,425) as an options budget. What does the insurance company do with that $575?

Not to get too technical but the company buys a S&P 500 call option “at the money” and sells an S&P 500 call option “out of the money.” The difference between what the carrier bought the option for and sold the other one for should equal $575. Based off today’s options prices, an “at the money call” would cost the carrier $747—which is more than our option budget. Too bad because if we had enough option budget for this call, we would have an IUL with unlimited upside, i.e. no cap. So, instead, we will buy that option and sell another one so we net-out to our $575 budget.

In order to capture our $172 ($747 minus $575), we need to sell a call for “out of the money” by about 11.5 percent (based on today’s prices). What we have just done is given the upside beyond 11.5 percent to somebody else! Voila! If it were 2007, our IUL product would have a cap of 11.5 percent.

What about today? It’s a big difference. Based on the math that uses 4.43 percent as a general account yield, we would only have a cap of 7.5 percent!

Now, you may be thinking, “But many IUL products are currently offering caps much higher than 7.5 percent!” You are right and this concern is addressed in a couple of my points below.

What are my points?
Point 1: The pressure that insurance carriers are feeling is real! Insurance companies are faced with a 37-year dropping interest rate environment and as a result they have been forced to adjust the pricing on policies as well as discontinue products. Not because they wanted to, but because they have had to.

Point 2. It is paramount that an agent is working with a carrier that knows what they are doing and how to hedge these products.

Point 3: If you are an agent, do your due diligence and partner with an IMO that knows how these products work and knows the carriers involved! These products are technical and therefore you should partner with technical people! Ask your IMO to “stress test” various products.

Point 4: Know that there are ways that a carrier can subsidize the option budgets with internal charges to give the product more upside than a 7.5 percent cap. Of course, additional expenses do come with additional risk. Thus, the importance of the “stress test.”

Point 5: If internal charges in the policy are extremely low and caps seem too good to be true, ask questions!

Point 6: Although I used IUL as an example above, know that dropping general account yields are not just an IUL problem, this is a term problem (increasing prices), this is a GUL problem (increasing prices), this is a whole life problem (decreasing dividends), etc.

Point 7: Good carriers will separate themselves from the bad over the coming years in how they treat the consumers with the caps, rates, dividends, etc.

Point 8: Don’t just disclose to the clients that caps can decrease on their policy. Set the expectation that they will! Underpromise and overdeliver.

Point 9: Needless to say, be prudent with illustration assumptions.

The silver lining:
The silver lining is that there will eventually be a point of “equilibrium” where the general accounts no longer yield more than the new investments put into the general account. I am hoping we are close to that point as the Moody’s Baa yield is not too much lower than the average general account yield. In the end, the value of all these products is relative to what else is out there and the value is still unquestionable. After all, prevailing interest rates have also dropped the rates of savings accounts, certificates of deposit, money market accounts, etc.

In Closing
The magic that these products provide, whether life insurance or annuities, lies in the mortality and longevity credits. With life insurance, if one dies prematurely there are thousands of other insureds in the insurance pool that pay for the death benefit of the deceased that could equal multiples of the premium the insured paid. Ben Feldman would discuss that with life insurance you can purchase “dollars with pennies.” With annuities you have the inverse: If you live until the ripe old age of 110, those in the “pool” that passed away early bought the “longevity credits” that guarantee you lifetime income. Mortality and longevity credits are what make these products special. By the way, the potential tax benefits of life insurance and annuities are kind of nice as well!

A couple decades ago (and about 50 pounds ago) I was a good basketball player. And by “good” I am not suggesting NBA “good,” I am suggesting high school all-state “good.” I was lean, had a good vertical jump and could run a mile in less than five minutes. Notice how I am speaking very much in past tense! Anyway, at 6’6″ and being able to move very well, I had a good combination. You are probably now wondering why I mention this in the context of Shaq and Steph Curry? Well, not only am I a fan of the two, you can often find me looking through a Steph Curry Jersey buying guide, but I have some interesting comparisons to make, so I will get there.

Here was my issue: The hoop could have been the size of the Grand Canyon, but if I was shooting beyond the three-point line, it was not going in! That didn’t matter to me, however, because each of us five players on the team had our own positions that we played and our own sectors on the floor that we favored. We played where we dominated! If past the three-point line I was airballing and if down-low I was dunking on people, where do you think I played 99 percent of the time? This logic does not take a championship-winning NCAA coach to figure out. Putting it simply, if someone was going to be betting on one of these US Sportsbooks, then there bet probably should have been placed on me making the most dunks by full-time.

So to my point and analogy, I view financial products as very analogous to basketball positions. You have some products that are great accumulation products for younger people that have 20-30 years until retirement. If one wants eight percent-plus returns, mutual funds, stocks, and ETFs have the ability to do this. Afterall, over the last 90 years the stock market has done well at hitting the three-pointers, as the S&P 500 with dividends has averaged around 10 percent. As the baby boomers saved for retirement in the stock market, they have done well in general by relying on the point guards (mutual funds, stocks, etc.) to shoot the three-pointers. However, with the oldest baby boomer now eight years into retirement and the youngest baby boomer only 10 years out from retirement, the ball needs to be passed to Shaquille O’Neal down low to win the retirement income game.

My analogy is that mutual funds, stocks, etc., may be great three-point shooting guards but annuities are great centers that play down low.

When I say that the capabilities annuities have in providing retirement income are just as unique as Shaquille O’Neal’s ability to dunk over people, I don’t believe I am exaggerating and here is why.

To step back a minute: This week I attended a meeting on structured products where I shared the stage with a lot of smart people that discussed structured notes, structured CDs and, of course, indexed annuities. A lot of people there were actuaries from insurance companies or quants from investment banks. The investment banks were in attendance because it is they who insurance carriers buy the call options/put options from in order to hedge indexed annuities and structured variable annuities. These investment banks also create indices that can be used in indexed annuity products instead of just the traditional S&P 500 index. Of course, we have seen a proliferation of these new indices within indexed annuities. Very smart people were at this meeting talking about indexed products!

Anyway, one of the speakers there was an individual that oversaw the retail insurance arm of one of these large investment banks and he discussed the prominence of indexed annuities with their field force. If you are already shocked by this, so was I! As you can probably concur, this investment bank’s “field force” I would think of as traditionally being the “stock jockey” types. Well, this individual said that within his arm of the company-which was the annuity and insurance arm-that 30 percent of his sales were now indexed annuities. Ten years ago who would have thought that a big investment bank would even bother to approve indexed annuities for sale, let alone have 30 percent of their insurance business be indexed annuities! Who would have thought that these products would have a very prominent position within these big Wall Street-type firms? By the way, their “insurance business” also included variable annuities which used to dominate the annuity game.

What was the reason his field force had really begun to embrace indexed annuities? Here is verbatim what he said:

“We have realized that indexed annuities with guaranteed lifetime withdrawal benefit riders provide levels of guaranteed income that cannot be replicated in the capital markets.”
-Anonymous Investment Banking Guy

What he is referring to is what I have been saying for years-no investment firm can copy what our products do!

