#25 | The Neutral Money Myth in Universal Life

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For an industry with something like $5 trillion in assets, we sure do fly under the radar. But both Forbes and the Wall Street Journal recently picked up the same story – underperforming life insurance products. Great. Just what we wanted. Fortunately, the spin for both was pretty neutral. They pointed out that life insurance products are underperforming largely because interest rates have fallen for the last 30 years and life insurers rightly passed through the lower returns to policyholders. Clients who bought a “cheap” product when illustrated at 12% found out that they were underfunding a rather expensive product when rates fell to 4%.

Everyone knows that simple sells. I totally agree with that as long as simplicity doesn’t lead to compression that leads to misunderstanding. Unfortunately, that’s pretty common with life insurance and UL in particular. UL marketing always conflates the interaction between the charges and the crediting rate. This creates the false narrative that the product has simple and unified mechanics that generate a fixed premium. In reality, the product is the policy charges and the crediting rate serves to offset the charges. The two parts generally move independently. The policy has a very expensive premium based on the current policy charges and guaranteed interest credits and whatever the policy may credit in excess of the guarantee serves to offset the policy charges. All a 12% illustrated rate is telling you is that the crediting rate is paying some of your premiums for you. But marketing practices prescribe that illustrations assume that the crediting rate is always in excess of the guarantee and that the policy should be funded under that assumption. The moment that doesn’t happen, guess what? The policy charges are still there and now the policyholder has to cover them. The money has to come from either premium payments or the crediting rate. Ignoring this reality and underfunding always results in either a premature lapse or large and unplanned catch up premiums.

But I think there’s a more fundamental misunderstanding at work. Even if someone understands the moving parts in Universal Life, they usually miss the interaction between the parts. People assume that a reduction in the crediting rate means that money expected to be earned is now not earned. The implication is that a small change in the crediting rate results in a small change in the product. In reality, a reduction in the crediting rate doesn’t turn a positive into a zero, it turns a positive into a negative. Dollars in UL exist only as cash value or insurance coverage. Cash value earns credits and insurance coverage is assessed policy charges. A dollar increase in cash value means that the policy now earns new credits and is not deducted policy charges for that dollar. A dollar decrease in cash value means lost earnings and new policy charges. There is no such thing as neutral money in Universal Life. It either works for you or works against you. A reduction in the crediting rate simultaneously lowers earnings and increases policy charge deductions. There are only plusses and minuses – no zeroes. There are a couple of major implications for this idea.

First, policy charges are quite a bit trickier than crediting rates. It’s easy to calculate the earned credit because it’s a fixed rate multiplied by the account value. Policy charges, particularly Cost of Insurance charges, change on an annual basis and generally increase over time. In the early years, money in life insurance can be much closer to neutral than in the later years. For example, policy charges in year 10 might be 0.05% per $1 of coverage but jump to 10% by year 40. In other words, a missed credit costs 0.05% at year 10 and 10% at year 40. The losses compound over time, so lower credits reverberate and increase in volume as the losses go unfixed. This is why underfunded policies look pretty healthy until they totally cave in. Once policy charges pick up, just a little bit of underfunding can cause a lapse in short order. As a result, policy charges should be a key part of choosing a life policy. Policies with high tail charges are more prone to heavily penalizing underfunding than policies with lower tail policy charges and have higher catch up costs.

Second, each funding pattern interacts differently with the credits and policy charges. Level premiums are more driven by policy charges than credits because the average account value is lower over the life of the product, so less money is available to earn the credits. For example, a level pay policy might have an average account value of $189k but the same policy funded with three premiums would have an average account value of $260k. The level pay premium increases by 25% if the crediting rate drops by 2% but the 3 pay jumps by 55%. Neither situation is particularly attractive, but the penalty is obviously much greater for the short pay. The nasty second order effect to this math is that products with inflated crediting rates look especially good for 1035 exchanges because most of the money comes in the first year. But if rates drop, these designs will be the most heavily penalized. IUL products have been looking especially attractive because they can illustrate high rates without showing the higher downside risk. Products with inflated rates also tend to be the ones with the highest tail policy charges.

Third, every non-guaranteed sale should be tested across a variety of interest rate scenarios. Illustrating only one scenario not only creates misconceptions about the reliability of the product but also the penalties for underperformance. Clients should at least see a best case (current rate) and a worst case (guaranteed rate). As I’ll discuss in an upcoming post, funding at the guaranteed rate premium actually delivers a host of benefits that allow the client to hedge downside risk and participate in more upside. But the idea is pertinent regardless of the funding pattern – client should be well educated as to the range of potential results and the fact that the actual results will always be different than the illustration.

When I talk about these ideas, one common objection is that interest rates are going up and illustrating based on the current crediting rate is conservative. They may very well be right, but that’s not the point. Life insurance should be conservatively sold and designed to mitigate downside risk, not bet on upside. If the producer was really such a good macroeconomist, he’d be a hedge fund manager. The reality is that no one has an idea what interest rates will do. Trade swaps if you want to make bets on rates. Don’t use a life insurance policy.

In short, non-guaranteed UL products can deliver a host of attractive benefits but need to be managed properly. Selling with a focus on the crediting rate is only asking for trouble. Instead, analyze the policy charges, consider a variety of funding patterns, do sensitivity testing for every sale and make sure the product is properly administered. You’ll pretty much guarantee that your client won’t get quoted in the next Forbes or Wall Street Journal article.

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