#116 | The Death Benefit IUL Dilemma – Part 1
Traditionally, life insurance professionals tend to talk about product risk in terms of the variability of the crediting rate, with UL on one end of the spectrum, VUL on the other and IUL in the middle. But that’s only part of the story. In products funded at the minimum premium to maintain coverage for life, the interaction of policy charges and even minor deviations in crediting performance create enormous long-term impacts. A single basis point difference in crediting rate can lead over-endowment or policy lapse. Now that carriers have realized that they can put the illustrated magic of indexing to work in IUL products designed to illustrate extremely low premiums, sometimes 40% lower than the same carrier’s Guaranteed UL offering, we have to grapple with how to responsibly design, implement and manage IUL products that will deliver the death benefit at the cost that clients are expecting. Otherwise, we’ll have another mess on our hands in the vein of vanishing premium Whole Life, 1980s UL and 1990s VUL.
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When we talk about performance risk in Universal Life, we tend to use the level and variability of the policy crediting rate as the best (and sometimes only) measure of risk. Life insurers are prone to put out marketing materials showing traditional Universal Life with a fixed crediting rate on one end of the risk spectrum and Variable UL on the other end, with Indexed UL planted smack in the middle. The story is simple, intuitive and, ultimately, woefully incomplete. Looking at the crediting rate in isolation as the only meaningful measure of risk treats life insurance as if it were a mutual fund, where the charges are always deducted as a percentage of the assets and, consequently, the performance of the fund is independent of the size of the investment. Needless to say, that’s not how life insurance works. Our products have a complex array of policy charges that can be pegged to the premium paid, the initial face amount, the net amount at risk and the account value, just to name a few. But credits are only earned by the account value. Focusing only on the riskiness of the crediting rate misses the broader point that performance in a life insurance policy is the result of the interaction of policy charges and the crediting rate, not a single factor in isolation.
It also misses the fact that risk is not volatility. Volatility is a measure of the variability of returns. Risk is exposure to loss. In the world of investments, the two words are often used interchangeably because variable returns mean exposure to loss. But what’s the definition of loss in life insurance? Loss, for a life insurance sale, depends on the metric of success for the product itself. In other words, in what situation does the life insurance policy cease doing what it was supposed to do? In accumulation sales, the goal of the policy itself is to deliver tax efficient accumulation at a stable cost as a percentage of the assets over time. If the policy has 1% drag from charges over 20 years at a 7% average crediting rate but the drag jumps to 2% when the policy performance declines, then the policy has embedded risk from its complex charge structure that exacerbates crediting volatility. The ability for a certain accumulation product to maintain its integrity across a broad spectrum of crediting outcomes is the key measure of product risk as it specifically relates to the goal of tax efficiency at a stable cost.
For death benefit sales, the goal is to maintain death benefit coverage. Success, for a death benefit sale, is binary – did the policy lapse or not? Gauging product risk in a death benefit sale is quite a bit trickier than in an accumulation sale. Accumulation sales are almost always overfunded to the maximum non-MEC limit and, once that happens, different products generally tend to exhibit very similar behavior across a spectrum of crediting rates* because performance is dominated by what they share in common – very large account values relative to death benefit. Deviations in policy charges matter little when account values are dominant. But in a death benefit sale, the goal is to have as low of a premium as possible to keep the coverage in force, which means the account value is low relative to the death benefit. If the composition of performance in any given year in an overfunded accumulation sale is 80% crediting rate and 20% policy charges, then the composition of product performance in any given year for a death benefit sale is 20% crediting rate and 80% policy charges. This is a really important distinction. Crediting rates are simple, linear and easy to explain. Policy charges are complex, non-linear and counterintuitive. No surprise, then, that products do crazy things when policy charges exert their influence on performance.
Take, for example, what happens to a very simple Universal Life policy when very slight alterations are made to the baseline design. Let’s assume that an $11,500 annual premium generates $2M of cash value at age 120 on a policy with a $1M death benefit. Most people would consider this to be a conservative premium estimation given that the policy over-endows at age 121. But what happens if the client pays $1,000 less than they were supposed to in year 11? The policy lapses at age 115. What about if just a single basis point is shaved off of the crediting rate? Policy lapses at age 110. By intuitive math, neither of these outcomes makes sense. But life insurance policy charges are not intuitive. In our minds, a butterfly flapping its wings in Australia can’t possibly create a hurricane in the Gulf of Mexico. But, in life insurance funded for death benefit protection, that’s exactly what happens. Policy charges create unintentional leverage on the results. Tiny changes accumulate, exacerbate and result in major long-term deviations from the plan.
In short, risk in life insurance isn’t just about crediting rate volatility. Accumulation products that are saturated with cash value generally hold their integrity as crediting rate volatility flows through the structure. Unless the policy has an extra charge and bonus mechanism that modifies the risk profile of the product at the crediting level, as PacLife PDX and John Hancock Accumulation IUL 2018 do, the crediting rate tends to move in lock-step with policy performance. But death benefit oriented products that are thin-funded have built-in leverage to the crediting rate from policy charges. A 1 basis point decrease in the crediting rate for an overfunded accumulation product usually means a 1 basis point decrease in the cash value IRR. The product still succeeds. A 1 basis point decrease in the crediting rate for a thin-funded death benefit product results in a prematurely lapsed policy. The product fails.
It’s no surprise, then, that advisors have traditionally gravitated towards using more volatile crediting methodologies in accumulation products rather than death benefit products. Even if producers can’t quite show the math for why crediting uncertainty is problematic for a thin-funded policies, they know it from experience. Witness UL policies sold in the 1980s and VUL policies sold in the 1990s. And yet, as Indexed UL has become the dominant accumulation product chassis, it’s almost inevitable that producers who believe the IUL story would eventually feel comfortable using indexed crediting in a death benefit application. Early IUL products geared towards death benefit solves gathered dust on the shelf because Guaranteed UL products were still cheap and plentiful. But as life insurers have increasingly exited Guaranteed UL and even traditional UL products geared for death benefit protection, they’ve also realized that Indexed UL offers a way to deliver low illustrated premiums without giving away the house on interest rate risk (as in Guaranteed UL) or lapse-supported mortality charges (as in traditional UL). It’s entirely possible to have a very profitable IUL that illustrates premiums 20-40% lower than a Guaranteed UL product sold by the same company. Obviously, the risk hasn’t disappeared. It’s just been shifted from the carrier’s balance sheet to the client’s – a distinction missed by virtually all clients and most advisors, especially the ones who believe that Indexed UL performance will always save the day.
Indexed UL for accumulation has its own issues, especially when leveraged through premium financing, illustrated income with indexed loans, some tax planning strategies and internal policy mechanisms like charge-funded multipliers and bonuses, but fundamentally the integrity of the product isn’t contingent on its performance. Indexed UL for death benefit is different. Uncertainty about both the level and variability of crediting performance has profound and potentially even unmanageable impacts on the ability for the product to do what it was sold to do. Over the next few posts, we’ll take a look at the unique challenges of using Indexed UL for death benefit protection, how certain policy designs exacerbate or reduce product risk and what it takes to successfully design, implement and service an IUL sold for death benefit protection.