#197 | PacLife Lowers Caps and Increases Illustrated Rates

I admit – this title is somewhat misleading. Yes, Pacific Life dropped caps across all of its Indexed UL products, but it only raised the illustrated rate for one particular account option in an indexed crediting account of its new Pacific Select VUL 2 product. Technically, these two actions are completely disconnected. The account option in the VUL wasn’t even a capped option and therefore didn’t get nicked in the decrease. But both of these actions show how challenging it is for life insurers to maintain caps and the many, many creative ways that they have for dealing with that problem.

Pacific Life’s decision to decrease caps might seem baffling if for no other reason than the fact that it’s so…small. Every cap reduction is read by the field as a black mark on a life insurer. Carriers avoid cap reductions like the plague, sometimes running six-figure hedge losses for months trying to buy time before they have to do the inevitable. Why then would Pacific Life bother to take the heat of reducing caps by just 0.25%, which equates to somewhere in the neighborhood of 0.1% in hedge costs. Seems like a bit of overkill, doesn’t it? But that’s not even the most bizarre part. No, the most bizarre part is that PacLife is making this decision nearly 60 days in advance of the new rates coming into play, which is two full hedging cycles (1/15 and 2/15) away. Option prices could easily change between now and then by more than the 0.1% that PacLife is theoretically saving by lowering the caps. Why wouldn’t PacLife just hold its breath until then? Why take the heat of doing a very minor cap change in the interim? It seems like a pretty strange decision, especially in light of the lead sentence in the announcement saying that PacLife made this decision after “careful and thorough analysis.”

When I first saw this announcement, one explanation popped into my head – PacLife is too big to wait. I’ve made the case in several other articles on this site that cap changes are driven as much by scale as they are actual hedge pricing. Companies with smaller blocks of IUL or lots of different renewal rates, like Global Atlantic, can afford to be in the red on their hedges for a long time before the sheer dollar amount of the losses becomes so overwhelming that rates have to drop. Companies with bigger blocks of IUL or consistent rates across all in-force products don’t have that luxury because being off by 0.1% in hedge expenses equates to hundreds of thousands of dollars (or even millions) in losses at every ratesetting cycle. After being the top seller of Indexed UL since 2009, PacLife certainly falls into that category. It’s hard to pin exactly how much of PacLife’s block is tied to Indexed UL, but you can safely assume that it’s over $15 billion in reserves. That equates to $1.25M in for every 0.1% in hedge costs per month. That’s not nothing, but it’s not exactly deadly, either. And that’s why I don’t think this is the real reason PacLife dropped rates.

The alternative explanation is a bit quirky and, I’ll admit, more than a little bit anecdotal and speculative. I’ve been hearing folks at other carriers for a while now say that people from PacLife have made passing comments about how hard it is for them to pass illustration actuary testing on their Indexed UL policies. For a quick refresher, illustration actuary testing is the certification stating that a policy’s illustrated performance can be supported by the policy charges and investment earnings from the policy. Passing illustration actuary testing, in theory, should not be a problem. Life insurers price for a profit, which virtually guarantees that they will pass illustration actuary testing – that is, unless their profitability relies on lapses or improvements in interest rates, expenses or mortality, all of which are disallowed for illustration actuary testing. The driving factor for passing illustration actuary testing in Indexed UL is the illustrated performance at the maximum illustrated rate, which has to be supported by the net investment yield of the company multiplied by 145%, which is the notorious long-term option profit assumption.

Let’s just assume, for a second, that PacLife was actually bumping up against illustration actuary testing problems rather than hedge cost problems. What would they do? Well, they’d lower their illustrated caps by just enough to squeeze by illustration actuary testing and they’d do it regardless of hedge costs because hedge costs are not the problem. But the tell-tale sign would be that they wouldn’t change any other rates in the product. Why not? Because those rates don’t matter for illustration actuary testing. So, for example, the cap on the international accounts wouldn’t change because the lookback rate for that account (5.64%) is less than the benchmark indexed account lookback rate with the new caps (5.67%). The same logic applies for accounts with participation rates and spreads. They’d also pummel their fixed account rates, which is exactly what PacLife did. It seems that PacLife is following this logic whether the true cause is illustration actuary testing or not.

The timing of the announcement is also an issue. Actuarial certifications are done annually. PacLife obviously passed for 2019 with the current rates. But 2020 is a whole new year with a whole new certification. Therefore, if illustration actuary testing was the root of the problem, they’d make the announcement at the beginning of the year – which, again, is exactly what they did. But they’d also give people plenty of time to hit the deadline because the certification occurs at the end of the year, not the beginning. So there’s no rush. Hence, the longer-than-normal transition period.

Why should you care about an actuarial issue? For two reasons. First, if my hunch is correct, then PacLife bumping up against actuarial certification issues tells you just how close to the edge they’re skating on their caps – and it’s not like PacLife has abnormally high cap. That spells trouble for other insurers, regardless of whether or not actuarial certifications were the core issue. But the second has to do with the strange move PacLife made in December to increase the illustrated rate of the spread account in its PacLife Select VUL 2 product from 5.64% to 7.55% with no change to the spread. In the world of AG49, how is that possible? The 5.64% is the maximum illustrated rate based on the capped account. No other account should be able to exceed that illustrated rate. And yet, that’s exactly what the spread account in Select VUL 2 is doing and by a whopping 1.9% rate. What is going on? Well, what’s going on is that Variable UL doesn’t have to abide by AG49. Yes, that’s correct, indexed subaccounts in a variable product do not have to follow AG49. Hence, PacLife preserved the hypothetical historical look-back methodology enshrined in AG49 to calculate the rate but removed the limitation imposed by AG49.

But here’s the real kicker, the thing that ties these two announcements together – indexed accounts in Variable UL don’t have to pass illustration actuary testing in the same way that a traditional UL or Indexed UL product does. VUL allows the full measure of gamesmanship, aggressive ratesetting and illustration warfare that was prevalent pre-AG49. The traditional school of thought is that the IUL illustration war wouldn’t infect indexed subaccounts in VUL because VUL is a securities product and only registered reps can sell it. But there’s a flaw in this thinking and it’s not hard to see – just look at what happened with VUL in the 1990s. Registered reps ain’t perfect either. Granted, the world today is much more stringent than it was back then, but an illustration war in VUL is still possible. And if what PacLife and PennMutual are doing with their indexed subaccounts is any indication, carriers are already starting to move their chips over to that game. Make no mistake about it, the illustration war in VUL could be every bit as nasty as the one in IUL, with the sole exception of reduced premium financing activity due to margin requirements for securities products.

PacLife’s seemingly innocuous announcement is, in fact, packed with insight. Now it’s just a question of whether other life insurers follow suit.

After this article was published, PennMutual made a similar move to lower caps by 0.5% (generally) and gave a long timeline until 5/1. Again, my hunch is that PennMutual is being driven by core economics but also potentially by illustration actuary testing, given the long timelines.