Financial advisors/securities reps-which I am one of-have traditionally discussed the “William Bengen four percent withdrawal rule of thumb.” That is, a retiree should take no more than four percent from their stock/bond portfolios at retirement in order to not run out of money in their retirement years. Well, conversely, with indexed annuities there are GLWBs that can guarantee five to six percent withdrawal rates for a 65-year-old. He is right-this cannot be replicated! It is only insurance companies and the magic of the “pooling” that insurance companies utilize that can allow annuities to stand out from mutual funds, stocks, bonds, etc. These longevity credits can only be “replicated” by the pooling that insurance companies do! Investment companies cannot do this. To explain the “pooling” that he is alluding to, here is a simplified story from a prominent retirement expert:

“There were five 95-year-old ladies sitting around the table playing bingo. One of the 95-year-old ladies looked up and said “This is very boring! We have been doing this for 30 years and it’s time to try something new. Let’s all put $100 on the table right now and whoever is still alive a year from now will be able to split the entire $500 pool.” They all agreed it sounded like fun so they each threw $100 on the table. One year goes by and the mortality tables show us that there are only four of those 96-year-olds still alive. One of them unfortunately passed away. What does this mean? This means that each of those four 96-year-olds get $125 at that point in time, which is $500 divided up four different ways. It wasn’t even invested in anything over that year but they each got a 25 percent return on their money!” -Moshe Milevsky

Now, I am not suggesting that annuities or these “longevity credits” will give 25 percent returns. It is the concept that those that pass away early pay for those that live too long via these “longevity credits.” This is the inverse of life insurance and this is what makes annuities irreplaceable, just like how life insurance is irreplaceable with what it does. Nobody would ever argue against the logic of life insurance so why do many-like Ken Fisher-argue against the logic of annuities?

The biggest wealth transition in the history of our country-$30 to $40 Trillion-is taking place. By “wealth transition” I am referring to the amount of money going from pre-retirement to post retirement. The ball is now being passed down low and there is one product that dominates this like Shaq-annuities. The fact that annuities are so unique compared to anything else out there is what we really need to educate consumers to as an industry. If the game has now turned into a game that needs to be played “down low,” then annuities are Shaquille O’Neal.

In today’s low interest rate environment, I like many of the volatility-controlled strategies that are being created that add to the accumulation story of indexed annuities. There is great value in these strategies that allow savers to possibly get higher returns. However, these products are not designed to outperform the stock market, just like you will never see Shaq in a three-point contest with Steph Curry.

So again, we as an industry need to educate about exactly where it is that annuities cannot be replicated, and it is not the “X percent potential return” story. Rather, it is how annuities can provide this irreplaceable value of longevity credits. If we can provide more education on these longevity credits, we can overcome the “ambiguity aversion” that exists among many consumers as well as some financial professionals!

The game has changed, and it is now a “down-low game.” That is, it is now a retirement income game. And fortunately, that is the game where all the money is today!

Steph Curry should stay at the three-point line, Shaquille O’Neal should stay down low, and nowadays I will not get anywhere near a basketball court.

The Pond That Had Never Been Fished

When I was about 12 years old and my brother was 10 my dad took us fishing at an old farm pond just north of Atlantic, IA-the small community in southwest Iowa where I was born. Of course, as I’ve written about in the past, this was a weekend ritual with my dad in the summertime just as hunting was the weekend ritual in the wintertime. Anyway, an old farmer my dad was friends with let us use his pond that was adjacent to a smaller pond. As we drove into the pasture in the pickup truck, we passed by the smaller pond that looked like it had never been fished before because it appeared to be lacking in opportunities. We went straight to the big pond where–over the next hour or so-we drowned a few worms without any bites. As a 12-year-old fidgety kid, I got impatient! As we were sitting there, I asked my dad if I could walk 100 yards or so to the other pond and try it. He said, “Go ahead, but you won’t catch anything.”

I walked over to the other pond, put a worm on my hook, and let it fly. As soon as that bobber hit the water it went straight under like a submarine! I was shocked as I wrestled to shore the biggest Bull Head that I have ever seen in my life. As soon as I pulled it out of the water, I began to run across the pasture to tell my dad and brother that I hit the motherload. Envision a 12-year old kid running across a pasture wearing a giant smile lugging a fishing pole that was about to break because of the giant fish swinging on the end. By the time I got to my dad and brother at the other pond they already had their stuff packed because they heard my commotion and knew I struck gold. They were already heading in my direction. An hour later we had an entire stringer filled up with about 40 fish. I am not exaggerating when I say that our bobbers were sinking as soon as they hit the water. These fish must have been on top of each other! I don’t know the science behind the abundance of fish in this pond, but one can certainly attribute a part of it to the fact that nobody had ever fished it. It may also have been the case because the pond was well protected and the Pond filter was regularly maintained. Or maybe there were other factors that helped the fishes in breeding abundantly! If only I had been an avid reader of fishing tips, advice, and news that you can find featured on websites like CatchandFillet.com and the many others found online, we might have hooked ourselves a lot more than just 40 or so fish!

A Lot of Fish and Retiring Fishermen
I think there is a similar opportunity today for new agents, carriers and agencies/IMOs. As we know, we are in the middle of the largest wealth transfer from pre-retirement into retirement in the history of our country. The baby boomer generation that controls $30 trillion in wealth is retiring and moving their money into IRAs, which we can help with. Eventually they will also transfer that wealth to the next generation, which we can also help with. To use my fishing analogy, the fish are multiplying by the day!

Furthermore, while you have this increasing demand for our services, what is happening to the “supply” of our services, or the supply of fisherman? As we know, the average agent is a baby boomer as well-at around 59 years old. A large chunk of them are and will continue to retire-leaving the fishing hole relatively free for the taking. I have seen several studies over the years-many of them by my friends at LIMRA-that cite 40,000 as the number of agents that need to be recruited per year to fill the gap that will be left by agents retiring. We have not been filling these vacancies and will continue to fall short unless we as an industry get our act together. Although this is a serious issue for our industry, it is the “motherload” for those agents coming into the business or those that will be in the business over the next decade or so!

What about technology filling this gap? Although technology is obviously a part of the research process for many consumers today, fortunately consumers still want to talk with a living, breathing human being before they actually purchase. Humans will still be in the mix!

Do a google search on “bringing new agents into insurance.” See what you come up with. You will find nothing profound outside of the typical “The average agent is almost 60 years old; selling insurance is hard; carriers need to embrace technology; etc.” There is not much out there because this is a hard problem to solve. Well, as I tell my kids, the beauty of things that are hard is that your competitors likely cannot do them-which means if you do them, the potential rewards are high.

How do we as IMOs and carriers attract new people into our business? Although one can write a novel on this, here are ten of my thoughts.

1. Be a Cheerleader: We need to continue to be cheerleaders for our industry and scream from the mountain tops the huge opportunities that exist for our recruits- because the fish are multiplying and we need more fisherman! Quantify the opportunities for these recruits! Our business is tough because we are selling something that is not immediately apparent like a beautiful new car or a shiny new Harley Davidson. By quantifying the opportunity you are putting them in the moment of enjoyment.
   
2. Look to the Millennials: Although at CG Financial Group a bulk of our production is from agents in the Baby Boomer category, we are also putting a significant focus on the millennials, which I define as roughly 22 to 39 years old. This is an 83 million strong group of talented people that are the largest working age group in the U.S. today. Research shows that this group is more conservative than their parents were when they were that age. They are a great audience for the “protection products” we represent. Also, millennials love the flexible hours and the work/life balance that can come along with being an agent. And again, this is a bright, technology savvy generation.
   
3. Agent Education, Training and Professional Development: This is a big one for me. As we know, the “feeding system” of the career companies that used to train the agents that later enter the indy distribution is not the same as it has been in the prior decades. Per LIMRA, the number of “affiliated agents” has declined by more than 40 percent over the past 40 years. Many carriers have embraced independent distribution to cut the costs of having the agents as employees. At the same time, our products have gotten more complicated, the tax code is now 75,000 pages long, regulation is vast, and consumers’ mindsets are more complicated than ever before! New agents need help!
   
   This means us leaders (agencies/IMOs/carriers) in independent distribution need to fill the function of education, training and professional development. You don’t just give a kid a fishing pole and have him learn himself! This can be difficult because training, education and professional development take a long-term view versus a quarter-by-quarter view. However, you enjoy the shade today because you planted a tree 10 years ago.
   
   Some carriers and IMOs have great training material but, like anything we buy in life, the packaging is almost as important as the product itself. As I say, “At McDonalds nobody ever buys the Bic Mac. They always buy the #1.” If a carrier or IMO developed a comprehensive training system that is packaged in a way that can be “turnkey” replicated by an agency for use with their newly recruited agents, that carrier or IMO would come closer to cracking the code. More coming from CG Financial Group on this “turnkey system.”
   
4. Education to the Client: This doesn’t necessarily pertain to recruiting agents, but it does pertain to keeping agents. As we know, 90 percent of agents that come into the business will not last in the business. Help them last by educating them on how to educate their prospects.
   
   In the annual Insurance Barometer Studies that LIMRA and Life Happens conduct, they often cite the lack of enough life insurance coverage being very correlated with the lack of knowledge consumers have of life insurance. In other words, the more educated the consumer is about the need and benefit of the products, the more coverage they have! I would argue this correlation exists regardless of the products being sold. Help the agents with the educational content as well as the media to use in educating their clients.
   
5. Social Media: To my previous point about the “media to use.” Social media is today’s equivalent of direct mail in the 1980s and 1990s. Social media is used by 85 percent of U.S. consumers as a whole and over 90 percent of millennials. Whether it is recruiting new agents or educating consumers, social media should be a top focus. Believe it or not, many of the agents and agencies working with CG Financial Group began with the social media relationship.
   
   For consumers, the below quote tells the story:
   “There are more than 42 million consumers in the market for financial guidance. About two-thirds of those using social-media sites for finance-related topics are looking for information on product and services (62 percent), or looking for reviews on financial professionals (61 percent). Consumers, predominantly Gen X and Millennials, are using social media when assessing financial professionals; 34 percent say they would research financial professionals on social platforms.”-www.Lifehappens.org.
   
6. Video: This is well known to all of us in the industry; Video works! All my first five points above should incorporate video. When it comes to “cheerleading” for our industry, use video. When it comes to education, use video. When it comes to social media, use video.
   
   A thought on video: If you have seen my videos, they are casual! Sometimes I am in a T-shirt after working out. This is because I have learned after creating thousands of videos that there is almost a negative correlation in how “polished” I am and the level of viewership. People are human and it is natural for humans to cringe at a stuffy looking person giving a stuffy message. Don’t get slowed down by feeling that your videos must be perfect!
   
7. Group Benefits: Some carriers have contracts that allow for group health benefits to the agents, even though those agents are not W2 employees. For obvious reasons this is a valuable benefit for agents coming into the business!
   
8. Mentoring: If you are an IMO and have staff that are recruiting new agents into the business, it may make sense to have a mentor assigned to those new agents should that new agent so elect. That mentor would be somebody like their marketer (or whatever the title is). This mentorship program may include bi-daily calls between the agent and their “mentor” as well as many other things. That mentor should be held accountable for activity with the agents that they are mentoring.
   
9. Persistence with Social Media: Social media is a beast that can defy gravity at times. Not just because they incorporate human behavior but also because there are algorithms in all the platforms that can boost your viewership. These algorithms I won’t go into, but I will say it is all about being consistent and persistent. For example, some days I will post something that I think is quite profound and only get 1,000 views. Another day I may post something that I think is nothing great but it gets 15,000 views. Example: One day I posted something I thought was fairly irrelevant to the audience. It was me just discussing how I got back my Series 7 after letting it go years back. Who cares, right? Well I got 130,000 views and probably 200 new contact requests because of that post. And many of those new contacts were reps that I later recruited! Be persistent and do not get discouraged.
   
10. Believe in Karma
    If you are doing the right thing and trying to help the agents and their clients you will eventually win. If you have a mindset of “abundance” and share openly, you will win. The “Abundance Mindset” is what Stephen Covey talks about when he says that you should share openly with others and there are enough “fish” to go around.
    
    Something funny as I look back at the fishing trip I mentioned at the beginning, is what happened a couple of hours into our fishing spree. An old farmer that my dad knew was driving his tractor down the gravel road. This gravel road was within shouting distance of the water’s edge where we were sitting. That farmer stopped to yell a few pleasantries to my dad. As you can imagine, the farmer asked “the question” that usually requires a thoughtful response from fisherman that are protective of their fishing hole. The farmer asked, “Are you catching any?” If you knew my dad, you could guess his answer: “Nope, just drowning a lot of worms.” As a naïve 12-year-old I was confused about why my dad said that-he should’ve been proud of what we just caught! He should also let that farmer know about the huge opportunity that exists! I spoke up and said “What do you mean dad? We caught a lot of fish!” And I pulled our stringer up out of the water to display what we just caught. I later learned from my dad that unless you want other fishermen to catch your fish, you never tell them how good your fishing hole is.
    
    Well, 78 million baby boomers and $30 trillion in wealth equals more fish than any of us can catch-and therefore we need more fishermen. So, don’t follow the advice of my dad-display your stringer proudly! Tell these new recruits about the amount of fish in this pond that you will give them access to if they join your agency/IMO/carrier. The opportunity has never been greater. Have an abundance mindset and you will win.

Last year I decided to buy my two sons (8 and 11 years old) and myself motocross dirt bikes. My intention was to find us another hobby that we could enjoy together. I grew up around dirt bikes but never did the motocross thing. Anyway, I bought us all the helmets, boots, pads, braces, etc. and we were going to be hardcore motocrossers! I vividly remember the first day where I loaded up the dirt bikes and took my kids an hour north of Des Moines to a Motocross track where we were going to christen the bikes. I have never seen a motocross track up close prior to this. Well, I remember pulling into the track drive, which was still empty early Saturday morning. I remember getting out to get a closer look at the track while my sons stayed in the truck. As I walked up the first dirt “jump” it seemed big…really big! As I was standing at the top of this mountain looking around, my 8-year-old opens his car door and yells from the truck, “Daddy, are we supposed to ramp that?” I said, “Not today Matthew.” Then we rode the little trails behind the track all day and had a blast!

At the end of the day we watched other riders, that looked to be high schoolers, effortlessly jump those “mountains” like it was muscle memory. The thought of getting to that point seemed impossible last year. Well, we are there!

The parallel is that the way we talk in our business is muscle memory to us just like jumping terraces is to pro motocross riders. If you have been in the business for a long time, what you know and the language you use is now ingrained in your DNA. Therefore, it can be very easy to overlook the lack of understanding that the general population has concerning our products. I am sure a year ago those young high school kids could not fathom why I would not even consider jumping a 15-foot terrace.

In that vein, I want to focus on a few questions/objections around cash value life insurance that I have recently heard from consumers. If you have been in the business for a long time, you have likely heard these questions/objections and likely effortlessly know the answers. Like the kid that effortlessly jumps the terraces. However, many times it is not just knowing the answer but knowing how to respond so the consumer actually understands the answer. Don’t overestimate what the general population knows!

Question/Objection #1: “How is the life insurance cash value non-taxable?”
This is a great question from consumers that do not fully understand cash value life insurance. To answer this question, I usually use the following verbiage to explain this:

Let’s say you pay premiums of $1,000 per year into an IUL or whole life policy. In year 20, and after paying $20,000 in premiums, the cash value has grown to $30,000. How can you gain access to that $30,000? One way is to cash it out. You can simply ask the insurance company for your money back and the insurance company will gladly send you the check. However, that is not the only thing that will be sent to you. A 1099 will also come that will lead to income taxation on the $10,000 you took out above and beyond what you put in. Conversely, if you do not want that 1099 to come, what can you do? Take a loan against the policy. There is a reason that financial professionals discuss policy loans rather than “withdrawals” when they discuss accessing policy cash values. This is because loans are not taxable and withdrawals above basis are! When was the last time you went to get an auto loan and received a 1099 on the amount you got from that bank? Never. Somewhere in the 75,000 pages of IRS Tax Code it says that policy loans are not taxed assuming the policy is not what they call a MEC.

