#144 | AG49 and Indexed Loans

During the original AG49 process, one of the most hotly contested topics was that of illustrated arbitrage with policy loans. In simple terms, illustrated arbitrage occurs when the earned interest on the loan exceeds the loan interest charge. It’s not as silly as it sounds. Policy loans are assets for the life insurer. Those assets throw off a yield, which is the loan interest charge. That yield is used to purchase equity call options for indexed exposure. Our industry has decided that it is appropriate to show that buying equity call options produces returns that are up to 50% higher than the yield used to purchase the options. Voila – indexed loan arbitrage. If you believe that Indexed UL products should illustrate better than UL products, you kind of have to believe that indexed loan arbitrage makes sense, despite some of its odd effects on the illustration. But what other financial instrument allows you to borrow against it with the presumption of sustainable arbitrage forever? Ah, that’s right – Whole Life.

That’s what made this topic so contentious for AG49. Many Whole Life policies that offer non-recognition policy loans do exactly the same math, the only difference being that the earned rate is tied to participating dividends rather than indexed interest credits. It’s kind of hard for a Whole Life company to fight against the idea of illustrated arbitrage on Indexed UL policy loans without endangering its own products. Hence, the final compromise for AG49 in Section 6, which states that “the illustrated rate credited to the loan balance shall not exceed the illustrated loan charge by more than 100 basis points.” Seems pretty straightforward, right?

But it’s not. AG49 primarily addresses what it calls the “credited rate,” which is referenced 19 times in the guideline. But AG49 only uses the words “illustrated rate” twice and only in the context of policy loans. What’s the difference between the two? Credited rate is a well-defined concept used in actuarial testing. Illustrated rate, on the other hand, doesn’t have a clear definition in the guideline. This has left a gaping hole in the regulation and insurers to their own devices about how to interpret it.

The most conservative interpretation is that regulators mean that the illustrated rate is the credited rate plus any other additions to the rate for illustrated purposes. Under this interpretation, the credited rate applied to the policy loan balance, inclusive of any fixed bonus or Index Return Multiplier (IRM) interest, cannot exceed 1% more than the illustrated policy loan charge. In other words, if the policy loan charge is 5% then the total credits illustrated to the policy loan are 6%, regardless of whether that 6% includes a multiplier or bonus interested. Unfortunately, only a couple of companies take this approach, especially if they have an IRM. PennMutual is a notable exception. They actually have a separate account with a different cap that produces a total credited rate, including their Index Return Multiplier (IRM) and fixed bonus, that’s exactly 1% higher than their loan charge. It adds some extra complexity

A slightly more aggressive interpretation is that “illustrated rate” only applies to the index-linked credits, so any fixed bonus can be added to the illustrated loan arbitrage. For example, John Hancock has both an IRM and a fixed bonus, but only the fixed bonus is added to the 1% arbitrage for illustration purposes. Most companies with only a fixed bonus, such as Columbus Life, add their fixed bonus to illustrated loan arbitrage but a few (Principal and AXA, notably) don’t. In the grand scheme of Indexed UL illustration warfare, adding a fixed bonus to illustrated loan arbitrage is a minor transgression. You can only go so far with a fixed bonus. The worst offender is Global Atlantic with their massive 1% bonus on Lifetime Builder Elite. But, as you’ll see, 1% is chump change in the world of IRMs.

But the most aggressive and, increasingly, the most common interpretation is that illustrated rate means only the illustrated crediting rate and does not encompass any additional interest from IRMs, fixed bonuses, mortality kickers, fairy dust, bitcoin futures or sports betting proceeds (now legal, probably not a future IUL “innovation.”) In other words, the only constraint is that the headline, AG49-compliant illustrated rate for the product be 1% higher than the illustrated loan charge. That’s it.

Taking this interpretation allows life insurers to de-fang the 1% restriction in AG49 for the purposes of illustrating policy loans. Take, for example, Product A with a 12% cap and Product B with a 10% cap and 15% multiplier. The price to hedge these two products is the same. Their illustrated rates are effectively identical, with Product A at 6.96% and Product B at 7.00% (6.09% x 1.15). Their real-world performance characteristics will also be virtually identical. And yet, Product B will illustrate significantly higher income than Product A simply because it the carrier interprets AG49 to allow the interest from the multiplier to be added to the 1% illustrated arbitrage restriction. In other words, a life insurer can dramatically increase its competitiveness on the illustration without spending a dollar. This is a deal that’s too good to pass up – which is exactly why companies are falling over themselves to take advantage of it.

And, of course, companies with massive, charge-funded multipliers have an even bigger advantage with this interpretation of AG49. In the example above, the life insurer can show an extra 0.9% of illustrated arbitrage just by lowering the cap and adding a multiplier. But if the life insurer has gone down the path of charging a fee in exchange for a huge IRM, the spread gets even bigger. Ballpark, I’d guess that PacLife PDX illustrates loan spreads in the range of 2-5%, depending on the funding pattern. Some of the new products hitting the market in February will be in the same range, if not higher.

The net result is that there could be at least 3 Indexed UL products that are identical in every way, including real-world performance, but illustrate different income solves based on the carrier’s interpretation of AG49. The differences between their illustrated income solves are purely and solely an issue of interpreting AG49. How is this good for the industry? It’s not. It’s terrible. And if you’re a life insurance agent, it puts you in a really weird spot. How are you supposed to know whether or not the illustrations you’re attempting to compare use the same AG49 interpretation? Most of the time, the illustration doesn’t specify how the life insurer shows credited loan interest because it’s purely an illustration technicality and not a part of the contract. Good luck. The only way to avoid the issue is to only sell products that are on the WYSIWYG list because they don’t have bonuses or multipliers, but that’s a pretty limited group.

My hope is that the NAIC will address this issue in their review of AG49, but I’m not sure how that will play out. It’s tricky. Eliminating IRM interest from the illustrated loan arbitrage is not so simple. There is no definition of an IRM in AG49 and it would have to be crafted, which would be a battle unto itself with plenty of collateral damage. And even if they could nail down the definition, why would regulators choose to eliminate only IRM interest and not fixed bonus interest? And if regulators choose to eliminate all bonus and IRM interest from illustrated arbitrage, wouldn’t that put IUL at a disadvantage relative to UL and Whole Life? But if regulators put a stamp on the aggressive interpretation, doesn’t that open the door to even more abuse and illustration warfare?

Solving this issue is a little microcosm of the challenges laying before the regulators in making changes to AG49, which we’ll tackle in upcoming articles once the process gets started. But suffice it to say that there is no easy answer. Until then, I strongly urge caution for any producer who is just benchmarking income from IUL products to make recommendations. You simply can’t do that these days and this issue of illustrating loans under AG49 is just one reason why.