A Review of Two Investment Options with Upside Potential and Downside Protection

The stock market remains volatile and bank account, CD, and treasury yields are near all-time lows. None of this is likely to change until the COVID-19 crisis ends, leaving many investors, including physicians, risk averse. In this environment, many physicians may be looking for investment options that provide some upside potential, with downside protection. We will briefly discuss two options that, if implemented properly, can achieve this result: equity-indexed universal life insurance policies and structured notes.

Equity Indexed Universal Life Policy Basics

An equity indexed universal life (EIUL) policy is a type of cash value life insurance policy, as it has a cash value/investment portion, as well as a death benefit. Cash value policies are also called “permanent” policies because they do not have a term after which they will expire (like “term policies”) and are intended to be kept in place until the insured dies.

There are several types of cash value insurance, including variable and whole life, where the cash values grow based a variety of methods. With an EIUL policy, the cash values are used to implement a collar strategy.

In a collar strategy, the insurance carrier sells call options and buys protective put options on positions they own. In return, the policy’s performance is tied to an index, such as the S&P 500, a market-capitalization-weighted index of the 500 largest US publicly traded companies.

Through the collar strategy, the carrier is able to guarantee the policyholder a floor, or minimum return (i.e., 0 percent) that protects them from losses. With an EIUL, if the index the policy is tied to goes down 20 percent, the cash value will not go down. EIUL policy cash values also have a ceiling, or cap, on the upside (i.e., 10 percent), which means that if the index goes up beyond the cap, the policyholder will get a portion of the total upswing (i.e., capped at 10 percent).

Because of their upside potential, combined with downside protection, EIUL products have been extremely popular since the Great Recession, with more than $2 billion being invested into new EIUL policies in 2018 alone.¹

EIUL Benefits and Risks

In addition to the downside protection/upside potential, EIUL policies have the benefit of the cash value growing tax free and, if managed properly, accessed tax free. Also, in many states, the cash value is protected from lawsuits by statute.

Like any investment product, EIUL insurance has various risks. One such risk is that EIUL policies are not 100 percent liquid—policies generally have a surrender period of eight to 12 years, during which, if one surrenders the policy completely, a surrender charge is assessed against the cash value. This charge can be avoided if one withdraws some, but not all, of the cash value.

Another inherent risk with EIUL and other permanent life policies is the possibility that the insured will not be able to adhere to the designed premium schedule. A policy’s size and costs are based on the premium schedule charted out when the policy is implemented (i.e., $10,000 premiums each year for ten years). A deviation from this premium schedule by the policyholder can result in a significant negative impact to policy performance.

Finally, because an EIUL policy’s cash values are managed by the insurance carrier, carrier solvency risk is also important to acknowledge. This is why using top-rated companies with 100 year+ track records is crucial.

Structured Notes Basics

Structured notes are “hybrid” securities, as they combine the features of multiple different financial products into one. Issued by some of the largest banks in the world, structured notes combine bonds and additional investments to offer the features of both debt assets and investment assets. In fact, according to published studies, there is $2 trillion invested in structured notes worldwide.

Structured notes are not direct investments; they are derivatives, as their value is derived from another linked asset. The return on the note depends upon the issuer repaying the underlying bond and paying a premium based on the linked asset, less the bank’s fee. Most structured notes generally have four common elements:

1. Maturity: can range from six months to many years. Most are three to five years.

2. Linked Asset: typically, a stock, bond, ETF, index, currency or commodity.

3. Payoff: the amount the investor gets at maturity.

4. Protection: the level of protection the investor gets if the linked asset loses value.

Case Study: Physician Phil

Physician Phil invests $100,000 into a structured note offered by Big Bank. The note is tied to the S&P 500 equity index with a 30 percent buffered protection level and a term of three years. By investing in this product, Phil will get the following payoff in three years:

If the S&P 500 is positive over the three-year period, Phil will get the $100,000 back, plus the growth based on the S&P 500, less Big Bank’s fee. In this way, Phil enjoys the upside of the note.

If the S&P 500 is negative over the three-year period, but not below the 30 percent buffered downside protection (down between 0-30 percent), Phil will get the full $100,000 back, less the Bank’s fee. In this way, Phil benefits from the downside protection of the note.

If the S&P 500 is more than 30 percent negative over the three-year period, Phil’s payoff will be subject to the downside of the index beyond 30 percent. For example, if the index is down 40 percent at the maturity of the note, Phil will lose only 10 percent on his initial investment (plus the Bank’s fee).

Structured Note Risks

There are several risks inherent in a structured note investment, including:

Complexity: Structured notes are complex financial instruments. Investors should understand the reference asset(s) or index(es) and determine how the note’s payoff structure incorporates them in calculating the note’s performance.

Market Risk: While some notes have buffers and other protection factors built in to reduce the impact of a bad market, the investor may still suffer a financial loss as with any other investment that is not FDIC insured or principal protected.

Lack of Liquidity: Should an investor need access to the funds in a structured note prior to maturity, they will be forced to sell the note on the open market. While there may be a buyer willing to purchase it at some price, typically it is at a deep discount to what the note is worth.

Issuer Risk: Ultimately, the structured note is only as strong as the issuer. If the issuer defaults, the entire principal could be lost.

Bottom Line: Work with the Right Advisor

Both EIUL policies and structured notes can be valuable components of a physician’s overall portfolio, especially for investors looking for downside protection with upside potential. Because these products are complex and contain inherent risks, working with a knowledgeable professional advisor to evaluate options is always recommended.

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This article contains general information that is not suitable for everyone. Information obtained from third party sources are believed to be reliable but not guaranteed. OJM makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.

1. https://www.investmentnews.com/indexed-universal-life-insurance-sales-continue-hot-streak-78621