(By the way, to be technical, it’s Section 7702A that says loans are not treated as distributions under Section 72.)

Almost every time, my response above will lead to the second question…

Question/Objection #2: “But that’s my money! Why do I have to take a loan from myself?”
This is where I discuss with the client that, first of all, she wants it to be a loan! Why does she want it to be a loan? Because of the tax advantages we just discussed. Second, it is not a loan “from herself” or “from her policy.” The loan is actually from the insurance company, just like a loan from the bank. However, the hoops that a bank would make her jump through in order to get a loan are non-existent with these policy loans. These loans are contractually guaranteed to be available to her without loan applications, credit reports, W2s, etc. This is because the policy loan is a very safe loan for the insurance company to make, even without all the formalities. Why is it a safe loan? Because that insurance company collateralizes the death benefit in case she were to pass away without paying back the loan. Also, the insurance company would collateralize the surrender value in case she doesn’t pay back the loan and wants to cash out her policy. Therefore on the illustration you will see that the cash value is never reduced when loans are taken. The only values that are reduced on the ledger when loans are taken are the surrender value and the death benefit. That is because of the “lien” assessed against those two values.

When you start thinking of a life insurance company (where the loans come from) as a completely separate entity from the insurance policy (where the client’s cash value is), one’s understanding of life insurance loans becomes a lot easier.

Objection #3: “I don’t trust insurance companies.”
Here is an interesting one… Not long ago I was having dinner with a friend of mine (John) where we were discussing everything we should not discuss—religion, politics and money. He is my age—a very youthful 41 years old—and owns a very successful construction business. He is the epitome of the American Dream and a self-made man. He never went to college, but since he was a teenager he understood that if he worked his tail off he would be rewarded. That has come true for him!

He is a good friend but very set in his ways and has some biases against the financial services business. By the way, my dad owned a construction business while I was growing up, so I have witnessed some of this “anti-white-collar bias” that exists with some blue-collar professionals like my dad and like my friend John.

Anyway, somewhere in the conversation I started discussing how he should look at a cash value life insurance policy, not only for the death benefit but also the ability to take loans against the policy tax-free for his kids’ college or his retirement. I expanded on the concept by laying out what the math on my personal policy looks like as I am the exact same age as he. After he asked for clarification on the loans and the tax status on the loans (as mentioned previously in this article) John indicated that he did not trust insurance companies as they are all out for making a big profit. He also made the statement that the insurance carrier will likely “jack up” the rate charged on everybody’s loans so they can make a “huuuuge” profit. At this point I dusted off my participating whole life bat, because he just threw a hanging curve over the middle of the plate for me!

I then asked John, “So let’s say the insurance carrier jacks your loan rate up to the maximum rate in order to get more profit. Who gets that profit?” He said, “The shareholders/owners get the profit which is the main objective with any corporation—not just insurance companies!” I said, “You are right! But what if you were one of the owners of the company? What if that massive profit that these insurance companies supposedly get were partially paid to you as a dividend because you are one of the owners?” He paused at this point because he was confused. I continued, “So by being an owner, not only do you vote on the Board of Directors for the company, you also get to participate in the profits that may be generated by what the insurance company does with your money and that of a million other policyholders.” After a long pause he says, “How do I do this without buying shares in the company?” I said, “What I just explained to you is how a participating whole life policy works where the policyholders are the owners of the company. You are the insured, you are your own lender, you are an owner of the company, and you also vote on the Board of Directors that run the company.”

I will be meeting with John next week to show him his own illustration that he requested.

As an IUL fanatic, I will say that I also love participating whole life insurance. To me, one is not better than the other; it is a function of where on the risk/return spectrum the client is. Riding the trails is not any better or any worse than riding the motocross track. It is all about what the client is comfortable with.

On March 9 we passed the ten-year anniversary of the bull market that started in 2009; almost tripling the duration of the average bull market. Since March 9, 2009, the S&P 500 has quadrupled. Now, by just looking at the duration of the bull market and comparing it to past bull market lifespans, that would be a rather simplistic approach to arriving at a prognostication of what the future holds in the market. Although my intent is not to “prognosticate” anything in this article, I have my opinions and will say that the more “analytical” approaches to coming to a prognostication would indicate that we could be in for a rough ride. I research the market a lot and I believe that more can be found in the behavior of the bond market than the stock market. Without going into a long description, I will say that inverted yield curve is not good! An inverted yield curve has preceded every recession in the last 60 years.

As we face the possibility of being confronted with significant angst from our customers, I thought it would make sense to repeat a message from one of my Broker World articles from a couple of years ago as I believe it warrants repeating.

About ten years ago I had a 6:00 am Southwest flight out of Omaha to Phoenix. I was dead tired because I had to wake up at 3:30 am to get on the flight. Nevertheless, I dragged myself to the airport. Waiting at the gate to get on the airplane seemed to take forever. All I wanted to do was get on the plane and take a nap. As I boarded the plane I was happy because there were probably about 50 people on the flight which would mean that I would likely have plenty of room to get comfortable and take my nap. Indeed, after I sat down I noticed that in my row it was just me and somebody across the aisle in the other seat that looked like he was probably a frequent traveler, as am I. Without going into detail, this guy looked the part. Anyway, as I sat there in my seat I started to doze off into a half-conscious state. I could feel the plane pull back from the gate and go through the long process of idling out to the runway. The feeling of the plane lumbering along through the obstacles to get to the runway is kind of a soothing feeling, a lot like rocking a baby to sleep. In my half-awake state I could then feel the plane’s full thrust kick in as I was pushed back in my seat. It was obvious we were now making our way down the runway. As we made it down the runway we were nearing the final stage where you just begin to feel the front wheel lift as we go airborne. Then, suddenly, BOOM! This is the point when my whole world got rocked. It felt like we hit a brick wall as I was jolted wide awake. We were then skidding down the runway as I pulled myself to the window in panic to see where the end of the runway was because we had to be close. I also glanced over at Mr. Frequent Traveler across the aisle, whose eyes were the size of dinner plates. He was looking back at me for confirmation we were not going to die, which I could not provide him. He was panicking, the other passengers were panicking and, worse of all, the flight attendants were panicking! By the way, when the flight attendants panic, you should panic too!

What felt like a lifetime finally came to an end. We finally slowed down and got it under control. As the dust settled and we began that slow idle back to the gate I could hear people sobbing toward the back of the plane. That is when the captain came on the intercom to tell us what had just happened. What did he say? In a very calm and stoic voice he comes on and says “Hello folks, sorry about that somewhat uncomfortable take-off attempt. As we began to get airborne we had a diagnostic code tripped in the system that indicated the right-side engine was failing so we had to abort our take off. We will have to take you back to our gate and see what we need to do to get you on your way home. We do apologize for the inconvenience and greatly appreciate your patience as we get you home safe and sound.”

With those calm words from the pilot, suddenly everything seemed OK! You would have thought that the pilot had been there and done that a million times! Isn’t it amazing how a few calming words can put you at ease? I had flown hundreds of flights a year up to that point and I knew that this incident was not normal for me nor for anybody else, including the pilot! I knew that flight was a near death experience. I knew this, my friend across the aisle knew this, and the flight attendants knew this. Even more interesting is, even though I also knew that it was the pilot’s job to project a sense of calm even if he were to think we were all going to die, it still worked! A lot like when you tell yourself a salesman is going to try to sell you something and you aren’t going to buy it. But once you hear the pitch you buy it hook, line, and sinker.

