Introduction
Indices, including those used in insurance products, such as fixed index annuities (FIAs), registered index-linked annuities (RILAs) and index universal life (IUL), use one of these three return types: price return (PR), total return (TR) or excess return (ER). These return types serve different purposes and are ultimately an element to consider as part of the overall construction of an index.
Price return measures the capital appreciation (or depreciation) of an asset. For an index, the price return measures the price fluctuations in the underlying constituents within the index.
Total return measures the price return of an asset with dividends added. As dividends are issued by underlying index constituents, the dividend amounts are theoretically reinvested in the underlying asset, which incrementally increases exposure to the underlying asset. As more dividends are issued, more shares of the underlying asset are added to the index (or theoretically “purchased”), which in turn generates dividends paid on the original investment as well as these new shares, which are then again used to “buy” even more shares.
Indices used in insurance products often contain exposure to an underlying equity index as well as a cash allocation. A total return index used with insurance products would also typically include the theoretical return on the cash component if the index has a cash allocation invested at a certain rate, such as the Secured Overnight Financing Rate (SOFR), the federal funds rate or the yield on a 3-month U.S. Treasury bill.
Excess return is often surrounded by confusion, since it can have different meanings depending on the context. To simplify the term, we are going to break “excess return” down into two definitions.
In its simplest form, excess return measures a return above some sort of baseline. The math is the same in both definitions, but the reason for using excess return can differ based on the industry.
- In the world of active management, excess return can be defined as the return above a benchmark, or “alpha”. Active managers of ETFs, mutual funds and hedge funds often measure the performance of their fund against a benchmark, like the S&P 500®. Their goal is often to create as much alpha as possible. In other words, they are looking to “beat the market.”
- In the world of indices used with insurance products (e.g., FIAs, RILAs and IUL), excess return measures the return of one or more underlying assets minus an interest rate. This interest rate is subtracted to help improve hedge efficiencies, often leading to cost savings for the insurance carrier, which may ultimately benefit the end policyholder.
It is worth noting that the term “excess return” is sometimes used as shorthand for “excess total return” or “excess price return” in the insurance space. Most indices underlying insurance products are excess total return indices, meaning the theoretical interest rate is subtracted from the total return of the underlying assets in the index. However, excess price return indices also exist in the insurance marketplace. For the purposes of this piece and in order to align with the S&P Dow Jones Indices naming conventions, “excess return” will be used to refer to “excess total return.”
It is not possible to invest directly in an index. Exposure to an asset class represented by an index may be available through investable instruments based on that index.
