Indexed universal life (IUL) is a type of cash value life insurance that has flexible premiums, itemized policy charges and a credited interest rate that is based on the performance of an index such as the S&P 500. Its market share has grown from almost nothing a decade ago to about 20% in 2014, with new premiums of about $1.6 billion. This growth has come at the expense of no-lapse universal life and non-indexed, nonguaranteed universal life.
The growing IUL sales have been accompanied by growing concerns about the illustrations that are used to sell it. Are the illustrated interest rates reasonable? Are the risks of policy loans clearly disclosed?
To address these concerns, the National Association of Insurance Commissioners (NAIC) has developed Actuarial Guideline YY (the “YY” is a placeholder for a future number), which will take effect in late 2015 and early 2016.
Advisors face four broad questions when they review sales proposals for indexed universal life policies. First, how does the policy work? Second, does indexed universal life offer better value for the money than other types of cash value life insurance? Third, how should you compare different IUL policies? And fourth, what are the benefits and risks of policy loans?
Buying life insurance on margin
Let’s start with the fourth question.
Unlike other types of cash value life insurance, indexed universal life makes it easy to concoct scenarios of profitably buying life insurance on margin. Some types of policy loans do not affect the credited interest rate, so you have the possibility of borrowing money from the policy at one rate while continuing to earn a higher rate. The sales illustration — really, just a piece of paper — says that you can be fabulously wealthy when you’re ready to retire. Of course, you also have the possibility of borrowing money at one rate while earning a lower rate, and then the results aren’t so pretty.
Agents have been illustrating favorable spreads of a few percentage points, which can create great-looking projections over decades. Actuarial Guideline YY says that you can’t use a spread of more than 1%. In other words, you can violate the basic principles of financial economics just a little bit, but not more. If state insurance regulators were in charge of human physiology, it would indeed be possible to be a little bit pregnant.
How do IUL policies work?
Now let’s look at the first question.
In 1992 a task force of the Society of Actuaries concluded that sales illustrations should be used to explain how policies work, but not to compare one policy with another. IUL illustrations fail for both uses.
Illustrations that assume a constant credited interest rate do not present a realistic picture of what will actually happen when the credited interest rate fluctuates from one year to the next, as it surely will. A premium that appears to be adequate based on a deterministic illustration might be severely inadequate based on a stochastic illustration.
Deterministic illustrations do not show how IUL policies work, but Actuarial Guideline YY blesses them. Its focus is on specifying the deterministic assumptions that must be used. If state insurance regulators were traffic engineers, they would study the best place to have accidents, instead of how to prevent them.
Actuaries know all of this. At a recent actuarial conference, Day 1 had a session on the provisions of Actuarial Guideline YY. No criticism of deterministic assumptions there. Day 2 had a session about how to model indexed products in the pricing process, with this warning: “Not appropriate to do deterministic runs assuming historical average growth rate. Stochastic modeling generally appropriate.”
See Hypocrisy #6 in “Six Hypocrises of the Life Insurance Industry.”
Is indexed universal life a good deal?
Let’s move on to the second question: Is there any reason to believe that indexed universal life will provide better consumer value over the long run? Of course, there is no real track record to examine, so you have to look at the pricing factors. Distribution costs have been at least as high for IUL as for other types of cash value policies, and there are fewer opportunities to use blending to reduce commissions.
The hedging programs that underlie the indexed interest rate on IUL policies are not likely to be cheaper for insurers to offer than the simpler investments that back other types of policies.
Mortality experience, reinsurance, cost of capital, administrative costs and lapse rates do not obviously favor indexed universal life.
So what’s left? The pieces of paper called sales illustrations. Indexed universal life lets agents who are not licensed to sell securities produce sales illustrations that can assume high credited interest rates, driven by stock market returns.
Actuarial Guideline YY does nothing to help consumers judge the relative merits of IUL versus other types of cash value policies. IUL uses derivatives to create indexing strategies that have different payoff structures — usually a floor and a cap — than occur with other types of policies. Any money’s-worth assessment has to estimate the economic value of the indexing strategies, combined with an evaluation of the various policy charges. What is the interest rate that is economically equivalent to the indexing strategy, and how do the policy charges in the IUL policy compare with the charges in other types of policies?
You should also go beyond the overall valuation to look at the probability distribution of the outcomes. There is certainly nothing wrong with principal-protected investment strategies in theory. An informed consumer might prefer that payoff structure to one with a higher risk of loss. But you can’t make that decision with the information that Actuarial Guideline YY requires.
How to compare IUL policies
This brings us to the third question: How should you compare different IUL policies?
We are still at the beginning of the learning curve for how to perform due diligence on IUL policies. The best article that I have seen so far is Zhixin Wu, Lei Liang, Huong Dao and Linh Nguyen’s “Fixed-Index Annuity Return and Risk Analysis as Long-Term Investment,” published in the March 2014 issue of the Journal of Financial Service Professionals. However, this is about indexed annuities, and indexed universal life is even more complicated.
Actuarial Guideline YY tries to create a level playing field across IUL products by setting constraints on the credited interest rates that can be illustrated. It starts with a hypothetical Benchmark Index Account, which uses a one-year, point-to-point S&P 500 crediting method with a 0% floor, 100% participation rate and annual cap. The annual cap is the current cap on a similar account within the policy, or the cap that would be the current cap if the insurer offered a Benchmark Index Account, as determined by the certifying actuary.
Using these parameters, the insurer calculates the geometric average annual crediting rate for all 25-year periods, starting with the first trading day in the calendar year that is 64 years before the current calendar year (i.e., 1/2/1951 for 2015 illustrations). The arithmetic mean of these crediting rates is the maximum credited rate that can be illustrated for a Benchmark Index Account.
For index accounts using other indexes and/or crediting methods, the maximum illustrated credited rate will be determined by the certifying actuary, but it cannot exceed the maximum rate for the Benchmark Index Account.
These maximum rates may be further constrained by the pricing assumptions that underlie the illustrations. If the insurer uses a hedging program, the insurer’s assumed earned interest rate cannot exceed 145% of the net investment earnings rate (gross earnings less investment expenses and default costs) of the general account assets that support the policy.
In addition to the projected policy values using an assumed crediting rate, illustrations must show the maximum and minimum 25-year average annual credited interest rates for the Benchmark Index Account and contain “a table showing actual historical index changes and the corresponding hypothetical interest rates using current index parameters for the most recent 20-year period.” In other words, you can apply the current cap to historical periods when the hedging costs — and therefore the supportable caps — might have been very different.
These complicated rules will have a few benefits. The maximum allowable interest rates will be less than what some agents have been using. Some policy designs and index accounts will disappear if they have an illustration disadvantage.
Actuarial Guideline YY is a disappointing exercise that lets insurance regulators and life insurance marketers claim to be helping consumers without having to change their business practices in a meaningful way.
If you want to have access to an indexing strategy within a life insurance policy, wait for more companies to add that option to their variable universal life policies. That will give you the flexibility to move out of the index account without having to get a new policy.
On June 4, a committee of the National Association of Insurance Commissioners adopted Actuarial Guideline YY as Actuarial Guideline 49 (AG 49).