The calm reassuring voice of the pilot put me and everybody else at ease even though I knew it was his job to create a false sense of security. The pilot became an instant hero. As a matter of fact, as we were deplaning I noticed several people hugging the pilot as they walked past.

When we got into the gate I called my friend who worked for another airline who pulled the incident up in his system. He said that incident I had just gone through was indeed a very big deal. He said that the airplane had been so far into the takeoff process that it passed what is called “V1” which is basically the speed of no return. He had stated that for the pilot to make the call to abort the takeoff at that point was a tough call because it was a choice between either getting airborne and having the plane fail in the air or aborting and running out of runway and crashing on the ground. The pilot chose option number two and fortunately it turned out fine.

My point is, you are your clients’ airplane captain. When they call you up because they are hitting turbulence in their lives, whether because they are losing money in the market, have a death claim, a long term care claim, etc., your value in these times lies in the way that you handle the situation. This is your opportunity to become a hero by doing the opposite of panicking and instead being a steady hand to those that are panicking. This is what top financial professionals do. They project a sense of “I have been there and done that and we will remedy this situation.” Imagine instead if that pilot came on the intercom and screamed out “Take cover! We are all going to die!” Panic is contagious and so is calmness. And people remember the “heroes” that gave them calmness in times of distress.

Are you that calming voice even at times when you are also scared for the client?

When I was getting started in the business there were times where I would get “panicky” because of a big meeting I had to conduct, a bad message I had to give to somebody, or a large audience I had to present to. I had a mentor back then who would always say, “You have done this a million times, and have you failed yet? No, you haven’t! So why panic now?” He would then go on to say “So what is the worst that can happen if you were to fail? It’s not like they can kill you.” For some strange reason those words have always stuck with me, “It’s not like they can kill me.”

We take our business very serious but keeping a perspective of what is important in life will also help you to not panic when things get stressful. We tend to let the negative trash in our heads believe that it’s a life or death situation if we fail at a task. It is not. This is why I have the utmost respect for our courageous men and women in the military. Their bad days on the job are way beyond the average person’s.

Not panicking is not only healthy for you, it is also healthy for your clients and your relationship with those clients. This is because having a positive mindset is a self-fulfilling prophecy. Meaning if you are always positive and never panic, clients feel that and will, in turn, be positive and will not panic. You are looked at as the “pilot” and therefore the creation of a positive environment is in your hands. Prospects/clients look to your mindset to form their own. And, the mindset that you have over the coming years could be extremely important if the market does what it is overdue to do.

Also remember, in almost any study out there that asks consumers why they left their advisor, the top response is almost always about communication or lack thereof. When the going gets tough, the tough communicate with their clients.

Is this you? You have had a successful career and you feel like you have worked your tail off. As a result, you have always gotten over the obstacles that you have been presented with—at least so far. You know you are not an idiot, you’re a quick learner and you have succeeded almost every-time—at least so far. You are a student of the business and not only know the business but also how to effectively communicate the need along with that need’s respective solution. Whether your customers have been financial professionals or retail clients, those customers have always given you great reviews and as a result you produced—at least so far. You feel like it doesn’t matter what type of product or service you are given, you will always be able to use hard work and effort to make sure that you succeed—at least so far. Do you love your work, your quality of work and take pride in doing a good job as well as getting well compensated for it? Is this you?

Is this also you? As much fun as you have had over your career and as much money as you may have made, you have begun to feel somewhat of a sense of emptiness. Is this emptiness brought about by the feeling that you are not able to influence your business as much as you would like because, in short, you work for somebody else? Furthermore, do you feel that, because you work for somebody else, the ideas that you would like to run with—that you know from your vast experience will work—are not being implemented? Do you feel that there is an imbalance between how much you care about your job and how much your job cares about you? Is this you?

Now, is this also you? Have you occasionally thought to yourself, “Then why don’t I start my own IMO/GA/agency?” But every time you ask that question, does the devil in your ear say that you will fail? That devil in your ear says, “Yes, you have been successful, at least so far, at almost everything you have done—but this time is different. Starting a business is different and you will fail.” That devil in your ear has also said things like the below:

• “The amount of knowledge around technology that you need today is beyond you…after all, you are a salesperson!”
• “You don’t have enough contacts to get the business running quickly.”
• “The IMO/GA/agency business is consolidating and only the big ones will succeed.”
• “You need massive contracts in order to succeed, which are very hard to get at the outset.”
• “Staffing at the appropriate levels is astronomically expensive.”
• etc.
• etc.
• etc.

If you are somebody currently in the position that I just explained, or one of the many successful IMO/GA/agency owners that read this publication, you are probably nodding your head because you know what I am talking about. You are either there, or you have been there.

The purpose of this article is to explain my high-level observations since I started my own marketing organization months ago, after several years of listening to the devil in my ear and not doing so. If I can help somebody change their lives for the better by writing about my experience then it was worth it. Much of the fine details are beyond the scope of this article, so if you want further advice please contact me.

Just Do It
I remember as a kid seeing old western movies where the cowboy would pull up to saloon on his horse, get off the horse and take the leather “leash” and merely wrap it one time around the post in order to keep the horse from bailing while the cowboy went to drink. As a kid, I always wondered how that would keep the horse in place. Heck, if the horse pulled just a little bit instead of just standing there, he/she would realize that it can run free! That is the equivalent of the devil in our ear. That devil is the psychological “leash” that tells us to just stand there and not pull.

Your gut is almost always more accurate than the devil in your ear. If you feel in your gut that you are the person I described in the first few paragraphs, and if you are financially able to—then rip the leash from the post! The other concerns about your ability to handle the technology, etc. will take care of themselves once you jump in. That’s right. Jump in and figure out the minor details later! If you have a value proposition and a plan/strategy for getting that value proposition in front of the right people, don’t sweat the small stuff yet.

One year ago I never would have thought that I could create a website, an agent microsite, marketing material, or a company “network” in our office. I was wrong! This stuff is not that hard! Although I am getting to a point where I don’t have time to do all the minor stuff and am hiring for it or outsourcing it, I learned that I am much more capable than the devil in the ear told me I was. You would be the same if you are the person in the first few paragraphs.

Again, if you have a value proposition that is unique from your competitors, don’t worry about what the “bigger guys” are doing. We have all read about the success stories of companies like Microsoft, Apple and Walt Disney, and how they started their businesses when the odds were stacked against them. But they succeeded! If you have a unique and strong value proposition relative to your competitors you will succeed.

But first, a word of caution about money—because that is one of the top determinants, if not the top, of whether you are able to do this.

You Need Money To Make Money
Now the bad news. There is truth to the cliché of “needing money to make money.” While starting an agency is not like starting a construction business, where you might need several pieces of $500,000 machinery, you still need money. Your LLC can be started with merely a couple hundred dollars. However, there are many other expenses—most of them technology. Here is a list off the top of my head: Errors and Omissions (both personal and agency), state insurance licensing fees for each state, computers, printers, website provider, antivirus/firewall for your network, email service like Constant Contact, Gotowebinar/WebEx, prospect lists, agency management system, health insurance. And the last one: Ultimately, if your business starts taking off, you will need staff!

