#201 | An Exchange Epidemic

There’s a famous (but apocryphal) exchange between the famous bank robber Willie Sutton and a reporter. When asked why he robs banks, Willie replied with: “because that’s where the money is.” The same could be said for why people exchange whole life policies – because that’s where the money is. And make no mistake about it, there is a lot of money in mature Whole Life policies, somewhere north of a half a trillion dollars at the Big 4 mutual companies alone. There is no good statistic on what percentage of new sales in the insurance business aren’t really new at all but, rather, exchanges from in-force policies, but the usual figure tossed around is 35% and you can bet that a significant proportion of that exchange premium is coming from Whole Life.

The irony is that the fact that Whole Life policies are being exchanged in such large volumes is actually an indication of how well Whole Life works, not its shortcomings. Whole Life is designed to reliably and predictably build a stash of cash value that ultimately endows the contract – and that’s exactly what it actually does. Bemoan falling dividend interest rates all you want, but the fact is that Whole Life dividends have been extremely strong relative to corporate bond yields over the past 30 years and Whole Life performance has been stellar by any measure. Years ago I heard someone say that the entirety of human history can be summed up as follows: one man toils for food, another man bonks him on the head and takes it. If mutual companies are the Whole Life companies slowly, studiously and consistently building the cash values of these policies, then the producers and companies exchanging those policies are the ones wielding the cudgel.

Of course, things aren’t quite that simple. Sometimes exchanging a Whole Life policy can make a lot of sense, particularly if the client wants more death benefit now. Clients would have a 15 year old Whole Life policy with, say, $1M of cash value and $1.5M of death benefit but their net worth had grown to the point where they had a real estate tax liability. Exchanging the $1M of cash value into a Guaranteed UL policy with a $3M guaranteed death benefit was a no-brainer considering that the Whole Life policy probably wouldn’t hit $3M with Paid-Up Additions until something like age 95 or 100. It’s kind of hard to make the argument that the client should keep the Whole Life policy if the goal is to maximize death benefit, but that doesn’t mean there aren’t tradeoffs. Clients say they don’t care about cash value until they really wish they had the cash value. Clients say they don’t care about future flexibility until they need future flexibility. Clients say they don’t care about a carrier’s ratings until they realize that their Voya policy is now being serviced by Resolution Life, who has exactly zero interest in servicing the policy, and the company is now capitalized as thinly as the gasoline sheen on a New York pothole puddle. However, on the whole, I’d say that switching from a mature Whole Life policy to Guaranteed UL or Guaranteed VUL for a client who just wants more death benefit is often a legitimate and reasonable swap.

But that’s not what I’m seeing these days. Instead, I’m seeing an avalanche of 1035 exchanges out of Whole Life and into Indexed UL policies designed to deliver maximum death benefit at lowest possible cost. I’ve seen these exchange pitches on Whole Life policies with anywhere from $100,000 to over $60 million in cash values, but the pitch is always the same – you should switch to this newfangled Indexed UL product because you can get more death benefit and better cash values. What could go wrong?

There’s just one little problem that these agents would like to not discuss – the fact that exchanging a mature Whole Life policy to a new Indexed UL policy resets the clock on all of the acquisition costs of the policy. The current Whole Life policies have about $17.5 million in them. The agent, no surprise, would like to exchange those policies to new Indexed UL contracts that illustrate about 40% higher death benefit at the maximum AG49 illustrated rate and earn a $3M+ commission. But over the first 10 years of the policy, the new and entirely incremental additional charges related to paying commissions, insurer overhead, profits and premium loads are a whopping $8.25 million, nearly half of the exchanged amount. To be clear – these are policy charges the Whole Life contracts would not have assessed because the Whole Life policies were already mature. How in the world is this a suitable exchange? How is it that a producer can make a straight-faced recommendation to exchange to a new policy that will eat up 50% of the exchanged value in incremental charges?

Simple. Indexed UL illustrates higher rates than Whole Life and higher illustrated rates cover up the new policy charges. The client, in other words, is willing to take a certain loss in the form of increased policy charges for the speculative prospect of earning higher rates in the Indexed UL product. Despite the fact that the agent proposing the exchange was a well-respected, long-tenured producer affiliated with a top-tier group, that was essentially the crux of his pitch – for which he did not even bother to include actual illustrations because they were “too complicated.”

As I’ve written about numerous times, this is a completely false and misleading argument. The AG49 maximum illustrated rate is calibrated to reflect returns that will cause the policy to lapse 50% of the time under the aggressive assumptions that current caps never change and historical equity returns are indicative of future equity returns. Telling a client that they can swap out of what is effectively a 100% certainty product, Whole Life, into an Indexed UL illustrated at a 50/50 success rate is ludicrous and not even remotely comparable. And yet, that’s exactly what I see every single time with these Whole Life to Indexed UL exchanges. It’s as if someone was being told to replace a heart valve that worked reasonably well all the time with a new heart valve that could work extremely well but would also fail about 50% of the time in the best-case scenario. Which one would you choose? Thought so.

The reality is that this exchange epidemic from Whole Life to Indexed UL is predicated on a maximum illustrated rate methodology codified in AG49 that was never designed, or intended, to be a performance projection. In other words, it was never intended to help people make the choice between a Whole Life policy and an Indexed UL policy. The two illustration methodologies are not comparable and, therefore, neither are the results. But this is an inconvenient truth. There’s far too much money being made in exchanging cash-rich, well-performing Whole Life policies into shiny new Indexed UL policies. But please, let’s not kid ourselves. This is not good business. If illustrated at the maximum AG49 rate, it’s not much different than wielding a cudgel to bonk your neighbor on his head and steal what he’s bringing home to his family. If you’re going to make the argument for an exchange from Whole Life to Indexed UL, show the IUL product at a reasonable rate of 4-4.5%, to equate the probabilities of success and make a fair comparison. When you do that, you’ll see the true colors come through.

One final story. I was recently contacted by an agent friend of mine with a very wealthy client who had recently been pitched an exchange from Whole Life to Indexed UL. It was the standard pitch where the Indexed UL is illustrated at the maximum rate (or close to it) to generate a higher death benefit, but the client was not a standard client. He ran institutional fixed income asset management for a major, multi-billion dollar firm. He told the agent that he “fully understood the risks” and wanted to make the exchange. I had a hunch that this client hadn’t actually been told the risks, so I sent the agent a list of questions to ask to make sure the client was fully aware of, for example, the fact that the agent had put the client in a proprietary index, was illustrating a charge-funded multiplier, was basing the illustrated rate on the historical backtesting of an index with a heavy fixed income component and that the illustrated rate implied a 35% option profit every year forever. The next day, the client sent a note that said he was no longer doing the exchange. What’s the difference between this client and the clients who make the exchange? This one had the full picture, both the illustrated benefits and the risks, and had a background in finance – and he chose to stick with his Whole Life policy. That should say something.