In a recent CU Today interview, Kirk stated:
[A] prominent insurance carrier recently reduced what’s called a cap rate. They have this wonderful policy that says we’re going to protect the policy owner from the downside. They say we’re not going to charge the cash value when the rate of return is below 0%. But in exchange for that downside protection, we need to limit your upside opportunity.
So, if the policy produces more than the “cap,” we get to keep the excess. If they invest and they produce 16%, and the cap is 12%, then the insurance company is 4% to the better. If they lower the cap, the insurance company keeps more of the upside and it becomes harder for the policy to produce the expected results.
Diving a bit deeper into the analysis, insurance carriers offering policies with floors and caps typically do not retain all of the investment risk themselves. Instead, they hedge their risks by buying and selling options.
Option pricing fluctuates based on expectations of future market performance and volatility. In the current environment, hedging costs have increased, increasing the financial pressure on carriers seeking to maintain cap rates.
In the face of this pressure, the insurance carrier must choose either to subsidize its hedging budget to retain the current cap rates, or stay within its hedging budget by lowering the cap rates. Therefore, reducing the cap rate in the example from 16% to 12% does not mean that the carrier is directly “4% to the better,” but it does mean that the carrier avoids the subsidies otherwise required to maintain the higher caps.
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