Two additional thoughts about “needing money to make money” are:

• I believe that, whether one is a principal of an IMO or just a personal producer, with today’s regulatory environment he/she should have an affiliation with a broker/dealer or an RIA firm—especially the RIA firm. The fiduciary genie is out of the bottle, if not from a regulatory standpoint then certainly from a client mentality standpoint. I have been asked a few times by some personal clients if I was a “fiduciary.” Now you are probably like me in that you always act in the clients’ best interest whether you are officially a “fiduciary” or not. However, licenses matter to the regulators! One of the first things I did when I started my business was to retake my Series 66 and Series 7 exams (I dropped them years ago). Not only did the exams cost money, but the fees associated with the BDs/RIAs range anywhere from $1,000 per year to upwards of $7,000 per year. I believe that in order to build a healthy business in financial services and to hedge against regulatory uncertainty you need a securities license. Starting your own business is an opportunity to start a business the healthy way.
• The main reason I believe you need a large cushion before you start your own IMO/GA is because of this: Relationships with agents are just like relationships with consumers. It takes time to develop. Before I elaborate, let me step back a second and discuss my opinion on the genesis of the negative reputation that “insurance agents” have. I think one of the reasons our profession has gotten the reputation it has is rooted in the way that many of us got started in the business. I was almost straight out of college when I worked as an agent for one of the big career insurance companies. I was on a “commission draw” that the company gave me for the first six months, which was good because I had virtually no money because I was young. On the very first day of my employment the clock started ticking for me to produce so I could offset that “draw” with commission. If this didn’t happen, I would be gone six months later. The urgency was huge. On day one I knew nothing about the business, but I did know the phone numbers of my friends, relatives, and even a few people I hadn’t spoken to in ten years that I was sure would be thrilled to get a call from me (sarcasm). Needless to say, over that first year I was more “aggressive” with potential customers than I am today. Why? Because I needed to be. I needed to put food on the table! I had no cash cushion.

The fact that I have been smart with my money over the years allows me to follow the pace of the customer, whether those customers are the agents or my personal clients. I am not going to starve if an agent does not have an immediate need for my services. Persistence and patience always win! Money buys patience and patience earns trust. Trust is what our industry revolves around.

Buy It As You Need It
Although you need money to make money, the good news is that you don’t have to go crazy at the outset. One thing I learned about running my own firm is that you get solicited every day. Everybody is calling you offering you this system or that system. It would eat up your whole day if you allowed it to. And some of the systems are good and you get tempted to buy. But at the outset there are certain things that you do not need, at least not until the proper time comes. For instance, one of the first systems I bought was Gotowebinar. Webinar was obviously crucial because this was how I was going to discuss my value proposition with my potential customers/agents. This was needed at the outset! On the other hand, I did not need to buy licenses in all 50 states at the outset so I didn’t. Now, however, every week I am buying a new license for a new state as a new agent from that state submits a case. Let the revenue precede the expenditures whenever possible! In other words, it’s easy to justify spending $100 to get licensed in XYZ state when there will soon be a $1,000 override check coming because of it.

So Many Reasons To Do It

• As mentioned, if you are who I described in the first few paragraphs, then building your own business is for you. Here are just a few reasons that you should run your own company:
• When you run your own business, it is very satisfying to know that every minute you work, every idea or tool that you create, is going toward the value of your company.
• You are building a legacy for your family, should they ever want to work with you.
• When you run your own company you can do business with whomever you wish. In order to run a healthy business you need to do business with those that will not be a liability to the firm—whether literally or figuratively. I have had to tell a handful of folks that I would not pursue a partnership with them for this reason.
• The upside is unlimited. I have a friend that just sold his IMO for a very large sum. I was talking to him about money. I said, “How long did it take you to make merely six-figures when you started your own IMO?” He said, “Five years.” I was hoping he would say five months! However, he then came back and said, “But I made seven-figures within ten-years and this was 30 years ago.” That is real money. Again, if you have the cash cushion and the time, it will be worth it.

Final Tip
I have been in the industry for over 20 years, have worked with many BGAs/IMOs and have learned what to do and what not to do. I have seen some awesome firms that have created their own awesome empires. I have also seen firms that have been built in an “unhealthy” manner. However, they have gotten so big that they can’t change now. In your company’s infancy, you have the opportunity to kill that monster while it is still a baby. Kill those bad habits and inefficiencies before they grow! (I wish somebody showed me the correct golf swing when I got started 20 years ago!)

Build your company the right way from the beginning by having a securities/fiduciary affiliation. Build your company the right way by being patient with your customers versus high pressure overpromise/underdeliver tactics. Build your company the right way by focusing on the relationships versus the transactions. When people do business with CG Financial Group, they do business with me personally, not the company. Don’t lose sight of that! I have seen many companies get big and have the founder get too “disconnected.” Thus, the culture that attracted customers/agents to the firm is now gone.

Lastly, build your company the right way by affiliating with other IMOs/agencies that will give you great advice. I have learned that when you go out on your own, you realize who your true friends are—those who truly want you to succeed versus those that view others’ success as a zero-sum game. As it turns out, I have many friends that have given me a lot of help. You know who you are, and I will forever be grateful.

Kids that are somewhere between the ages of five and 10 are funny to talk to. This is because they are old enough that they have become smart enough to make observations that are accurate. Yet, they are not so old that they have become politically correct. As a result, the observations they make flow out of their mouths the very second those observations register in their brains. For instance, once my family and I were on our boat at the lake and I was wearing just my swimming trunks. My eight-year old—Matthew—after giving me a curious stare for about three seconds said, “Daddy, you need to start eating at subway instead of McDonalds.” By the way, if an eight-year old tells you that you are fat, you can bet that you are indeed fat! Their worlds are so simple and non-political that they have no motives, no agendas and no reason to say anything other than what they believe to be the truth. They are still unpolluted by political correctness and 100 percent unfiltered.

However, many times the free-flowing thoughts of young kids lead to small disagreements among each other. For instance, a couple of months ago Matthew came into the house very frustrated and was crying— like he does five times a day. At that point I cynically asked, “What is the problem now Matthew?” He then went on to explain that he had just had an “argument” with his best buddy and neighbor—Blake—who is also eight years old. They have a love/hate relationship. I asked Matthew what the argument was about this time and in his chipmunk sounding voice he responded, “We were having drama over who’s dad was the strongest.” My laughter did not do much to sooth Matthew’s frustration. (By the way, I was hopeful however that Matthew pled a convincing case!)

This is analogous to what frequently happens in financial services when everybody is fighting over market share by trying to separate their product from another product. Sometimes it gets petty enough that some of us in the industry—whether carriers, IMOs, or agents—start to lose focus over the real problem that consumers are faced with today. To give an example: I have attended hundreds of conferences over the last 20 years. At these conferences, where life and annuity agents are being presented to by carriers and/or marketing organizations, it is not uncommon to hear the presenters—usually wholesalers—say something like “Because of all of these great product features that my product has, it is able to provide your clients with $20 more in distributions per year than my competitor’s product.” A lot of times this conversation is based off illustrations that are purely hypothetical and based off minute details that nobody cares about.

Another example: I recently heard a webinar that a carrier was doing for agents and this carrier was comparing how the product he was showcasing was superior to the competitors’ products because of the way that the “loan arbitrage,” as he put it, was much more aggressive. He went on to state that because of the massive multiplier on his product and the resulting credit that comes from it, it would illustrate much higher distributions than his competitors. He proceeded to explain that this is because the “multiplier credit” is not the same as a high illustrated rate. What this means is that his product was effectively exempt from the AG-49 rule that mandates no more than one percent “arbitrage” between the loan rate and illustrated rate, therefore his product was better. He also went on to flex his intellectual muscle to discuss how, with his product, the frequency with which the premium is swept from the fixed account into the indexed account was better than the others. I can go on and on about what I heard. Unfortunately, this happens frequently in our business.

The question that I always ask while hearing one of these presentations—or preparing my own—is: Would the end consumers care about this and will this information help the agents write more business as a whole? If the topic is something that clients would care about, then I can guarantee that the audience (whether agents or IMOs) is going to care. Why? Because eventually that language must be spoken at the point of sale, and if you are helping formulate that language your value as a wholesaler is significant. When was the last time a consumer asked an agent how big his/her multiplier was versus his/her competitors? Or how frequent the sweep dates were versus the competitors? This never happens. These comparisons are made not at the client level, but rather at the level of the IMO and/or carrier. Why are we doing this?

