RILAs: How Do Insurance Companies Do It?

Question mark symbol for FAQ information problem. Illustration AI Generative
Question mark symbol for FAQ information problem. AI Generative Illustration

One of the most popular whitepapers that I have created for financial professionals is titled Indexed Products: How the Watch Is Built. This whitepaper speaks to how insurance companies price fixed indexed products (annuities and life). In this whitepaper, I effectively create an indexed annuity based on today’s interest rates and options prices. I show how the options are bought and sold to create a “cap” of X percent. If you would like that whitepaper, email me and I will get it to you. That whitepaper is a great segue into this conversation on RILAs. However, with or without that whitepaper, this article will still be digestible.

I will not necessarily explain in detail “How the RILA Watch Is Built.” However, I will give you some level of technical details on how it is possible for insurance companies to create a RILA, especially without assessing any additional fees to the client. Afterall, the “there has to be additional fees” response comes up a lot with RILAs.

So, let’s take just one product example. Let’s say we have a RILA that has a floor of 10 percent and a cap of 15 percent. This means that the highest downside is that the client can lose 10 percent and the highest upside is 15 percent. That 15 percent is a great cap in today’s marketplace! When you compare that to one of the top fixed indexed annuities that has a cap of 11.5 percent, 15 percent looks very good! So again, how do the companies do it?

The actuarial logic of RILAs is similar to indexed annuities; bonds support the product guarantees and options provide the upside potential. However, in this RILA product example, we aren’t just talking about call options we are also talking about put options. Let me explain with 100 percent hypothetical numbers while using the S&P 500 as our index…

Let’s start with fixed indexed annuities. With a fixed indexed annuity, following is how they are created. This is a very abbreviated version of the aforementioned whitepaper. Based on the bonds the carrier invests in, we may have a “call option budget” of four percent for our call options. That four percent (of the entire premium) is what we have to purchase the call options. However, the carrier generally doesn’t just purchase call options with indexed annuities, they also sell call options.

With the four percent in the carrier’s pocket, the carrier will buy an “at the money” S&P 500 call option that will give them 100 percent of the upside potential in the S&P 500 over the next year. However, that “at the money” call option may cost seven percent versus the four percent that the carrier had as a call option budget! So, what does the carrier need to do to get their net cost down to four percent? The carrier needs to come up with an extra three percent obviously. That is where the carrier will sell an “out of the money” call option that gives the upside beyond the “out of moneyness” to somebody else. In our very hypothetical example, a call option that is “out of the money” by 11.5 percent is what the carrier will sell, because that is where they can sell the option for around three percent of the “notional value.” (Note: Again, these numbers are not accurate based on today’s options pricing, but it is the concept that matters.)

So, what the carrier has just done was buy one call option that gives them the growth on the S&P 500 up to infinity from today’s S&P 500 value. However, because buying this one option was too expensive, they also had to sell an option that gives somebody else the upside potential beyond 11.5 percent. This is how an indexed annuity is made that has an 11.5 percent cap. The more “out of the money” the option is that the carrier sells, the higher the cap will be to the client. However, the more “out of the money” the option is that is sold, the less the option premium will be that the carrier will get back. So, in this example, the carrier finds that the amount “out of the money” to get three percent back is indeed 11.5 percent. Our cap of 11.5 percent is created.

For the options folks, what I just explained above was a “Call Option Debit Spread” where the net cost/debit was four percent of the notional value/client’s premium. For the folks that are not options-savvy, that last sentence never happened!

Now, with my RILA example that has a very large cap of 15 percent, how can this be done without additional fees? First, they would do almost exactly as I discussed with the indexed annuity, where they bought and sold call options to net out to a certain call option budget. However, they would have a call option budget higher than four percent, perhaps six percent! Thus, by having a six percent call option budget, they are able to buy a cap that is 15 percent, instead of 11.5 percent.

Where did that extra two percent budget for our call options come from, especially since the insurance company is not applying an extra fee to the client? With RILAs, the carriers are able to supplement their call option budget by selling “Put Options.” Put options—when bought—give somebody money when the market falls. If you bought a put option on the S&P 500 and the market lost 20 percent, you are likely going to get paid—especially if you bought an “at the money” put! A put option is the opposite of a call option. But you can also sell put options so that when the market tanks, you have to be the one paying the counterparty the amount the market has dropped (below the strike price). Why on Earth would you sell a put option? For the option premium. Like selling anything else, you get money in exchange for it. With options, this money is called the “premium.”

So, what the company did with our hypothetical product that has a -10 percent floor and 15 percent cap was, they sold an “at the money” put option on the S&P 500. By just doing this, the insurance company got a great “premium” for selling this to somebody else (investment bank for example). However, by the carrier just selling this “at the money” put option, this means that the insurance company/consumer would now be 100 percent exposed to the market should it fall. We don’t want the client to be 100 percent exposed; only 10 percent exposed. So, the carrier will then purchase a put option that is 10 percent “out of the money.” This means that somebody else participates in the market’s loss beyond 10 percent. This is how the floor of -10 percent is created.

The put option that the carrier sold was two percent more expensive than the option the carrier purchased. This is because they sold an option that was “at the money” and they purchased an option that was “out of the money.” So, by doing the above selling and buying of put options, the carrier garnered an additional two percent that then gets added to the call option budget that allows them to buy a very high cap of 15 percent. All at the cost of exposing the client to the downside of -10 percent.

In short, by the client being exposed to the 10 percent downside, the insurance carrier is able to afford options that give that same consumer 15 percent to the upside. The carrier did all of this without adding an additional fee to the client.

For the options folks, with RILAs the “Call Option Debit Spread” is supplemented by a credit that the carrier has created via a “Put Option Credit Spread.” Again, for folks that are not familiar with options strategies, move that last sentence to the trash bin of your memory.

Charlie Gipple, CFP®, CLU®, ChFC®, is the owner of CG Financial Group, one of the fastest growing annuity, life, and long term care IMOs in the industry. Gipple’s passion is to fill the educational void left by the reduction of available training and prospecting programs that exist for agents today. Gipple is personally involved with guiding and mentoring CG Financial Group agents in areas such as conducting seminars, advanced sales concepts, case design, or even joint sales meetings. Gipple believes that agents don’t need “product pitching,” they need mentorship, technology, and somebody to pick up the phone…

Gipple can be reached by phone at 515-986-3065. Email: