Life Insurance Illustration Games: Understanding IUL Policy Challenges

Quick Article Guide

Here’s what we'll cover in this post:

• Illustration Study Background
• Increased Complexity in 2024
• A Brief History of Indexed Universal Life
• The Introduction of AG 49
• The Implementation of AG 49-A
• Addressing Propriety Index Manipulation
• The Introduction of AG 49-B
• Issues with AG 49-B
• Conclusion

Illustration Study Background

In 1992 the Society of Actuaries published an examination of illustrations and illustration practices associated with the purchase of life insurance. Its conclusion “… when illustrations are used to show the client how the policy works; (it is) a valid purpose of the policy illustrations. Illustrations where typically used, however, to portray the numbers based on certain fixed assumptions – and/or are likely to used to compare one policy to another- are an improper use of the policy illustration.”

In other words, when the Society of Actuaries examined how life insurance illustrations were used, they detemined that it was appropriate to use illustrations to explain how a cash building life insurance policy works. However, using these illustrations to show numbers based on fixed assumptions or to compare different policies was misleading to consumers.

Furthermore, the study went on to say, “How credible are any non-guaranteed numbers projected twenty years in the future, even if constructed with integrity? How does the consumer evaluate the credibility of two illustrations if they are from different companies? Or even if they are from the same company if different products with different guarantees are being considered? Most illustrations problems arise because the illustrations create the illusion that the insurance company knows what will happen in the future an that this knowledge has been used to create the illustration.”

Increased Complexity in 2024

If using illustrations to compare policies was a problem in 1992, it is ten times worse in 2024. Now, we have Indexed Universal Life (IUL), a product that wasn't available in 1992. IUL is the most complex, least understood, and multifaceted product ever created by the insurance industry. Traditional life insurance plans like Term Life, Whole Life, Universal Life, Guaranteed Universal Life, and Variable Life are all relatively straightforward in comparison.

A Brief History of Indexed Universal Life

When Indexed Universal Life (IUL) first became popular around 2010, there was no standard method for illustrating the product across carriers. A particularly concerning sales tactic was to present a very attractive flow of tax-free income through policy loans, where the indexed loan would charge a variable or fixed loan rate.

The collateralized portion of the cash value for the loan would still earn the indexed interest rate, thereby creating leverage. The difference between the loan rate being charged and the interest rate earned could be as high as 5% at some carriers! When marketed to consumers, IUL seemed like a no-brainer, but attractive illustrations often masked the complexities and potential downsides of the product.

The Introduction of AG 49

To bring some consistency and uniformity to illustrations and curb the abusive illustrations of loans, Actuarial Guideline 49 (AG 49) was implemented in September 2015. This guideline set the maximum illustrated crediting rate of an index to be the lower of the geometric average of the last 25 years using current caps and floors, or 145% of the portfolio rate supporting the product. Additionally, the maximum spread between the loan rate and the crediting rate was capped at 1%.

Problem solved, right? Not so fast. Carriers adapted by offering multipliers and buy-up caps, allowing IULs to promise more upside potential for clients willing to accept less downside protection. By paying a fee, the interest credited to the index could be multiplied. For example, a 6% index credit multiplied by 180% becomes 10.8%. This made the illustrations look great year after year.

However, in the real world, when the index is negative and the floor is 0%, the client gets 0% credited to the account, but the fee is still charged, leading to a decrease in account value. The leveraged loan also looks appealing. A loan rate of 5% complies with the 1% maximum difference between the index rate (6%) and the loan rate, but the illustration shows a 10.8% crediting rate with the multiplier.

The Implementation of AG 49-A

The National Association of Insurance Commissioners (NAIC) responded by revising AG 49 to AG 49-A, which became effective on December 14, 2020. This update prohibited companies from illustrating multiplier effects and reduced loan leverage to 0.5%. Additionally, there was a change in the use of the Benchmark Index Account (BIA). The BIA was introduced in the original AG 49 to standardize the lookback calculations that determine the maximum illustration rate.

When a carrier offered an index strategy that uses the S&P 500 annual point-to-point with a 0% floor and 100% participation rate, the cap rate used in the 25-year look-back calculation had to be the current caps offered by the carrier.

A different BIA could be used for each index strategy offered. Under AG 49-A, only one BIA could be used for all index strategies, and the cap for the BIA could not exceed the cap that could be purchased using the company’s annual net investment earned rate.

Addressing Propriety Index Manipulation

Despite these regulations, insurance companies continued to manipulate illustrations by introducing proprietary indices. They create the proprietary index by using an asset allocation that looks excellent when looking back 20 years. The proprietary index can illustrate up to the allowed BIA rate, but the option cost is lower for the proprietary index.

With the cost savings from the lower option cost, the carrier then gives a fixed interest bonus to illustrate returns above the BIA rate without the bonus. It also can be added to the illustrated loan arbitrage to show higher income flows. The irony is that those clients who use the proprietary index strategy may be disappointed.

If the return on the option budget for both the proprietary index and the S&P index are the same, say 30%, the overall return will be lower for the proprietary index that budgets 3% for the proprietary index and 4% for the S&P 500 index. There is no reason to believe that an artificially engineered index will have a greater return.

The Introduction of AG 49-B

In May 2023, AG 49-B was introduced in response to the proliferation of optimized indices. The revision establishes a ratio between the illustrated rate on the Benchmark Indexed Account and the cost to hedge the account for all indexed accounts. If the Benchmark Indexed Account illustrates 7.5% and the hedge budget is 5% to illustrate that rate, the ratio is 7.5%/5% - 1 or 50%. This ratio is multiplied by the hedge budget of any proprietary index to establish what can be illustrated.

For example, a proprietary engineered index would have a 10% rate with a 5% budget based on the historical lookback. If the ratio established was 50%, as in the example above, it would only be allowed to illustrate a 7.5% rate. If the budget was 3.5% to illustrate a 7.5% historical rate, the illustrated rate would be one plus the 50% ratio established by the Benchmark times the 3.5% budget, or 1.5X 3.5% = 5.25%. The 1.5% budget savings could be bonused to show a total illustrated rate of 5.25% + 1.5% = 6.75%.

The bottom line is that all indexed accounts with identical hedge budgets will illustrate identical maximum rates. Accounts with higher hedge budgets will illustrate the same as the Benchmark S&P 500. Accounts with lower hedge budgets than the Benchmark will illustrate lower rates, including those with bonuses.

Issues with AG 49-B

AG 49-B has some problems. Insurers can still apply fixed-interest bonuses to illustrate loan arbitrage. It does not require companies to disclose their hedge budgets or that there be a standardized way of calculating the hedge budget across carriers.

The illustration wars continue, however. There are three tactics that some companies have used to boost their illustrations. Interest rates are at very high rates compared to five or ten years ago. Some companies have created a portfolio of new premium money and use the higher interest rates from the portfolio to create a larger options budget to boost cap and participation rates.

Older policyholders do not share in the higher interests to boost their rates. Of course, the new premium portfolio will eventually converge to the same yields, but the illustrations will look good in the meantime.

The second way to boost illustrations is through illustrated loan arbitrage. As mentioned previously, AG 49-B does not prevent companies from adding a bonus to illustrate loan arbitrage. The illustrated income generated from a policy can be boosted by 35% by using the bonus account, even though the returns are supposed to be equal.

The third way a carrier can boost an illustration is by using a hypothetical Benchmark Index. Some carriers do not offer a Benchmark Index Account. Instead, they run the maximum illustrated rate using a hypothetical Benchmark Index Account that is not offered for policyholder allocation. The carrier can then engineer a Benchmark Account Index to boost the ratio used for the other account illustrations and thereby boost the illustration values of the allocations that are offered.

All these iterations of carriers boost the illustration values, the response with new regulations, and then carriers find a new way to boost values make it clear that comparing illustrations is not the best way to evaluate a life insurance policy. There is a better way. To learn more, see our article, 'Life Insurance Policy Evaluation and Comparison Methods.'

Conclusion

AG 49-B was expected to have a detrimental effect on the sale of IUL policies. However, its primary objective is to protect consumers from being misled by overly optimistic illustrations.

It's crucial for consumers to emphasize the fundamental advantages of IUL, such as downside protection coupled with potential gains linked to market indices, rather than basing decisions on possibly unrealistic forecasts. Understanding these guidelines is pivotal in making informed choices that secure families, ensure financial stability, and preserve capital.

An independent agent can offer unbiased advice, compare policies from different carriers, and ensure that consumers fully comprehend the implications of these regulatory changes. This expertise helps consumers navigate the nuances of IUL policies and make choices that align with their long-term financial goals and protection needs.

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