Don’t get me wrong, agents need to know the ins and outs of products and “how the watch is built.” Heck, I have trained on deep product and concept analytics and will continue to do so. That is one of my differentiators as an IMO. The reason I do this is somewhat of a paradox: The greater an agent understands something, the easier it becomes for them present it simply. As Einstein said, “If you can’t explain it simply, you don’t understand it well enough.” Again, it’s an interesting paradox.

At this point you may be thinking I am contradicting myself. Allow me to explain. There is a difference between educating agents on the information they need to know and shining spotlights on very niche technical features, or features based off “hypotheticals,” in order to incite a reason for IMOs/agents to sell those products. The latter is not what our industry needs. The industry does not need “my product is better than your product,” or as I now call it, “my dad is stronger than your dad.” What the industry needs is the training that agents care about and the language and solutions that clients demand. This is much more important than “my product is better than yours.” I don’t believe that any agent in the industry would say that he/she has the problem of not having good products to represent.

The above is why at my company/IMO we create content based off two points of view, which I will share with you:

1. Client up: This is where we put ourselves in the clients’ shoes and think about what would interest them. What clients care about is living out their retirement dreams, not outliving their income, hedging tax increases, understanding this complicated world of finance, trusting their agent/advisor, etc. Again, by creating content from the mindset of a client, agents can not only use effective content but also speak the language that clients seek. By the way, this is also why I personally produce—to be on the front lines so that I can continue to understand the needs of the clients.
2. Agent down: Here we put ourselves in the minds of the agent. The typical agent wants to learn practice management, simplification, marketing practices, behavioral finance, how to be better at building trust with the clients, etc.
   

A couple of months ago I saw a video clip on LinkedIn of two antelope fighting in the desert of Africa. The video went on for about a minute that showed these two scuffling about in circles and knocking heads. What was the issue they were disagreeing about? Obviously, I have no clue. However, I can guarantee that their disagreement was not as severe of a problem as what was approaching them from about a mile out. As they were distracted bickering with each other, what started out as a tiny speck in the background was quickly getting larger and closer. It was a lion! By the time they pulled themselves out of the distraction it was too late—at least for one of the antelopes. Unfortunately, the ending was not a happy one for that antelope.

We as an industry should not be like Matthew arguing with Blake. Or antelopes fighting with each other. We need to address the bigger issue—the lion. To me the lion represents the millions of households that don’t have life insurance, long term care insurance or savings for an adequate retirement. To me, the lion represents the fact that over a third of all households would feel an adverse financial impact within one month of the death of the primary wage earner. To me, the lion represents the fact that the number one reason people do not buy life insurance is because they believe it is too expensive, while at the same time they have misperceptions about exactly how expensive life insurance really is. Educating each other on how to have these conversations effectively is how we address the lion. That should be our focus.

Now please excuse me—because I must go arm-wrestle Blake’s dad.

In part one we discussed the differences between traditional fixed UL and IUL—with UL the general account yield generates an interest credit to the client, whereas with IUL the general account yield is instead used as a call option “budget.” We also discussed the expenses within UL and IUL. With this column we dive into the details about the call options strategy that is purchased with the options budget.

Hypothetical Product Design
The most prominent FIA and IUL design is an annual reset, point to point, with a cap design. Meaning, if a product has a cap of 10 percent on an IUL and the market goes up five percent over a year, the client gets a credit of five percent. If the market goes up 15 percent over a year, the client gets a credit of 10 percent. If the market plummets 40 percent, the client gets a zero percent credit. Of course, with all these scenarios the “big three” of expenses is deducted as well. This product design is what I use in my explanation below.

With this structure, carriers typically do not just buy call options in order to give the client those product attributes. Rather, they buy and sell call options. The “buying and selling” of call options is the bull call spread strategy that I will discuss in a bit. But first, let’s discuss options in general.

Options Explained
Options are a subcategory of derivatives. Derivatives are contracts whose value depends on an underlying asset. Examples of derivatives are futures contracts based on oil, collateralized debt obligations based on company debt, and call options based on a company’s stock or an index. In other words, the value of “derivatives” is “derived” by an underlying asset. The derivatives that we want to focus on in this column are call options on the S&P 500 Index.

The definition of a call option is: The right but not the obligation to buy an underlying asset at an agreed upon price (Strike Price) by a certain point in time (Maturity Date). With indexed annuities and IUL, that “asset” is usually the S&P 500. (Note: There are many indices that can be used in indexed product designs. There have also been many new volatility-controlled indices that have come to market. However, the S&P 500 is the focus of this column because of simplicity and prominence.)

Options are also generally separated by American style call options and European style call options. The style that is most prominently used with IUL is the European style that can only be exercised when the option matures. Naturally, if the IUL product the carrier is hedging is an annual reset design, then that carrier would buy (and sell) options with a one year maturity.

So again, with a one year maturity, at the end of that one year period the options expire worthless (if the market is flat or drops) or worthwhile (if the market increases and the option is exercised). Our $430 that the carrier is allocating to the options strategy can be 100 percent decimated if the market drops. This is why options are extremely risky. The tradeoff is, however, that options have huge upside leverage that allows the carrier to take only $430 to link the client’s entire $10,000 to the S&P 500. Below I explain more.

What in the World is a “Bull Call Spread?”
First the carrier needs to purchase a call option that will give the client’s $10,000 the upside of the S&P 500.

Well, based off the S&P 500 being at 2,670 today as well as the pricing characteristics of call options today (strike price, volatility, interest rates, etc.), a call option on a “notional value” of $10,000 will cost the carrier seven percent or $700**. By purchasing this call option on a notional value of $10,000, this means that if the S&P 500 goes up 15 percent, per the example in chart 1, then the company would get $1,500 to pass through to the client. By the way, a $1,500 gain on only $700 in options demonstrates the huge upside leverage that options have. Furthermore, if the market went up 20 percent or 30 percent, then the option purchaser (carrier) could get a relatively massive $2,000 or $3,000 gain respectively. Again, however, the tradeoff is that with options you also have a relatively high probability of losing all your $700, i.e. the mudhole.

Remember that the agreed upon price that we would buy the asset (S&P 500 in this case) for is called the “strike price” and when the asset/index moves above that strike price it is considered “in the money.” You can also see above why volatility affects option prices. If the market never deviated from the dotted “strike price” line, then there would never be any payoff to the carrier nor risk to the investment bank. Thus the bank would sell the option cheaply. However, when the market zigs and zags is when it is more possible to end up “in the money.” Hence, higher option costs with higher volatility.

In our example the S&P 500 finished the year “in the money” by 15 percent. This means the carrier could get $1,500 from the investment bank. This is a good thing!

However…

At this point I know what you are thinking: “But the above is impossible because the carrier does not have an options budget of seven percent or $700! The carrier only has 4.3 percent or $430 to spend on options!” You are correct! Therefore, the carrier would actually do a second trade in addition to the original options purchase. This is where the carrier needs to sell an option back to the investment bank to “net out” to a total cost of $430 or 4.3 percent. Before we go there, let’s discuss “strike prices” some more.

The fact that we bought the S&P 500 index with a strike price of 2,670 means that we bought an “at the money” call option. Naturally, with call options, the lower the strike price, the more expensive it would be. To exaggerate, if we were to buy a call option on the index at a strike price of $5,000 (almost double the current index level) it would not cost $700 because the chances of the S&P 500 almost doubling over the next year is next to nothing. Therefore, that option would cost almost nothing because it is of no risk to the counterparty (investment bank) and is also of little value to the purchaser (insurance carrier). So, the higher the strike price, the cheaper the option; the lower the strike price, the more expensive the option.

So now that the carrier purchased the option in the above diagram that is 2.7 percent (seven percent minus 4.3 percent) beyond their options budget, the carrier needs to dial in at what strike price they should sell a call option. To put in accounting terms, they have a debit of $700 and now they need a credit of $270 to arrive at the options budget.

The higher the strike price the better from an IUL cap standpoint, because the strike price on the option the carrier sells is what determines the cap! Yet the higher the strike price, the less the credit is to the carrier to get down to the option budget. Where is that magical intersection we are looking for? In order to keep the math simple let’s assume it is 10 percent. That is, the strike price on the option we will sell is 10 percent “out of the money” per chart 2. This means that we sold an option with a strike price that was 10 percent higher than the current index level. Because the carrier is effectively not participating in any index return beyond the strike price on the option they sold, 10 percent is the cap on the IUL. Voilà! The product is now fully hedged!

In summation, by our hypothetical carrier buying an option (at the money) for seven percent and selling an option (10 percent out of the money) for 2.7 percent, the net cost is their option budget of 4.3 percent. This is how carriers arrive at IUL and indexed annuity caps. Albeit, the math with indexed annuities is slightly different as we will discuss.
(Note: Technically, based off today’s option prices, a 4.3 percent option budget will buy a cap slightly less than 9 percent. I used 10 percent for simplification. Furthermore, the options budgets vary by carrier and could be greater than my hypothetical 4.3 percent.)

Just for fun: What if the carrier instead sold a 15 percent “out of the money” option in order to provide a high 15 percent cap to the IUL purchaser? In this case the carrier of course would still purchase the $700 call option but at what price would they sell the 15 percent out of the money option? Only around one percent! Remember, with call options the higher the strike price the cheaper the option. Thus, this product design would cost the carrier almost six percent (seven percent minus one percent), which is obviously way beyond their 4.3 percent option budget.

With my example shown in Chart 1 and Chart 2 you may be thinking: “Could a carrier subsidize the options budget by imbedding additional expenses into the policy so they could offer a higher cap like the 15 percent example in Chart 1?” The answer is, to a certain extent they can. For example, there have been many innovative product features that have come to the market such as interest multipliers. These can effectively work like higher caps and many times are subsidized by higher policy charges. (Note of caution: There are, however, product and illustration regulations that put limits on what carriers can do with the creativity around product and the illustrations. This speaks to the notion that these are non-securities products. If a carrier gets too out of hand with loading up expenses to subsidize the options budget in order to get the consumers massive upside, the product will get into “securities” territory with the regulators.)

Static Hedging Versus Dynamic Hedging
A very brief note on static hedging versus dynamic hedging. What I just explained was static hedging and not every carrier does this, although I believe most of them do. Some may do both static and dynamic hedging.

In last month’s column I discussed how I love shooting precision rifles. The problem with high powered rifles is the cost of ammo. It costs a lot of money to buy precision ammo and it still is not “customized” to your firearm. So years back I said, “Why should I pay somebody to do what I can do myself when I can do it even better?” So, I bought the ammo presses, dies, the projectiles, etc., and I started making my own ammo. I have saved money over the years and I have also been able to customize my ammo.

Some carriers feel the same way about their hedging as I do about ammo. These carriers might say, “What can the investment bank do that I cannot do?” and hedge the indexed products themselves without the bull call spread. This is called dynamic hedging. When a carrier buys and sells the options like I’ve related, that is “static hedging.” There are positives and negatives to both.

Why the Difference in IUL and Indexed Annuity Caps?
Many people have asked me how IUL policies are able offer double digit caps while annuity products are offering four to six percent on the design we discussed. The primary reasons are:

Usually IUL is priced as a “portfolio rate” product where the blended general account yield is what determines the pricing. Conversely, indexed annuities are typically priced with “new money” interest rates. This allows for more yield “horsepower” to be available for IUL than with indexed annuities because, as we discussed, new money has been paying less than general account portfolios. This may change when interest rates start increasing.

IUL carriers don’t depend as much on the general account “spread” as indexed annuity companies do because of the expense levers that IUL companies have. This means generally higher call option budgets for IUL.

Because of the longer duration nature of IUL it is easier for the carriers to “wait out” interest rate slumps relative to annuity carriers.

General Account Yields Continue to Decline
As we have discussed, when a client sends the insurance company a premium check for a life insurance policy the insurance company backs that life insurance liability by purchasing assets within their general account portfolio. Over time these insurance companies accumulate billions of dollars of these assets in various securities. Per Milliman, at the end of 2015, US Life Insurers’ general accounts consisted of 76 percent bonds on average, of which a large majority were investment grade corporate bonds.*

It’s not breaking news that life insurance carriers (and everybody else) have seen 37 years of dropping yields on bonds. Because of these persistent low interest rates, insurance carriers have been forced to reprice their annuity and life insurance products many times over. This is because of the resulting decreases in general account yields. To put numbers to it: At the end of 2007 the general account yield for US life insurance focused insurance companies was 5.72 percent. Only eight years later (end of 2015) that yield had dropped to 4.59 percent.* Thus, it is no mystery why caps on IUL have decreased. As a matter of fact, if you were to do our IUL math today based off of the 2007 general account yield of 5.72, you would see that caps would be in the neighborhood of around 3.5 percent higher today, all else being equal. Very substantial!

Of course, the general account yield is the “weighted average” of all the yields of the securities the insurance company has in inventory. As the bonds that the carriers bought say 15 years ago mature and are replaced by new lower yielding bonds, the company’s general account yield continues to get watered down. Here is a simplified example of the current conundrum insurance companies are fighting: If an insurance company’s general account has a “blended yield” of 4.5 percent and this year has $20 million in bonds from 15 years ago that are maturing, they must reinvest that $20 million in today’s low rate environment. The yield on the bonds that are maturing could very easily have been seven percent. It does not take a mathematician to understand that unless you replace those “old” seven percent bonds with “new” seven percent or greater bonds, the general account yield is going to continue to be watered down. So, interest rates could actually rise from here and it still would not stop the yield compression for insurance carriers.

The silver lining: There will eventually be a point of “equilibrium” where the general accounts no longer yield less than the new investments put into the general account. I am hoping we are close to that point as the Moody’s Aaa yield is not much lower than the average general account yield. The Moody’s Baa yield is actually above five percent, which is more than the average general account yield of 4.59 percent.

Dropping general account yields is not just an IUL problem, this is a term problem (increasing prices), this is a GUL problem (increasing prices), this is a whole life problem (decreasing dividends). In the end, the value of all these products is relative to what else is out there, and the value is still unquestionable. After all, prevailing interest rates have also dropped the rates of savings accounts, certificates of deposit, money market accounts, etc.

Insurance companies are faced with an unprecedented 37 year dropping interest rate environment and as a result they have been forced to adjust the pricing on policies as well as discontinue products. Not because they wanted to, but because they have had to.

In Closing
The magic that these products provide, whether life insurance or annuities, lies in the mortality and longevity credits. With life insurance, if one dies prematurely, there are thousands of other insureds in the insurance pool that pay for the death benefit of the deceased that could equal multiples of the premium the insured paid. Ben Feldman would discuss that with life insurance you can purchase “dollars with pennies.” With annuities you have the opposite: If you live until the ripe old age of 110, those in the “pool” that passed away early bought the “longevity credits” that guarantee you lifetime income.

Mortality and longevity credits are what make these products special. By the way, the potential tax benefits of life insurance and annuities are kind of nice as well!

References:
*Milliman: Investment strategies of US Life Insurers in a low interest rate environment.
** https://www.barchart.com/stocks/quotes/$SPX/options?expiration=2020-01-17)